Although a substantial proportion of the property and casualty insurers of the United States are owned by their policyholders, the current industry trend for these mutual insurers is to demutualize. They want to become publicly held stock companies so that they can compete more effectively, diversify, engage in mergers and acquisitions, and get access to their huge reserves of capital. For example, Prudential, one of the country’s biggest insurance companies, announced in March that it intended to demutualize.

Being a publicly held company puts much more performance pressure on management, often to the good of the company and the policyholders. But demutualization is a time-consuming and expensive process, and not every mutual insurer wants to experience the rigors of public ownership. There is another solution, one that will give mutuals many of the same benefits, with less risk and cost.

The capital burden

The return on the equity of US mutual insurers has declined from as much as 30 percent, in the 1970s, to around 5 percent in 2001 (Exhibit 1). Mutuals have limited freedom to use their surplus capital,1 because of regulations protecting policyholders and creditors, so over time they have amassed huge amounts of excess capital: in 1999, just 20 percent of the top companies had accumulated a total of $180 billion. Indeed, mutual insurers are making most of their profits not from the sale of insurance products but from their investment portfolios (which are based on the growing policyholder surpluses).

Mutual insurers could distribute more of their profits to their owners (that is, the policyholders), but in practice this would be difficult. It would be necessary to identify all of the current and past policyholders and to address complex fairness issues, such as the different amounts of money the policyholders have paid in and the different lengths of time they have been doing so. Enormous administrative costs and effort are involved as well. Finally, distributing more money to policyholders—self-liquidation, in effect—would not make mutual insurers more competitive in the insurance industry.

Competition has increased

Meanwhile, the whole property and casualty industry has become increasingly competitive as companies with more efficient business models have emerged. For example, Geico (a unit of Warren Buffett’s Berkshire Hathaway) and Progressive are old companies that have revamped themselves and their strategies in the past decade or so and substantially increased their market share. They no longer use the industry’s traditional distribution model—that of independent local insurance agents—a change that has cut their costs and allowed them to organize their operations around more uniform products and procedures instead of dealing individually with every broker, agent, and client. They own the client relationship more completely and can sell other products to those customers. Consequently, they have been free to underprice their competitors to gain market share. In auto insurance, for example, Progressive’s market share has doubled since 1995 and Geico’s has increased by almost 50 percent. By contrast, the top auto insurers—such as State Farm and Farmers Insurance Group—lost market share during the same period.

The Internet has made this direct-distribution model even more effective: potential customers can go on-line for insurance quotations and information about policies or products. Overall, the performance of these companies has been striking. Progressive, for instance, maintained an NPW²-to-policyholder surplus ratio of 2.1 in 1999 and 1.9 in 1998, twice the industry average (see sidebar "The declining ratio").

To demutualize or not to demutualize?

The conventional response to this heightened competition has been to demutualize, moving capital to a holding company that is free to make more attractive investments and subjecting it to the demands of the stock market. In addition to Prudential, 18 major insurers have demutualized since 1997.

Demutualization makes it easier for companies to engage in mergers and acquisitions. Companies in the insurance industry are consolidating to gain scale advantages over their competitors by, for example, spreading infrastructure costs over a larger volume of business. There were 26 major acquisitions in the life insurance industry alone from 1997 to 1999. But acquisitions are a double-edged sword: with this newfound M&Amp;A ability comes the risk of hostile takeovers, which may require management to take strong action, such as laying off personnel. In fact, according to A. M. Best, demutualized insurers cut their workforce by 40 percent, on average, after restructuring.

These drawbacks and the huge costs involved—for example, $229 million for Metropolitan Life Insurance when it converted to a public company in 1997—mean that demutualization is not for everybody, particularly since the mutual-insurance industry is full of fairly small and midsize companies. Of 393 mutual property and casualty insurers, 290 have assets of less than $300 million. Of the top 90 life and health mutual insurers, 28 have total assets of less than $300 million. For these insurers, the costs of converting themselves into public companies can defeat their objectives by wiping out a substantial chunk of their capital. So if demutualization is not for them, they still have the same competitive problems as the rest of the property and casualty industry and will need to find creative ways of working within the constraints of the mutual structure to use their assets more productively.

Leveraging assets

Given those constraints, mutuals have the choice of either reducing the capital they tie up in physical assets or using their existing assets to invest in new higher-growth, higher-return businesses. To achieve these aims, they can use a sale-and-leaseback mechanism, a corporate-finance method popular in asset-intensive industries such as utilities: an asset is sold, usually to a financial or real-estate buyer, and the seller, in this case the mutual insurer, leases the asset back to continue using it in the seller’s business. This approach allows the mutual insurer to reduce the capital tied up in its insurance business and to invest, for example, in new and more profitable businesses. Mutuals can also build new higher-growth businesses by bringing in third-party partners and setting up new companies that use the mutual insurers’ assets and capital.

Sales and leasebacks

By using a sale-and-leaseback structure, mutuals can get capital out of their businesses (see sidebar "Legal conditions for sales and leasebacks"). They can sell assets such as branches and call centers, for example; get those assets back under long-term leases; and retain first dibs at future lease renewals. The buyer pays the mutual insurer for the asset, reducing the capital used in the insurer’s existing business and providing funds for new uses (Exhibit 2).

Mutuals should ask themselves two questions before they take the plunge:

1. Do the assets have a natural buyer? Such a buyer is likely to be a company, such as GE Capital, that is in the business of buying assets and leasing them back or, in the case of real estate, an REIT (real-estate investment trust) or a commercial real-estate owner or investor.
2. How will the liberated capital be used by the insurer, and what are the economic benefits?

On top of these considerations, not-for-profit mutuals have more incentive to sell than do their for-profit counterparts: they pay no tax and therefore cannot exploit the tax shield that the for-profits enjoy on the annual depreciation of an asset. In executing a sale and leaseback, any for-profit buyer of the asset will receive this tax benefit, presumably boosting the price the buyer is willing to pay. The sums involved can be substantial. The value of the tax shield in today’s money (accounting for inflation, for example) would equal about $20 million to $30 million for every $100 million of assets.

Thus, a for-profit mutual insurer calculates the economic benefit differently. Before the insurer decides whether a sale/leaseback is in its economic interest, it must compare the tax benefit from the depreciation of its asset with the increase in expected earnings on an investment made with any newly liberated cash.

Building new businesses with outside investors

Since the mutuals’ business returns as a percentage of total assets are also low and declining, they must look for new business opportunities (Exhibit 3). Besides capital, plenty of mutual insurers have other underutilized assets, such as strong brands and large customer bases that can easily be leveraged into new growth businesses. For example, the Automobile Club of Southern California, a $1.2 billion mutual property and casualty insurer, has a network of 60 branches in California, New Mexico, and Arizona; upward of three million loyal customers; and more than $1 billion in excess capital. It could, among other things, launch an on-line insurance marketplace, a subsidiary to provide underwriting and policy services to e-insurance start-ups, or an automotive "infomediary" business.³ But regulatory restrictions mean that mutuals must structure these new businesses carefully. One method is for a mutual insurer to find a third-party co-investor to set up a company for new ventures and to capitalize them with loans.

Although insurance restrictions make it hard for mutuals to buy stock in noninsurance businesses, loans carry far fewer restrictions. To qualify, a loan must represent no more than 70 percent of the borrower’s total capitalization, together with the sum of loans and whatever money the shareholders have put in. The mutual must also hold less than 50 percent of the stock of the noninsurance company so that it won’t be considered part of the mutual insurer and thus included in the insurer’s financial statements. To comply with these restrictions, the mutual must bring in a third-party co-investor, a venture capitalist, or some other strategic partner to acquire 51 percent or more of the new entity’s stock and to provide the necessary initial investment capital, so that the new company will qualify for a follow-on loan from the mutual.

The brand value, customer base, and industry experience mutuals could bring to new ventures will likely attract third-party investors

The most attractive businesses for this approach are those that can use the mutual’s other assets—for example, the call centers or the brand name. At the same time, the loan provides the new entity with the benefits of a tax shield on interest (which is deductible for tax purposes, much as mortgage interest payments are for individuals), in addition to capital and access to other assets (Exhibit 4). As long as the mutual company’s loans are treated as debt for tax purposes, this interest tax shield can be worth as much as 20 to 30 percent of total borrowing to the new company. Third-party investors are likely to be attracted by the brand value, customer base, and industry expertise an established mutual could bring to a new venture. The expertise of a venture capital firm can often improve the chances for the new venture’s success as well. WalMart, for example, brought in the venture capital firm Accel Partners to launch Walmart.com because of Accel’s considerable expertise in helping start-ups grow.

In an increasingly competitive industry, mutual insurers need to use their capital more productively. Becoming a public company by demutualizing is an expensive way to change. Other financial-engineering tools can improve a mutual insurer’s return on capital, with far less cost and disruption. If this capital can be unlocked and invested more profitably, the opportunities are enormous: mutuals could grow faster, reshape themselves as low-cost corporate lenders (such as GE Capital), or finance higher-margin activities (for instance, financial or estate-planning businesses). Releasing the $180 billion in surplus that generates annual returns of only around 5 percent and moving that money into higher-performing businesses (such as banking and financial services) that earn 18 percent could raise annual returns by roughly $30 billion. If these firms were then to be valued as similar public companies are, the value of the mutual industry would actually increase by as much as $500 billion.

The declining ratio

With the steady buildup of excess capital, the ratio of net policies written (NPW) to policyholder surplus, a measure of the ratio between new business and the capital used to create it, has declined sharply over recent decades. From an average of 2.7 in the 1970s, the ratio slipped to 2.2 in the 1980s and to 1.5 in the 1990s. By year-end 1998, the property and casualty industry’s ratio had dipped below 1.0 for the first time in over 30 years (exhibit). Life and health insurers have experienced a similar but less drastic trend: for the 5 years ending in 1999, their NPW-to-policyholder surplus ratio was 2.16, about 10 percent below the average of the preceding 15 years.

An obvious solution—lowering the price of insurance products and, presumably, selling more of them—just isn’t possible, primarily because when state regulators approve a type of insurance product (once "a book of insurance is opened," in industry parlance), future rates on the same type of insurance sold to new customers must follow the same pricing structure. Nonmutuals can invest their surplus capital in other ventures and, in fact, make most of their money from investment profits. But regulations constrain mutuals from doing much with this capital, so their returns on capital are worse.

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