A prime difference between the mutual and the stock form of corporate organization with respect to insurance companies relates to the ownership rights to the insurer’s surplus. A stock life insurance company is owned by its shareholders and is operated for their interests. Stockholders possess individual title to defined portions of the company’s surplus. When they desire to terminate their relationship with the firm, they can sell their equity interest, that is, their stock. Stockholders look to their companies to operate in such a manner so that the value of their stock appreciates and/or the dividend performance is good. As owners of the company, stockholders elect the board of directors to run the company.

The precise nature of the ownership of a mutual insurance company has long been debated and is somewhat imprecise. However, members of a mutual insurer possess certain membership rights and the company has an obligation to operate in the interest of its members. The definition of who is and who is not a member may depend upon the insurer’s by-laws and/or the applicable state law. But as a general proposition, membership consists of the insurer’s participating policyholders. The members of a mutual life insurance company elect the insurer’s board of directors and are entitled to participate in the insurer’s earnings by means of policyholder dividends. Although members have a claim on an insurer’s surplus as a group, they do not possess individual rights to any portion of the surplus. They forfeit any equity interest they might have when their policy terminates or lapses for any reason.

At various times for various reasons a stock insurer might desire to convert to a mutual company and a mutual insurer may seek to convert to the stock form of organization. Such activity can pose significant regulatory implications as to insurer financial condition and/or market conduct operations.

In times past, some stock insurance companies have converted to the mutual form of organization. Such changes were primarily motivated by management desires to (1) gain freedom from the demands of stockholders and/or (2) 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 the retirement of the insurer’s outstanding capital stock coupled with a transfer of control of the insurer to the policyholders.

The laws in several states outline the procedure for mutualization. Generally after the mutualization plan is developed by management and approved 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 policyholders in accordance with the provisions of state law. The plan must include, among other things, 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 soundly continue operations.) Typically, the plan 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 cancelled, leaving the insurer fully mutualized.

Although in theory the process of mutualization is quite simple, in practice some stockholders may refuse to surrender their shares, feeling, for example, that the price is too low. However, unless they are successful in court, ultimately they have little alternative but to turn in their stock since usually no other market for their shares will exist after adoption of the mutualization plan. Nevertheless, the complete process may take considerable time.

In recent years mutualization has not proven to be very popular.

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 a 25-year period from mid-1968 to 1993. 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, the organizational form of an insurer has come to be perceived as highly important in the increasingly competitive marketplace due to its impact on the ability of the insurer to raise capital and its flexibility to adapt to changing marketplace conditions. Consequently, a growing number of mutual insurers have either undertaken demutualization, have considered, or are considering doing so.

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

First, the mutual insurer’s ability to raise capital is essentially limited to retained earnings from underwriting gains, investment income, and borrowing. In contrast, stock insurers not only can draw upon retained earnings, they also can raise capital by offering for sale common, preferred, and convertible stock, financing alternatives such as convertible debentures and warrants, and the full range of debt instruments. Other than regulatory compliance costs, for a stock insurer the economic cost of raising low cost equity capital is limited to future dividends to be declared and paid to stockholders. Typically dividend yields expected by investors are significantly less than long-term debt yields. Furthermore, the stock insurer controls the amount of dividends paid to shareholders in a given year since there are no contractual obligations to pay dividends. Thus by affording a means to more easily raise low cost investment capital, a stock insurer may be better positioned for rapid growth 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 emergence of the integration of financial services.

This is not to say that mutual insurers possess no means of accessing outside capital. This might be done through various debt instruments such as surplus notes (although regulatory conditions imposed on surplus notes may render them less than attractive to prospective investors). However, when borrowing from other financial institutions, mutual insurers are at a distinct disadvantage since lenders are generally subordinated as to right of repayment to the policyholders of the mutual in the event of an insolvency. Consequently, the borrowing power of a mutual is severely restricted since rates and terms offered by financial institutions have been less attractive than a typical senior debt offering. Also at best there may be only very limited access to equity capital. Second, because of its ability to buy, sell, or exchange its own stock, a stock insurer possesses greater flexibility to expand through acquisitions and/or diversification. A stock insurer seeking growth through acquisitions possesses an advantage over its mutual counterpart in that the stock insurer can acquire another company through the issuance or exchange of its stock. The use of equity securities to accomplish such acquisitions can be attractive to the shareholders of the acquired company from a tax perspective, thereby aiding in the consummation of deals on terms more favorable to the insurer. Mutual insurers lack this ability to use stock to facilitate such acquisitions.

Also, unlike mutual insurers, stock companies can create upstream holding companies which enable expansion and diversification into other insurance- and noninsurance-related businesses beyond the confines of insurance investment regulation. Effective diversification in the financial services industry is said to require use of an upstream holding company.

Third, the stock vis-à-vis the mutual form of organization offers additional competitive means of noncash incentive compensation (for example, stock options and payroll-based stock ownership plans) to attract and retain key officers, directors, and employees.

Fourth, although relative tax disadvantages were first imposed on mutual (vis-à-vis stock) insurers in 1959, such disadvantages were largely eroded by some imaginative reinsurance arrangements. The Deficit Reduction Act of 1984 reinstated relative disadvantages in a different form. The Act limited the deductibility of dividends paid to policyholders by a mutual insurer. This and other changes shifted more of the industry’s federal tax burden to the mutual companies. Mutuals view the federal tax law as biased in favor of stock insurers. Conversion to a stock company might result in tax savings.

Before a mutual company opts to demutualize, it should consider very carefully alternative and, perhaps on balance, better means to achieve its objectives before embarking on the difficult process of conversion. Conversion to the stock form of organization poses significant disadvantages as well as advantages.

First, the cost and the complexity of the demutualization process are mon-umental (for example, valuation and allocation of surplus to policyholders, and legal, regulatory, actuarial, accounting, and tax problems). As a consequence, the cost of demutualization and the required distributions to policyholders could significantly deplete the insurer’s surplus, impairing its ability to function.

Second, following conversion, by virtue of being a stock company, the insurer becomes accountable to stockholders and vulnerable to hostile takeovers. An insurer considering demutualization should seriously consider this risk, especially smaller and medium-size insurers which might be attractive targets for a large conglomerate seeking to diversify operations, a financial institution seeking to provide a fuller package of financial services, or another insurer desiring additional growth or a diversification in its investment portfolio.

Third, once a mutual insurer converts to a stock company, it becomes subject to the ongoing expenses and problems of complying with federal and state securities laws including the expenses of annual reports to shareholders and related communications from which mutuals are largely exempt. Quarterly and annual financial reports must be filed with the Securities and Exchange Commission as well as annual reports and proxy statements that are distributed to shareholders. Stock insurers are subject to much more intense public scrutiny as the Commission, investors, securities analysts, certified public accountants, as well as insurance regulators, constantly oversee their activities.

Fourth, demutualization represents a dramatic change of corporate philosophy and may constitute a very difficult step for those insurers long committed to the mutual model.

The history of demutualization reflects several instances of abuse centering on the distribution of a mutual company’s surplus and/or the transfer of ownership or control flowing from the conversion. On several occasions, management effected a conversion for the purpose of transferring control of the company to themselves with little infusion of capital on their part. Furthermore, to the detriment of the policyholders, the distribution of surplus redounded to the benefit of the existing management rather than to the policyholders who traditionally are deemed to be owners of the mutual insurer.

The perceived inequitable results of such conversions generated legislative responses including several states prohibiting demutualization. In 1923, the NAIC reflected the prevailing sentiment in proposing a model law prohibiting a mutual insurer from converting to a stock company. Other states enacted laws which, while permitting demutualization, were designed to prevent recurrence of past abuses. These achieved varying degrees of success.

More recently, some states repealed total prohibition against demutualization. These and other states enacted new laws to strengthen protections and vest substantial authority in the insurance commissioner to monitor the conversion process to ensure that the interests of the mutual policyholders are adequately safeguarded. State willingness to shift from the earlier prohibitory approach stemmed from (1) the recognition that conversion to a stock company may be essential to the viability and survivability of some mutual insurers in today’s changing competitive marketplace, and (2) increased confidence in the state’s ability to fashion a regulatory framework to achieve an appropriate balance between legitimate business objectives and the interests of the policyholders.

Currently, most states regulate either directly or indirectly the demutualization of insurers. Generally the law of the insurer’s domicile governs. In addition to the state law governing demutualization, if the demutualization plan contemplates the creation or involvement of a holding company or merger, the appropriate state holding company and/or merger law is also applicable, as are federal securities and antitrust laws.

There are basically three alternative approaches to demutualization: (1) some form of direct or pure conversion, (2) merger, and (3) bulk reinsurance. In a pure conversion, the insurer issues stock and distributes cash or other assets to policyholders in payment for their ownership or equity interests in the surplus of the mutual. In a merger, the mutual insurer creates or acquires a stock subsidiary and merges into it, with the surviving stock company issuing stock and/or distributing cash or other assets to policyholders in payment for their ownership or equity interests in the surplus of the mutual. In a bulk reinsurance arrangement, the mutual acquires or establishes a stock subsidiary, reinsures all of its business in-force with the stock subsidiary, and transfers to it all of the mutual insurer’s assets and liabilities, after which the mutual dissolves. In exchange for the business reinsured and the assets and liabilities transferred, the stock company issues stock and/or distributes cash or other assets to policyholders in payment for their ownership or equity interests in the surplus of the mutual. Furthermore, each of these alternative methods of demutualization can be modified so that the new stock insurer is held by a parent holding company. In most states some rather complex laws apply to each of the basic alternatives as well as to the creation of a holding company.

Regardless of the mode of demutualization selected, in adopting a plan to demutualize an insurer, the company’s board of directors makes a very fundamental decision affecting the basic structure of the insurer and the ownership interests of the policyholders as well as causing valuation of the insurer and the distribution of consideration to the policyholders. It is fairly well established that the directors of a mutual insurance company owe a duty to its policyholders akin to the duty owed by the board of directors of a stock company to its shareholders. Thus the board is subject to the judicially imposed business judgment rule imposing a duty of due care. In effect, the rule states that if the board has shown the proper degree of care in formulating its decision to undertake a corporate action, the court will not substitute its judgment as to the merits of the decision. The business judgment rule requires that the board act in good faith, not be personally interested in the subject matter of the decision, and be adequately informed. To avoid liability, the board should establish a clear record of informed preparation and decision making.

Pure Conversions. In a conversion of a mutual insurance company to a stock insurer, the insurer is transformed into a shareholder-owned enterprise through a process in which policyholder-members’ rights are exchanged for valuable consideration, such as cash, additional benefits, and/or shares of stock in the resulting company. If an objective of the conversion is to raise new equity capital, that step could be taken at the same time as the conversion or postponed as a separate step later on. If new capital is raised, the ownership of the insurer will be shared between the former policyholder-members and the new investors/shareholders in the company. When no new capital is initially raised, the former policyholder-members will, at least initially, own all the shares of the converted company. In some situations, the converted insurer may be acquired by another company, in which case the policyholders-members will typically be compensated in the form of cash or additional benefits. In other cases, the converting mutual insurer may be attempting a restructuring in which an upstream holding company is created. Here the parent company would typically own all of the shares of the converted insurer with the policyholder-members receiving shares in the holding company. Additional shares sold to the general investing public would be shares in the parent holding company.

The pure conversion approach involves amendment of the articles of incorporation of the mutual insurer to reorganize the company from a mutual to a stock form of organization. Although a few states prohibit conversion and some states neither prohibit nor authorize conversion, a majority of states now have statutes expressly authorizing a mutual insurer to directly convert to a stock company.

Many state statutes expressly provide that the corporate existence of the mutual company converting to a stock insurer does not terminate, that is, the converted company is deemed to be a continuation of the company that converted. Other state conversion laws provide that the conversion involves an amendment of the insurer’s charter or articles to make clear that the stock company is a continuation of the mutual. Since the converted insurer is not a new corporate entity, it is subject to the same contractual obligations as the former mutual. Hence the converted stock insurer must continue all the policies in force at the time of the conversion in accord with their terms. The newly converted stock company is subject to suits and other liabilities of its predecessor. And it maintains its legal rights, including its certificate of authority as an insurer in each state where it was licensed as a mutual.

In essence, the conversion process involves three distinct approval processes.

Board Approval. The board of directors must determine whether the conversion is important to the future ability of the insurer to achieve its objectives and that conversion is in the interest of the policyholders. Procedurally, the conversion process commences with the adoption of a resolution by the board of directors of the mutual insurer stating the benefits to the policyholders. Even in states where an initiating board resolution is not required, it is common corporate practice for the board of directors to initiate the conversion process, including the necessary charter and bylaws amendments, by a formal board resolution.

All states authorizing conversion require the mutual to develop a plan of conversion. Among other things, conversion plans address issues related to the distribution to the policyholders of their equity in the mutual insurer. (These issues are noted below.) Although requirements vary from state to state, commonly a supermajority (typically two-thirds) vote of approval of the conversion plan by the board of directors is required.

Regulatory Approval. After approval by the insurer’s board of directors, the second approval process which must be successfully negotiated before a conversion can be effectuated is the regulatory approval process. Conversion statutes generally require the submission of the conversion plan and other materials to the insurance commissioner of the insurer’s domiciliary state and condition the effectuation of such conversion upon, among other things, the approval of the commissioner. Some state statutes mandate the commissioner to order an examination of the mutual insurer as well as an appraisal of the company. Such appraisal and examination provide a basis upon which the conversion plan and its approval can be founded. Although a majority of states do not mandate such examination and/or appraisal, the commissioners therein would appear to have authority to do so if the action is deemed appropriate to protect the interest of the policyholders or the public. Typically the commissioner can employ outside experts to conduct the valuation function. Furthermore, while a few states simply permit, most states require the commissioner to hold a hearing on the plan of conversion.

Statutes vary by state as to the standards for commissioner approval. Several require the commissioner to disapprove the conversion plan unless it meets specified criteria which relate generally to (1) the fairness of the plan to the policyholders and (2) adequate capitalization of the resulting stock company. Other statutes provide that the commissioner shall approve the plan unless he or she finds that the plan violates the law or is contrary to the interest of the policyholders or the public. Generally when standards are incorporated in the conversion statute, they preclude plans vesting control in or distribution of surplus to management and mandate that surplus be distributed to the policyholders. Other statutes simply grant discretion to the commissioner as to whether or not to approve the plan.

Perhaps the most difficult issues with which the board of directors must cope in the development of the conversion plan and which the commissioner must review in approving or disapproving the plan are those related to the distribution of surplus to the policyholders of the mutual insurer. While it is easy to assert that policyholders own their mutual insurer, it is more difficult to determine that portion of the surplus to which an individual policyholder is entitled since (1) a mutual company does not record the amount which an individual policyholder has foregone when the company retained earnings in lieu of paying policyholder dividends and (2) portions of surplus are attributable to former rather than current policyholders. In varying specificity, the pure conversion laws govern the procedures to be used in accomplishing the conversion. Some of the laws prescribe the method of determining how much, to whom, and in what form the company’s surplus must be distributed. Although the requirements for obtaining such approval may vary between different states, some of the important requirements relate to the following.

First, what method should be used in valuing the distributable surplus?

A key issue in valuation of a company is whether prime reliance should be placed on regulatory judgment or market values. Regulatory decisions on value, even with the best expert advice, inevitably will differ from market judgments. If regulatory value is too high, outside investors will be more difficult to obtain. If regulatory value is too low, someone will reap a windfall.

Second, what is the aggregate amount of surplus which must be distributed to policyholders? Whatever the precise or imprecise statutory definition as to the aggregate amount to be distributed, to gain regulatory approval, the merger plan needs to be perceived as being fair to the policyholders as a group from a financial viewpoint.

Third, which policyholders are entitled to receive the distributed surplus? Some authorities believe that since all of the policyholders, living and dead, contributed to the surplus, all policyholders or their heirs should share in the distribution. Others believe only current policyholders should participate. Still others have concluded that only those policyholders who have had policies in force for a minimum specified period of time (for example, 3 to 5 years) should participate in the distribution. States vary in specifying to whom the surplus should be distributed.

Fourth, what portion of distributed surplus should go to each policyholder? Although a few states impose statutory formulas as to the allocation of the amount to be distributed among policyholders eligible to receive distributions, most states have opted simply to mandate that the conversion plan contains a formula that is fair or that the plan allocates to each policyholder his or her equitable share of the amount to be distributed. To demonstrate compliance with such statutory standards as well as for internal purposes, a mutual company contemplating conversion commonly will engage outside experts, such as consulting actuaries, to develop a distribution formula and provide the board of directors with an opinion as to the fairness of the allocation called for in the plan and by the statute.

Fifth, what should be the form of surplus distribution (for example, cash and/or stock)? If the insurer distributes the surplus in the form of cash, it may weaken its financial condition to the extent of impairing its ability to effectively function and/or raise additional capital. On the other hand, to distribute shares of stock in the converted company might severely dilute the number of stockholders to an unmanageable and/or very costly proportion. Some statutes require that the distribution is to be in the form of stock of the converted company or of stock and/or cash at the option of the policyholder. Other statutes are more flexible.

Finally, should insurers maintain separate blocks of business or separate accounts to maintain the mutual’s dividend practices and/or liquidation preferences with respect to those who are policyholders at the time of conversion? Some state statutes provide that a mutual insurer may convert into a stock company pursuant to any one of several plans specified in the statute or pursuant to another plan which is fair and equitable to the mutual policyholders and is approved by the commissioner. Several of the specified plans require the resulting stock company to operate the mutual’s policies and contracts in force on the effective date of the conversion as a closed block of business for dividend purposes only. Several of the specified plans also require the establishment by the resulting stock insurer of an account providing a preference in liquidation to persons who were policyholders of the mutual at the time of conversion.

In addition to considerations directly pertaining to the distribution of surplus to policyholders of the mutual insurer, several state conversion laws include provisions imposing limitations on management and other insiders to avoid unjust enrichment at the expense of the mutual policyholders. For example, some statutes provide that the commissioner shall not approve a conversion plan which seeks to reduce, limit, or affect the number or identity of the insurer’s members entitled to participate or to give members of management any unfair advantage. Even in states without such explicit statutory provisions, presumably the commissioner would reject a plan in which management appears to take such actions. Furthermore, many statutes provide that the mutual’s directors, officers, agents, and employees may not receive any consideration, other than their regular salaries and compensation, for aiding the proposed conversion except for that provided in the merger plan.

Policyholder Approval. The third approval process, which must be successfully traversed in order to effectuate a conversion, involves the policyholders of the mutual insurer. Conversion statutes generally require a meeting of mutual policyholders be held at which policyholders can vote to either approve or disapprove the merger plan. Commonly, but not always, statutes provide for reasonable and timely notice of the meeting.

Most statutes which address the issue as to which policyholders are eligible to vote specify either current policyholders or establish policyholders as of a certain record date. However, most statutes do not specify the date by which a policyholder must be a member to be eligible to vote. But as a practical matter, the process of soliciting proxies compels the insurer to establish a record date.

Although most state statutes provide that each eligible policyholder is entitled to one vote regardless of the amount of insurance he or she owns, some states may limit eligible voters, for example, to those with policies having face amounts of $1,000 or more and/or having been in force for at least a year. Also some states may accord policyholders with voting power relative to the amount of insurance the policyholder possesses with the mutual. Most state statutes expressly authorize proxy voting and some states authorize vote by mail.

Before voting, policyholders are provided with a comprehensive set of materials describing the conversion plan, including what will be received in exchange for surrendering his or her membership rights. Most states require a supermajority affirmative vote, usually by two-thirds of the policyholders who are both eligible to vote and actually do vote on the conversion plan. A few states require only a majority vote or do not specify the amount needed. Once all the approvals are obtained, the conversion can be effectuated.

If a state neither expressly prohibits conversion nor has a statute expressly authorizing such conversion, a second possible (albeit risky) approach to pure conversion is a common law conversion. That is, a mutual insurer converts to a stock company by simply amending its articles of incorporation. However, there is considerable general and some insurance case law pertaining to corporate mergers and consolidations holding 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 if they are to be challenged by the insurance commissioner or, even if approved by the commissioner, by disgruntled policyholders.

In addition to either conversion pursuant to a conversion statute or under the common law, a third approach to conversion may also be available to some mutual companies. In those states where a mutual company is established under a special charter or legislative enactment, it may be possible to achieve a conversion through a statutory amendment of its charter.

Demutualization by Merger. In states which either expressly prohibit a pure conversion of a mutual insurer to a stock company or have not enacted an express pure conversion authorization statute, the option(s) of a merger and/or bulk reinsurance may be available as a means to demutualize. The former is discussed here, and the latter in the immediately following subsection.

To effectuate demutualization through a statutory merger, the mutual insurer organizes or purchases a stock subsidiary company and then merges into the stock company, with the stock company being the survivor. The mutual company then ceases to exist. The surviving stock company issues stock and/or distributes cash or other assets to the mutual insurer’s policyholders in payment for their equity or ownership interests in the mutual.

As is true with respect to pure or direct conversions, demutualization by means of a merger must also go through three approval processes: approval by the board of directors of the merging companies, approval by the insurance regulator, and approval by the policyholders of the mutual insurer and the stockholders of the stock company.

State statutes generally require that the mutual-to-stock conversion process be initiated by resolutions approved by majorities of the board of directors of each of the merging companies.

All statutes permitting a stock-mutual merger require the merger plan to be filed with the insurance commissioner and condition the effectuation of the merger upon the commissioner’s approval. Although some state statutes do not require a hearing on the merger, many do and others leave the matter to commissioner discretion. Most of the merger statutes set forth general standards to be applied to the merger by the commissioner. Although varying somewhat from state to state, commissioner approval of the merger is typically conditioned upon satisfying one or more of the following standards: (1) equitable to owners of the merging companies, (2) does not lessen the protection and service currently provided to the merging companies’ policyholders, (3) serves the interest of the general public, and (4) complies with all applicable state laws. While merger statutes typically do not contain substantive requirements as to the content of the merger plan (in sharp contrast to many of the conversion statutes), where the merger is being used to result in a conversion from a mutual to a stock company, the commissioner will expect the merger to be no less equitable to policyholder service and protection as that accorded under a conversion statute.

Most state statutes permitting a demutualization merger also condition the merger upon approval by the owners of the merging companies. Typically, statutes require that the notice of the meeting must be reasonable and must be approved by the commissioner. Such notice should include relatively extensive information and materials including a copy of the plan of merger and a discussion of the reasons for the likely effects of the merger. Merger statutes commonly authorize the policyholders of the mutual insurer and the stockholders of the stock company to vote on whether to approve the proposed merger. States vary as to whether each policyholder has only one vote vis-à-vis some other allocation of voting power as between policyholders (for example, one vote for each $500 of insurance held). Most statutes expressly contemplate the use of proxies or mail ballots and none prohibit their use. Also, most states require an affirmative vote of two-thirds of the policyholders and stockholders of the votes cast.

And finally, most state merger statutes prohibit management compensation in a manner comparable to the conversion statutes discussed above. Furthermore, the surviving company becomes vested by operation of law with all the rights, assets, duties, and liabilities of the nonsurviving company.

Demutualization by Bulk Reinsurance. The third approach to demutualization involves bulk reinsurance of the mutual insurer’s business with a stock company. Such a transaction might proceed in accord with the following pattern. The mutual acquires or establishes a stock subsidiary. The mutual then reinsures all of its business in force with the stock subsidiary and transfers all of its assets and liabilities thereto. In exchange the stock subsidiary issues shares of its stock for distribution to the mutual company’s policyholders. Then, the mutual insurer is dissolved. A possible alternative may involve an outside company seeking to acquire the mutual. This company could establish or acquire a stock insurer subsidiary with which the mutual could reinsure its business and to which the assets and liabilities would be transferred in exchange for cash. The mutual could then distribute the cash to its policyholders in liquidation. Under this scenario, ownership of the new stock insurer would be in the control of an upstream holding company rather than the mutual insurer’s former policyholders.

Most, but not all, states authorize bulk reinsurance of life insurance as between mutual and stock insurers. While states generally do not expressly require that the boards of directors adopt resolutions as to such reinsurance, normally board approval would be the appropriate action in entering into an agreement for bulk reinsurance and the transfer of assets. All states do require that companies develop a plan relating to the reinsurance of the ceding insurer’s business in force. As is the case with the pure conversion and merger approaches to demutualization, key issues in the bulk reinsurance demutualization process include how much in the aggregate should be distributed to the policyholders, which policyholders should receive the distribution, how much should be distributed to each policyholder, and what types of assets can be distributed.

Most states require the approval by the commissioner before a bulk reinsurance demutualization plan can be effectuated. Whether or not the approval is required, the commissioner possesses the authority to examine the insurer and hold hearings on the proposed transaction. Most statutes provide that the commissioner may not approve the reinsurance agreement if it is found to be unfair or inequitable to the mutual’s policyholders and/or the agreement would substantially reduce the protection or service currently provided to the holders of the policies being reinsured. The generality of such standards affords the commissioner considerable discretion in approving a bulk reinsurance plan. Some statutes impose additional standards, such as that disapproval is required if the agreement would tend to materially lessen competition in the insurance business in the state or the agreement may not be approved unless the stock insurer is solvent and can lawfully engage in the type of insurance that is to be reinsured.

In addition to board approval and regulatory approval, most bulk reinsurance statutes condition the effectuation of the reinsurance agreement on approval by the mutual’s policyholders. While the majority of such statutes contemplate that each policyholder’s vote counts equal with that of other policyholders, a few provide for unequal voting rights. Furthermore, most states require an affirmative vote of two-thirds of the votes cast on the reinsurance plan.

In addition, several statutes subject any management compensation in connection with the bulk reinsurance transaction to commissioner approval. A few states afford rights to policyholders who oppose the reinsurance agreement.

Finally, unlike the other approaches to demutualization, in the bulk reinsurance situation, the process must be integrated with the requirements of the state’s liquidation law and with court orders made pursuant thereto. This arises from the fact that the mutual will be distributing stock and/or cash in a voluntary liquidation.

In short, 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 organized or acquired by the mutual company. After the transaction, the mutual insurer is dissolved. To effectuate a bulk reinsurance demutualization, the transaction must be approved by the commissioner and, in some states, by the mutual policyholders. Management will need to demonstrate that the terms of the proposed transaction are fair and equitable to the policyholders. 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 policyholders are fairly treated.

Licensing/Readmission Problems. If the demutualization is effectuated by means of 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 achieved in advance of the actual demutualization, the new insurer might find itself unable to do business in many states for some time.

Furthermore, many states impose a seasoning requirement on insurers applying for admission to do business in the state, that is, such an insurer 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 the seasoning period runs. (However, some states waive the seasoning requirement in the demutualization situation.) Also, some states take the position that 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 review the 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. The now-converted stock company theoretically is not a new, separate entity. One court held that the mere amendment of articles of incorporation does not create a new company. However, there is no guarantee that this conclusion will be accepted by a particular state in which the surviving stock insurer seeks to do business.

Comparison of the Alternative Approaches to Demutualization. If a state has a conversion statute, most insurers seeking to demutualize are more likely to convert rather than pursue the merger or bulk reinsurance alternative. First, under a conversion statute, the mutual insurer is immediately transformed into a stock company with no loss of corporate identity or continuity. In contrast, a demutualization by merger or bulk reinsurance usually results in a different corporate entity which could require relicensing in a number of (if not all) states in which the mutual had done business. Second, a demutualization effectuated through a merger or bulk reinsurance arrangement may be more vulnerable to challenge by dissatisfied mutual policyholders. Finally, since approval by the commissioner is required regardless of the approach selected and since the commissioner is most likely to apply the same standards and requirements as set forth in the conversion statute to a merger or bulk reinsurance demutualization anyway, as a general proposition the mutual insurer is most likely to opt for the conversion approach if it is available in the state of domicile.

Federal securities laws impose both registration and reporting requirements on securities that are to be sold to or traded by the public. Since one objective of a demutualization is to replace the policyholder’s equity in the mutual insurer with publicly sold and traded securities, the demutualization process by its very nature may be subject to the federal securities laws.

The stock of the demutualizing insurer or its holding company that is issued to policyholders constitutes a security within the meaning of the Securities Act of 1933. The issuance of such stock constitutes a sale for the purposes of the Act when undertaken pursuant to a policyholder vote or consent. As a consequence, barring some exemption, such stock must be registered with the Securities and Exchange Commission.

The exemption commonly relied upon in demutualizations is Sec. 3(a)(10) which, in the demutualization situation, requires that (1) the issued stock not be bought entirely with cash but rather be exchanged in whole or in part for outstanding securities, claims or property interests, (2) there be a fairness hearing by the state insurance commissioner, (3) all policyholders be entitled to appear at the hearing, and (4) the commissioner determine that the terms and conditions are fair. If this exemption applies, no registration of securities under the 1933 Act is required. Furthermore, such stock would be freely transferable without compliance with Rule 144 under the 1933 Act, which, among other things, establishes limits on the resale of certain securities issued without registration.

Under the Securities Exchange Act of 1934, stock held by the public must be registered in accordance with the provisions of that Act if such stock is listed for trading on a national exchange. Furthermore, if either a demutualized insurer or its holding company is of even moderate size and its stock is relatively widely held (which is most likely the case when distributed directly to the policyholders), it is quite probable that such stock must be registered under the 1934 Act in the absence of an exemption even if it is traded in the over-the-counter market rather than in an exchange market. Although such an exemption would ordinarily be available to the stock of an insurer, such is not the case with respect to the stock of its parent holding company, if any. And it should be noted that most of the provisions of the 1934 Act establishing reporting and other requirements with respect to tender offers (that is, the Williams Act) would be applicable with respect to the stock of an insurer whether such stock was registered or was exempt from registration.

In short, generally speaking, conversion from a stock to a mutual insurer is no longer in vogue. Contrastingly, in recent years, for any one or a combination of several reasons (some valid business reasons, some designed primarily to benefit the management of the insurer), the pattern has shifted to increasing interest in and actual efforts to demutualize. Although state insurance regulatory responses to abuses have been quite varied, they have also been quite real as the regulators seek to safeguard the interest of the mutual insurer’s policyholders while, at the same time, enabling management to function flexibly and effectively in a rapidly changing competitive environment.