AVOIDING THE OBSTACLES

However, as in the case of every major corporate transaction, there will be issues which may seem subtle when planning for the demutualization.  Chances are these issues may not even be topics of discussion, much less subjects for board consideration.  Because the nature of these matters make some professionals and even management uncomfortable, they usually are avoided.  But the failure to acknowledge and prepare for potential problems could seriously hamper or even jeopardize the transaction.  To avoid these Adeal stoppers@ in the midst of an ongoing demutualization, corporate policymakers should heed the following suggestions.

Before the company hires legions of lawyers and other deal facilitators, and announces the demutualization to the public, a comprehensive financial analysis should be prepared for consideration by the board.  This analysis should take the form of financial statement projections (for the next three to five years) that include highly specific assumptions.  It should illustrate what the demutualized stock company may expect from operations and how the demutualization will affect the company=s financial condition, cash flow and operating ratios.  Prepare the numbers for the Aworst case,@ Amost likely case@ and Aoptimum case@ scenarios.

SURPLUS DISTRIBUTION

When drafting the assumptions, remember to include the effect of the distribution of the company=s surplus.  Most demutualization statutes require this distribution to be made to policyholders, and it typically takes the form of cash and/or securities.  Moreover, some demutualization laws require that the participating business be operated as a closed block for policyholder dividend purposes.  Make sure that the assets to be allocated to these closed blocks, together with projected revenue, are sufficient to support the business -including provisions for payments of claims, expenses and taxes -and that they provide for the continuation of current dividend scales.

This exercise also will help the company gain an idea of the magnitude of the effort that will be involved in converting its financial information from statutory accounting principles to generally accepted accounting principles.  Since all public stock companies report results on a GAAP basis, these projections must be done based on GAAP and should include a SAP comparison.  Accounting experts have indicated that this SAP to GAAP transformation may be relatively simple for property/casualty companies, but could entail a major expenditure of time and money for larger life insurers.  Thus the sooner these projections are prepared in the demutualization consideration process the better, as they will aid in uncovering any number of previously undiscerned problems that might arise later in, for example, the preparation of the securities offering documents.

A further suggested course of action is to collect the recent public securities offering materials of the insurers that have already converted to stock form and note the financial and other disclosure that is now being required of them (either formally or informally) by the SEC.  Once the GAAP numbers are produced, the company should then prepare the more important disclosure tables.  Compare the company=s GAAP results and ratios against industry averages; find out where your company stands vis-à-vis its stock form competitors.  Then speak to industry analysts to determine how they view and price the companies that they follow.  Property/casualty insurers should pay particular attention to disclosures concerning unpaid claims and claim adjustment expenses.

As an appendix of this review, formulate an analysis of the federal and state income tax consequences of demutualization.  The change from mutual to stock form may be structured as a tax-free reorganization or recapitalization or as a taxable sale of assets.  The IRS will provide a private letter revenue ruling based upon the particular facts of the subject demutualization.

The best advice in following this recommended course of action is to remain objective and allow the numbers to speak for themselves.  If the projections do not make economic sense, proceed cautiously and try to find a better solution.  If, however, the numbers reflect a cash infusion, capital enhancement and a profitable deployment of proceeds, it may indeed be time to Ago stock@.

A COSTLY PROCESS

It also is important to realize that demutualization is expensive and may end up being significantly more costly than original projections indicate.  Corporate boards do not like to hear this, and advisers do not like to admit it.

There are a number of reasons for the high cost of demutualization.  First, it is a relatively new process in a number of jurisdictions, and there is an accompanying learning curve that must be mastered by the state insurance offices and by the company itself.  In addition, demutualization is an extraordinary corporate transaction in which extraordinarily complex legal, accounting, actuarial and valuation issues may arise.  That, in turn, calls for the engagement of professionals who possess the knowledge and expertise to assist you.  These professionals usually limit their practices to certain specific areas which encompass stock conversion, and as with experts in the medical profession, they may be relatively pricey.

Finally, a demutualization is time-consuming.  A good rule of thumb is that it will take about 12 months to demutualize.  (Some firms may take longer to do this while some may take less time.)  Obviously, the combination of an uncertain regulatory process, new and/or complicated issues, time-based fee professionals and a lengthy approval process will make for a costly transaction.  One way to view this is to compare the demutualization to a complicated merger.

One of the difficulties in planning for demutualization is projecting the expenses related to the transaction.  The professionals and the service providers (printers, demutualization agents, public relations firms, and so on) will be happy to give your company a quote or an estimate of their total bill.  How reliable will that quote be? If the assumptions are spelled out in detail and appear reasonable, it will probably be credible but it may be nowhere near the magnitude of the final bill.  Why not? Because demutualization is a lengthy, uncertain process with new and complex issues.

For example, the company may not have expected to endure two hearings (if, for example, another state=s insurance commission rightly or wrongly decides that this is necessary to satisfy its statutory requirements), or three rounds of comments from the SEC or the requirement to pay for the state=s experts.  Such expenses can be controlled in a number of ways, including the following:

(1)  Do some comparison shopping and ask for a fee cap.  Make sure that all quotes are based on substantially similar assumptions.  It is the company=s job to communicate these assumptions to the service providers.  The insurer may not, in all instances, however, be able to obtain fee caps due to the nature of the demutualization process discussed above.

(2)  Take the advice of your professionals.  For example, let your lawyers decide when its is appropriated to ask for a printer=s proof.  One of the fastest ways to run up a printing bill is to go to a proof too soon and then end up making numerous Aauthor=s alternations.@  These bills are not the printers= fault, since he or she is merely accommodating the client=s wishes.  Moreover, some alternation obviously will be necessary when, for example, changes in the documents must be made in response to regulatory agency comments.

(3)  Set the ground rules early.  Most of the firms assisting you will require reimbursement for out-of-pocket costs.  These expenses include airfare, hotels, meals, ground transportation, and so on.  If these costs are controlled within your organization, they should be similarly controlled in your arrangements with your independent contractors.  A requirement that these expenses be reasonable and documented  should be sufficient.  By obtaining reasonably detailed estimates and undertaking certain expense control measures, the insurer should thus be able to avoid a large measure of Apost-deal sticker stock.@

THE REGULATORY ATTITUDE

Many insurers pride themselves on their close, congenial working relationship with their stateinsurance department, and a relationship generally founded on the basis of mutual trust and respect is both commendable and desirable.  Do not, however, expect to be able to Atrade@ on this relationship while undergoing the demutualization process.  State insurance departments have historically been helpful and even facilitative in the industry=s demutualizations.  However, they take their statutory mandate very seriously and will act in a professional manner that some insurers may characterized as Acold@ or Abureaucratic@.  This attitude may appear entirely different than the one experienced prior to beginning the demutualization process.

The insurer should not be offended by this, nor should it assume a defensive posture.  Understand that in many cases the state insurance department will find that the insurer=s plan of demutualization is Afair and equitable to policyholders,@ and this determination will ultimately permit the demutualization to move forward and may serve to shift potential liability away from the insurer.  Therefore it is the task of the insurer to make certain that the state insurance department fully and fairly undertakes its task and makes the appropriate findings.  Note that when the state insurance department holds a hearing on the fairness issue, the hearing also may be used as the basis for an exemption from the registration requirements of the Securities Act of 1933.

Here are some suggestions with respect to the insurer=s interaction with the state insurance department during the demutualization process.

$                   Stay in touch.  Meet early and often with the regulator so that he or she knows what the company is doing, how the goal is to be accomplished and the reasons for the demutualization.

$                   Be prepared.  Do not expect the insurance department to do your work; do not schedule meetings when there is no subject of substance to be discussed.  Put forth considered proposals and seek the regulators= concurrence (or non-objection).

$                   Try to implement a procedure which keeps regulators in other states apprised of your progress and of any issues that might affect the policyholders in their jurisdictions.

$                   Be sensitive to the regulator=s role.  Avoid actions that might appear to compromise the department=s appearance of impartiality.  Do not attempt to engage in ex parte  discussions during the hearing phase of the transaction.

$                   Do not ask persons holding political office to intervene on the company=s behalf, even if there may be a legitimate constituency concern.  Regulators have always been sensitive so this approach and are even more so in light of the recent Keating hearings.

$                   Make the job as easy as possible for the department.  State regulators generally have tight budgets.  With that in mind, make sure the agency receives sufficient courtesy copies of filings, supply relevant information again even if it may already be in the regulator=s files and, with the agency=s permission, provide the regulator with drafts of prepared forms, such as notices and orders, that it must issue during the process.

The insurer doesn=t need a Afriend@ at the state insurance department as long as it acts legally, ethically and professionally.  Abiding by these suggestions will help to achieve that goal.

PLANS AND PREPARATIONS

In the final analysis, the company must be prepared for the unexpected.  While this sounds like a contradiction in terms, the insurer can prepare itself for some of the twists and turns on the road to demutualization by proper planning and by laying the appropriate groundwork before starting the wheels in motion.  Here are a few suggestions, taken from the experiences of other companies, that may be of some help.

First, survey the company=s constituencies and determine their reaction to the proposed demutualization.  How will the stock conversion sit with policyholders, employees and creditors? Is the reaction neutral to positive? Or will one group sue to enjoin the demutualization as the agents did in the Union Mutual transaction?

Next, build in safeguards to protect the plan from legal or ethical attack.  If some directors or officers may be offered something in the transaction that others will not receive, make certain that the company=s interest is separately represented, that the negotiations are carried out on an arm=s-length basis and that these Aprerogatives@ are adequately disclosed to policyholders, potential investors and the state insurance department.

Finally, keep the investors informed.  Because the demutualization process is lengthy, it may become difficult to maintain investor interest as the transaction progresses.  Obviously a binding contract helps, but these types of contracts will generally provide for Aouts@ -provisions to permit investors to abandon the deal due to general economic or market conditions.  (Recently, underwriters have begun to insist on broader Awar-out@ clauses due to the conflict with Iraq.)  Moreover, bull markets have been known to fizzle suddenly, causing investors to become less passionate about stocks in general and new issues in particular.

A well-orchestrated investor relations program will help keep the deal moving over the inevitable rough spots.  This program must be coordinated both through counsel and the investment advisers.  Although such handholding is time-consuming, it may well ensure the success of the demutualization in the long run.