Canadian Underwriter
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Demutualizing The Economical


January 1, 2011   by David Gambrill, Editor


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The Economical Mutual Insurance Company is publicly exploring a path of demutualization, potentially leading to a new ownership of the mutual insurer, be it through an initial public offering (IPO) or a sale involving another, “strategically aligned” company.

The company’s board of directors announced its recommendation in a press release dated Dec. 14, 2010. A final recommendation on demutualization and a schedule for completion is to be presented to mutual policyholders at the company’s next annual general meeting, scheduled for May 26, 2011. Mutual policyholders will subsequently be asked to decide whether or not to demutualize.

The board’s recommendation to its mutual policyholders has the industry’s punditry burning the midnight oil. Analysts at BMO peg The Economical as the country’s sixth-largest property and casualty insurer. The company wrote a little more than $1 billion in premiums as of the end of 2010 Q3, based on data from the Office of the Superintendent of Financial Institutions (OSFI). In the same period, it reported an underwriting loss of $70.9 million, a net income of about $7.4 million and a healthy minimum capital test score of 226%.

Most importantly, the company has equity. In its latest OSFI filing, The Economical reported equity of $1.22 billion, based strictly on retained earnings. The company confirmed to Canadian Underwriter and other media this equity is spread out among “approximately 1,000” mutual policyholders. And while this does not actually translate into each mutual policyholder being worth $1 million, it does highlight the burning interest right now in how mutual policyholders can unlock the true value of their policies.

Demutualizing a P&C Insurer

The Economical’s proposed path of demutualization re-kindles a longstanding debate about a mutual insurance company system that has been part of the industry’s fabric since the late nineteenth century. A 2010 report authored by Ronald C. Hitchlock, an insurance broker and chartered accountant, Demutualization a Canadian Insurance Challenge, notes the farm mutual insurance system, owned by mutual policyholders, arose in the late 1800s at a time when rural consumers did not have access to needed insurance coverage at reasonable rates.

The ownership structure of a mutual insurer is identified in company bylaws, and is determined through the issuance of policies. Under some ‘open’ models, anyone holding a policy counts as an owner. Other ‘closed’ models distinguish between mutual policyholders and policyholders who are not owners and do not participate in the profits or surplus of the company. (The Economical operates under the latter model, referring to non-owner policyholders as ‘wholly cash plan members.’)

Generally speaking, under closed models, mutual policyholders have agreed to assume additional responsibility for the stewardship of the company. For example, mutual policyholders may buy into longer-term, three-year policies. In addition, they may receive dividends or be liable for the losses of the company. One weakness commonly associated with the mutual insurance model generally is that the mutual system limits efforts to raise capital. If a mutual insurance company requires additional capital, its chief option is to find more policyholders by selling more policies. But the Canadian insurance industry has evolved into an increasingly competitive marketplace; it has therefore been increasingly difficult to achieve growth in the marketplace strictly through the sale of policies.

Demutualization is intended to remove this restriction on raising capital. It would do this in one of two ways. One  is through an initial public offering.  Members are issued shares and keep their policies “Then we can issue more shares through the capital markets, which will allow us to raise additional capital so we can grow earnings and revenues at a faster pace and do larger acquisitions than what we would otherwise be able to do,” says Karen Gavan, chair of a special committee
 The Economical formed to examine its future options for growth.

A second way is “a sponsored demutualization, which would involve a transaction with another strategically-aligned company that would invest in Economical to acquire a significant ownership position, perhaps as much as 100%,” as the company puts it.

Of course, this second potential path has fully engaged the industry rumour mill. Analysts such as BMO and the CIBC speculate that such a “strategically aligned company” might include the nation’s largest property and casualty insurer, Intact Financial Corporation. Others see a more likely partner being an institutional investor, rather than an insurance company investor. The policyholders will be receiving more information about this aspect of the proposal prior to the May 2011 meeting, Gavan notes.
 
Regulating the Process

The rumour mill may be working overtime, because the regulatory process for demutualization is itself in a state of flux. Demutualizing a property and casualty insurance company in Canada is as rare as a total solar eclipse, if not unique.
Life insurers in Canada went through the demutualization process a little more than a decade ago. Parliament passed new legislation followed by regulations from the Department of Finance.

But life insurers do not sell the same kinds of policies as property and casualty insurers. Therefore, some would argue the value of P&C policies must be calculated differently. For example, life insurance contracts basically have one insured peril (life/death), whereas the P&C contracts cover a multitude of insured perils. Life insurance contracts are long-term (typically 10 years), and premiums are actuarially sound and fixed for the life term of the contract. P&C premiums, however, are market-driven and based on actual loss experience across the line of insured perils. These considerations would affect how the policies are valued.

The Economical has thus entered into discussions with OSFI and the Department of Finance Canada to discuss how to fairly value the company’s policies. The Department of Finance would be the ultimate arbiter of the demutualization plan, assuming the mutual policyholders decide to go that route. The fact that the process is new for the regulators raises the possibility new legislation is required to proceed. “We did discuss whether or not the life company demutualization regulations could be utilized, but there are enough differences between the life insurance policies and property and casualty company policies that a specific P&C company demutualization regulation is likely required,” said Gavan, who has experience on the life side.

OSFI says it is “premature” to know how the negotiations will unfold. “You may be aware that although demutualization of a mutual P&C insurer in Canada is permitted under the Insurance Companies Act, regulations need to be developed,” OSFI spokesman Rod Giles said in an emailed response. “Developing the regulations is a federal government responsibility (Department of Finance) and consultations with stakeholders would be done. The regulations would need to provide fair and equitable treatment to policyholders and preserve the safety and soundness of the demutualizing insurer. The decision on demutualization resides entirely with mutual policyholders and their respective board of directors.”

Debate About the Board

But who will these board members be?

One complicating factor is that a public debate about the future composition of The Economical’s board of directors has become entwined in the debate about demutualization. One Toronto firm, VC & Company, placed ads in newspapers starting Nov. 12, 2010, coll
ecting signatures from mutual policyholders calling on the current board to be replaced. The proposed new board would then consider the option of demutualization.

Despite the current board’s recommendation to demutualize, VC& Company has collected the 100 signatures it requires to put the option of a new board before the mutual policyholders.

Michael Woollcombe, a lawyer and executive vice president of VC & Company, suggests the mutual insurer’s current board took too long to consider demutualization, treating the option initially as a kind of “elephant in the room,” not to be discussed. In his view, the board was motivated by the actions of VC & Company and therefore cannot be relied upon to follow through on its strategy now.

For its part, the company sent out a letter dated Nov. 29, 2010, urging mutual policyholders not to sign up with VC & Company. Basically, The Economical suggested VC& Company’s call for a new board was unnecessary, since the insurer’s special committee, chaired by Gavan, was already considering the path of demutualization anyway.

On the issue of leadership, the company says the current board can be trusted to complete the job. “The board is committed to demutualization,” says Katherine Kipper, vice president of marketing and communications at The Economical Insurance Group (TEIG). “We believe that it is the right path. We are on record with a very clear direction. They [the current board members] have a responsibility to make sure that what’s done is in the best interests of the mutual policyholders. They [the mutual policyholders] will have the opportunity to approve that.”

Woollcombe also raises the issue of transparency, claiming the current board should have been more transparent during the process towards demutualization. Specifically, he notes the current board is withholding the exact number of its mutual policyholders.

But linking mutual policyholder value to the exact number of mutual policies is a misleading oversimplification, according to Gavan. Given the rules for determination of individual value have yet to be established, knowing the precise number of mutual policyholders will not provide any more useful guidance to individual policyholders today, she says, adding this is not in fact an issue. Gavan notes the company is not legally required to disclose the number of its mutual policyholders. In addition, the company has not disclosed the specific number to prevent the possibility of people benefiting from inside information of the VC & Company actions.

“The reason we are not disclosing it is that VC & Company have been quoted in the media as saying they’ve been working on this [plan to replace the current board with one that would consider demutualization] for a period of six months,” she says. “We are certainly undertaking a detailed audit to ensure that no policies were issued using inside information. We’re not subject to securities regulations, but it would not be in anyone’s best interests if someone had acted upon some inside information about what VC&Co were exploring doing.”

Following VC & Co’s first public solicitation, the company said it immediately “instituted a moratorium on the issuing of new mutual insurance policies.”


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