Most life insurance in force today is written by commercial life insurance companies. Although theoretically coverage could be issued by an individual or a partnership, to ensure the promise of security, it is essential that the insurance provider be permanent in order to be around when its long-term obligations come due. Since the corporate form of organization tends to be more permanent than other alternatives (a corporation�s existence continues beyond the death of any or all of its owners), it is the only form of business organization sanctioned by state law to underwrite life insurance.

Generally speaking, there are two different types of life insurance corporations, stock and mutual insurers. Both types of insurer must meet the formation, licensing, capital and/or surplus, and other state law requirements to do business. (See chapters 26 and 27 on the regulation of insurance.)

To obtain the initial operating capital necessary to enable a new company to begin to operate, the founders of a stock insurer sell shares of stock in the company that is being created. (In the future, if more funds are needed, additional shares may be offered for sale.) The people who purchase transferable ownership interests in the shares of stock own the insurer. If the company operates successfully, the value of the stockholders� investments will grow. Hence they may profit both by income from periodic payments (stockholder dividends) and gains arising from the sale of their stock. On the other hand, if the insurer is unsuccessful, the stockholders may lose some or all of their investment.

Whatever the ultimate result, a stock insurer is organized and operated primarily for the purpose of earning profits for its stockholders. In its quest for profits, a stock life insurer offers a wide range of products and services that benefit not only the insurance-consuming public (policyowners, insureds, and beneficiaries) but also the public at large (insurance protection, savings mechanisms, sources of investment funds for business and government, and employment opportunities).

The stockholders elect the board of directors that in turn appoints and oversees the management and operation of the company. Although it is not unknown for dissatisfied stockholders to vote to replace board members and thereby change control of the company, because of the number and dispersion of stockholders, direct replacement of the board is very difficult and therefore rare.

Nevertheless, management is subject to other forms of accountability that restrict trading the insurer�s stock in the open market. The investment community constantly monitors management performance. Changes in stock prices, among other things, reflect stockholder views on management performance. If stockholders believe that the performance is poor, they can sell their stock, which drives the share price down and leaves management vulnerable to a hostile takeover. Thus a stock company�s management is under real and constant pressure to generate an acceptable level of earnings that translate into stockholder dividends and increase the value of the stock.

At the same time, policyowner interests are neither irrelevant nor ignored. Although policyowners in most stock insurance companies lack legal control over management, successful business operations in a competitive marketplace require a certain degree of customer satisfaction and a good business reputation. Furthermore, life insurers are subject to comprehensive state insurance regulations aimed at fostering policyowner interests.

The surplus of a stock life insurer is the amount by which the insurer�s assets exceed the sum of its liabilities and capital (capital is the amount of money the stockholders have invested in the company). Stockholders share in the insurer�s surplus either through liquidation of the company or the payment of stockholder dividends.

Liquidation. Although an insurer may be liquidated in a situation that benefits stockholders, liquidation typically occurs when an insurer becomes financially impaired with little prospect for recovery. After the insurer closes down and the assets are gathered pursuant to a court order for liquidation, any assets remaining after satisfying the insurer�s liabilities are distributed to the stockholders. Usually, however, few if any assets remain for such distribution.

Stockholder Dividends. Cash dividends are the usual means by which stockholders receive part of the insurer�s surplus. A gain in the company�s surplus may arise from a specific provision for profit in the gross premiums charged for its policies or from favorable interest, mortality, and expense experience compared to the assumptions in the establishment of premium rates. Management may elect to pay a portion of its surplus to stockholders in the form of dividends as compensation for the use of their capital funds, it may retain surplus to enhance policyowner security against future adverse contingencies, or it may utilize surplus to finance insurer operations, such as new business, acquisitions, and so forth. If shareholders are dissatisfied with their dividends or the growth in the value of their stock, as noted above, they may either sell their shares or seek to replace the existing board of directors.

Traditionally stock life insurers issue nonparticipating policies for which they charge fixed premiums. These policies are sometimes referred to as guaranteed cost policies since they involve neither future increases in premiums nor refunds. (Stock companies cannot issue assessable policies that would permit an insurer to demand an increase in the premium to recapture losses.) Under a nonparticipating policy, policyowners do not share in the profits the insurer experiences (hence the term nonparticipating). In stock companies issuing only nonparticipating policies, the entire net worth of the insurer, while available for the protection of policyowners against adverse developments, represents assets held for the ultimate benefit of the shareholders.

Many stock life insurers currently issue (or have at one time issued) participating life insurance either exclusively or in addition to nonparticipating policies. As explained earlier, under a participating policy the policyowner shares (participates) in the insurer�s gains through policyowner dividends. Most states impose no special regulation on participating insurance sold by stock insurers. In the absence of any special charter provisions, statutory restrictions, or other legally binding agreements, the insurer�s entire net worth, after payment of dividends to participating policyowners, is held for the ultimate benefit of the shareholders. However, the charters of some stock companies and a few states limit the extent to which stockholders of the company may benefit from profit on the participating business.

Like a new stock company, a mutual insurer needs funds to operate. However, it issues no stock and has no stockholders. Instead, the initial funds come from the first premiums paid by the original policyowners or monies the insurer borrows. However, it is difficult to attract a sufficiently large number of individuals who are willing to apply for insurance and pay the first premium to a company that is not yet in existence and unable to issue policies until it has the specified number of applications, premiums, and the minimum initial surplus required by statute. Although mutual insurers play a major historical role in the life insurance business, because of these reasons and the lack of a profit incentive in their formation, few (if any) new mutual insurers are being formed. A new mutual insurer may emerge, however, from the conversion of an existing stock company to a mutual company (a process called mutualization).

In theory, the policyowners own and control a mutual company, but the actual ownership continues to be a subject of debate. Nevertheless, it is clear that a mutual company�s policyholders possess certain rights, including the rights to vote and to share in the insurer�s surplus. The company is obligated to operate in their interests, and its primary purpose is to provide reliable and low-cost insurance to its policyowners.

The management of a mutual insurer is virtually immune to pressure from policyowners. With no publicly traded ownership interests, the threat of outside takeover is not a factor. Although policyowners have the right to vote for the board of directors, each policyowner is entitled to only one vote, regardless of the number or size of policies he or she owns. Moreover, a collective effort by a diffuse body of policyowners is most difficult; the cost to an individual of organizing a challenge to management will most likely far exceed any possible financial return. Consequently, the mutual insurers� directors and management wield control that is virtually unhindered by the exercise of the policyowner�s right to vote. Nevertheless, they must be cognizant of policyowner interests to be successful.

Mutual insurers are subject to the protections afforded by state insurance regulation. However, they are not subject to the conflicting pressures of also having to satisfy stockholder interests.

Mutual life insurers issue participating policies. Although they are theoretically owners of a mutual insurer, participating policyowners do not have individual access to the insurer�s surplus. Rather, the assets represented by the surplus are held by the company for the benefit of the policyowners as a group. Except through the insurer�s possible liquidation or demutualization, an individual policyowner participates in the surplus via distribution of a policyowner dividend declared by the company�s board of directors. Management has broad latitude in declaring dividends, albeit subject to regulatory constraints and mandates. Since the participating policyowner typically pays a premium higher than that for a comparable nonparticipating policy, the policyowner dividend usually reflects this excess amount plus a share in the insurer�s gain in operations.

Generally, mutual companies issue only participating policies, but some mutuals also issue nonparticipating policies. It is not uncommon for a mutual company to issue some of its nonforfeiture options and dividend options on a nonparticipating basis. Nonparticipating term insurance riders are sometimes attached to basic participating policies. A few mutual companies have even offered a regular line of nonparticipating life insurance, although some states have restricted or prohibited them from doing so.

A question often raised by prospective buyers is whether they should purchase life insurance from a stock or a mutual company. The relative desirability tends to focus on the comparative financial strength and the price of protection afforded by the two types of insurers. Although there are some theoretical differences, the debate generally has more academic than practical interest. The basic factors determining an individual insurer�s financial solidity and price competitiveness are the quality of its management, management�s philosophy toward allocating gains in a way that reduces policyowner costs, and the insurer�s regulatory supervision, rather than inherent differences between the stock and mutual forms of organization.

At the end of 1996, there were an estimated 1,695 United States legal reserve life insurance companies. Approximately 95 percent were stock companies; the remaining 91 companies were mutuals. Mutual life insurers, which are usually older and larger, possessed nearly 38 percent of the assets and wrote nearly 38 percent of the life insurance in force.

In times past, some stock insurance companies have converted to the mutual form of organization. The primary reasons for conversion have been management�s desire to gain freedom from stockholder demands or to avoid being taken over by another company through a change in stock ownership. (Since a mutual has no stock, a potential purchaser has no stock to buy.) In essence, mutualization involves retiring the insurer�s outstanding capital stock and transferring control of the insurer to the policyowners.

The laws in several states outline the procedure for mutualization. Generally, after the mutualization plan is developed by management and ratified by the board of directors, it must be approved by the insurance commissioner of the insurer�s state of domicile, by the stockholders, and by the policyowners in accordance with the provisions of state law. The plan must include the price of the shares and the terms under which they will be purchased. (The price must be sufficiently high to induce the stockholders to sell but not so high that the insurer will lack adequate surplus to continue operations soundly.) The plan typically establishes a trust to receive the shares from the stockholders. Since the stockholders representing a majority of the stock must approve the plan initially, the bulk of the stock is usually turned over to the mutualization trustee promptly after the adoption of the plan. This places control of the insurer in the hands of the trustee until the last shares are received, at which time the stock may be canceled and the insurer is fully mutualized.

Although in theory the process of mutualization is quite simple, in practice some stockholders may refuse to surrender their shares, perhaps because they feel that the price is too low. However, unless they are successful in court, the stockholders ultimately have little alternative but to turn in their stock since no other market for their shares usually exists after adoption of the mutualization plan. Nevertheless, the complete process may take a long time, and mutualization has not proven to be very popular in recent years.

An estimated 105 mutual life insurance companies converted to the stock form of organization between 1930 and 1969. Sixteen mutual life insurers did so over the 25-year period from mid-1966 to mid-1991. Nevertheless, prior to the 1980s, demutualization generated relatively little regulatory concern, as evidenced by the lack of laws or regulations in many states governing the process. In recent years, however, an insurer�s organizational form has been perceived as highly important in the increasingly competitive marketplace because of its impact on the insurer�s ability to raise capital and adapt to changing marketplace conditions. Consequently, a growing number of mutual insurers have either undertaken or are considering demutualization. Some companies have sought new legislation to enable mutual life insurers to become holding companies for stock life insurers.

The reasons underlying demutualization stem primarily from the perceived competitive disadvantages of the mutual form of organization.

Ability to Raise Capital. First, the mutual insurer�s ability to raise capital is limited essentially to retained earnings from underwriting gains and investment income and to borrowing. In contrast, stock insurers not only can draw on retained earnings but they also can raise capital by offering common, preferred, and convertible stock for sale; by financing alternatives such as convertible debentures and warrants; and by utilizing the full range of debt instruments. The ability to raise investment capital more easily puts a stock insurer in a better position to grow rapidly in insurance writings, to finance development of new insurance products, and to avoid statutory or practical limitations inherent in debt financing. Furthermore, access to outside capital may better enable an insurer to strengthen a weak financial statement. The importance of full access to capital has increased with the integration of financial services.

Expansion Flexibility. Second, because of its ability to buy, sell, or exchange its own stock, a stock insurer possesses greater flexibility to expand through acquisitions or diversification. Unlike mutual insurers, stock companies can create upstream holding companies that facilitate expansion into other businesses, perhaps even non-insurance-related businesses, beyond the confines of insurance regulations. Effective diversification in the financial services, in fact, depends on use of an upstream holding company. For example, in the absence of an upstream holding company, a life insurer�s acquisition of a bank would be subject to the investment restrictions placed on life insurance companies. It could also render the insurer itself a bank holding company subject to federal banking as well as state insurance regulations. (See discussion of holding companies later in this chapter.)

Noncash Employee Incentives. Third, the stock form of organization offers additional noncash incentive compensation (for example, stock options and payroll-based stock ownership plans) to attract and retain key officers, directors, and employees.

Tax Advantage. Fourth, with the Deficit Reduction Act of 1984, the tax advantages insurers used to enjoy have eroded significantly. The Act limited the deductibility of dividends mutual insurers pay to policyowners. This (and other changes) shifted more of the industry�s federal tax burden to the mutual companies. Many mutuals view the federal tax law as biased in favor of stock insurers. Conversion to a stock company might result in tax savings.

However, before a mutual company opts to demutualize, it should carefully consider alternative (and perhaps better) ways to achieve its objectives prior to embarking on the difficult process of conversion. The cost and the complexity of demutualization are monumental (valuation and allocation of surplus to policyowners, along with legal, regulatory, actuarial, accounting, and tax problems). The cost of demutualization and the required distributions to policyowners could significantly deplete the insurer�s surplus, thus severely impairing its ability to function. In addition, following conversion, by virtue of its being a stock company, the insurer becomes accountable to stockholders and vulnerable to hostile takeovers. Moreover, once a mutual insurer converts to a stock company, it is subject to the ongoing expense and problems of complying with federal and state securities laws from which mutuals are now largely exempt.

The history of demutualization includes several cases of abuse in the distribution of a mutual company�s surplus or the transfer of ownership or control flowing from the conversion. On several occasions, managers effected a conversion for the purpose of transferring control of the company to themselves with little infusion of capital on their part. The distribution of surplus redounded not to the benefit of the policyowners who traditionally are deemed to be the mutual insurer�s owners but to the existing management.

The perceived inequitable results of such conversions generated legislative responses, including several state laws prohibiting demutualization. In 1923, the National Association of Insurance Commissioners (NAIC) reflected the then prevailing sentiment by proposing a model law prohibiting a mutual insurer from converting to a stock company. Other states enacted laws that, while permitting demutualization, were designed to prevent recurrence of past abuses.

More recently, some states have repealed the total prohibition of demutualization. These and other states have enacted new laws to strengthen protections and vest substantial authority in the insurance commissioner to monitor the conversion process and safeguard the interests of the mutual policyowners. State willingness to shift from the earlier prohibitory approach stems from (1) the recognition that conversion to a stock company may be essential to some mutual insurers� viability and survival in today�s competitive marketplace and (2) increased confidence in the state�s ability to fashion a regulatory framework that balances legitimate business objectives and policyowner interests.

Currently, most states regulate insurer demutualization either directly or indirectly. Generally, the law of the insurer�s domicile governs.

Although there are basically three alternative approaches to demutualization�some form of direct or pure conversion, merger, or bulk reinsurance�the basic steps in the process are similar. A specified number of the board of directors must prepare and adopt a plan and submit it to the insurance commissioner in the insurer�s state of domicile. The insurer must demonstrate that the demutualization is fair and equitable to the policyowners, that there are sound reasons for the conversion, and that the reorganization is in the interest of the company and the policyowners and not detrimental to the public. The commissioner may order an examination of the insurer and obtain an independent appraisal value of the company. After review, public hearing, and approval by the commissioner, policyowners are given notice of the conversion and an explanation of what they will receive in exchange for giving up their membership rights in the insurer. If the requisite number of policyowners vote in favor of the plan, and the insurer obtains final approval from the commissioner, the company proceeds to implement the conversion. If the company will be issuing securities to the public, it may also be required to register them with the Securities and Exchange Commission and state securities commissioner(s) prior to their sale.

Pure Conversions. The pure conversion approach involves amending the mutual insurer�s articles of incorporation to reorganize the company from a mutual to a stock form of organization. A majority of states now have statutes expressly authorizing a mutual insurer to directly convert to a stock company. Virtually all of these states condition the conversion on obtaining the approval of the commissioner, whose function is to ensure that the mutual insurance company�s policyowners are treated equitably. Generally, such laws preclude plans vesting control in or distribution of surplus to management and mandate that surplus be distributed to the policyowners.

Determining the portion of surplus to which an individual policyowner is entitled, however, is difficult because (1) a mutual company does not record the amount that an individual policyowner has forgone when the company retained earnings in lieu of paying policyowner dividends, and (2) portions of surplus are attributable to former, rather than current, policyowners. In varying degrees of specificity, the pure conversion laws govern the procedures to accomplish the conversion. Although the requirements differ among states, some of the laws prescribe (1) the method of valuing the distributable surplus, (2) the proportionate amount of total surplus that must be distributed to policyowners, (3) which policyowners are entitled to receive the distributed surplus, (4) the determination of each policyowner�s share of the surplus, (5) the form of surplus distribution (cash and/or stock), and (6) the percentage of policyowners necessary to approve the conversion.

If a state neither expressly prohibits nor expressly authorizes conversion, a second possible (albeit risky) pure conversion approach is a common law conversion�that is, a mutual insurer converts to a stock company simply by amending its articles of incorporation. However, many general laws and some insurance case laws pertaining to corporate mergers and consolidations hold that a corporation cannot effect such corporate structural changes in the absence of express statutory authority. Thus the validity of common law conversions is highly suspect whether challenged by the insurance commissioner or disgruntled policyowners.

In states where a mutual company is established under a special charter or enactment, it may be possible to achieve a pure conversion through a statutory amendment of the company�s charter.

Conversion by Merger or Bulk Reinsurance. States that expressly prohibit a mutual insurer�s pure conversion to a stock company and states that have no pure conversion authorization statute may afford mutual companies the option of a merger or bulk reinsurance. To effect demutualization through a statutory merger, the mutual insurer organizes or purchases a stock company, the two companies merge, and the stock company is the survivor. The mutual company therefore ceases to exist. Under the bulk reinsurance approach, the mutual insurer cedes all of its insurance business and transfers all of its assets and liabilities to a stock insurer the mutual company has organized or acquired. After the transaction, the mutual insurer is dissolved.

Both a statutory merger and bulk reinsurance conversions must be approved by the insurance commissioner and in some states by the mutual policyowners. Again, management has to demonstrate that the terms of the proposed transaction are fair to the policyowners. Pursuant to either statutory prescription or commissioner discretion, the commissioner is likely to evaluate many of the same factors codified in the pure conversion statutes in determining whether the mutual policyowners are treated fairly.

If the conversion is by a merger or bulk reinsurance arrangement, some very difficult practical readmission problems could arise if the surviving stock company is not licensed to do insurance business in the states where the mutual insurer had been licensed. Many insurance departments have taken the position that the mutual company�s certificate of authority is not transferred to the surviving stock corporation. Thus many states require the surviving stock company to file for admission to do business in that state, submit all of its policy forms, pay all fees, and make all statutory deposits required of new foreign insurers. This takes time, and unless it is done in advance of the actual demutualization, the new insurer might be unable to do business in many states for some time.

Furthermore, many states impose a "seasoning" requirement on insurers. An insurer applying for admission to do business in the state must have been actively engaged in the business of insurance for a specified period (typically 3 years). If the surviving stock company is newly created and lacks previous operating experience, it may be unable to obtain a license to do business until after the seasoning period. (Some states waive the seasoning requirement in the demutualization situation.) In some states, if the surviving corporation has been in existence for less than a year, in the absence of an annual statement, the insurance department will not even review the company�s application for admission.

When the conversion from a mutual to a stock company is achieved by the pure conversion procedure, these readmission problems are more likely to be avoided because the new stock company is not a separate new entity. One court has held that the mere amendment of articles of incorporation does not create a new company. However, this conclusion may not be accepted by a particular state.

Although most life insurance in the United States is written by commercial companies, there are other nongovernmental providers of life insurance, including fraternal benefit societies, assessment societies, and savings banks. Since these other providers write only a small portion of the total amount of life insurance in the United States, their treatment here will be very brief.

Fraternal life insurance is issued by fraternal benefit societies that were formed to provide social and insurance benefits to their members. They provide life insurance on a basis similar to that offered by commercial insurers. The modern fraternal life insurance certificate or contract is akin to a commercial company policy and contains most of the provisions found therein.

Although most assessment associations today utilize the level premium and do not operate solely on an assessment basis, these providers do not establish actuarially based premiums as do commercial and fraternal life insurers and can still levy assessments when needed. On occasion problems have arisen when policyowners have been unaware of the association�s right to charge such assessment.

In 1907 Massachusetts enacted a law authorizing savings banks in that state to establish life insurance departments to sell over-the-counter life insurance and annuity contracts to persons residing or working in the state. The Massachusetts law sought to provide a system of low-cost insurance by eliminating the sales costs of agents� commissions and home collection of industrial insurance premiums. In 1938 and 1941 respectively, New York and Connecticut enacted similar legislation. Efforts to establish savings bank life insurance in other states have proven unsuccessful. Savings banks have the authority to sell the normal types of ordinary policies, annuities, and group insurance. The terms of the contracts are similar to those of commercial life insurers. However, the maximum amount of insurance any one applicant can obtain is limited by law in each state.