Mutual Companies: Mutual Friends Or Harbingers Of Hard Times?

But not so fast, contend the proponents of the mutual structure. Isn't insurance a long-term business? Witness the ravages of asbestos litigation on policies written decades ago, or the ongoing crisis over workers' compensation insurance.

Without shareholders hanging on every earnings statement or stock analysts looking over their shoulders, companies owned by policyholders can adopt the long-term perspective that insurance requires. They can price near breakeven, giving the policyholder a better insurance deal, and sit comfortably on a cushion of carefully invested capital to insulate themselves from adverse claims trends.

Stock ownership, on the other hand, can place undue emphasis on opportunism, leading to irresponsible underwriting and lightweight reserves.

One of the strongest examples to support pro-mutuals thinking is the State Farm group in Bloomington, Ill., which entered 2000 with such robust capitalization that it could weather underwriting losses of $9 billion in 2001 and $6 billion in 2002 yet still emerge with a very strong capital position. It could also buy the time needed to remedy inadequate pricing, tighten policy conditions and achieve far better operating results by 2003.

Nor does the accusation of inefficiency hold true in the case of San Antonio, Texas-based USAA Group. It is one of the largest personal lines insurers in the United States, which achieves an expense ratio around 15 percent, compared with the prevailing 25 percent of peer companies. And USAA is on course for a combined ratio of around 90 percent for 2003.

Although a reciprocal company (in which each policyholder is both an insurer and an insured), it exemplifies the key advantages of a mutual, with high-quality customer service, 96 percent persistency and an unmatched brand identity.

Kemper's problems, meanwhile, had little to do with the company's structure, but with poor underwriting–an infirmity to which stock companies are by no means immune. Kemper, based in Long Grove, Ill., would certainly have been able to raise new capital more freely as a stock company, but the likely outcome would have been to defer its demise.

Access to outside capital is another major element in the case made against mutuals. Their only mechanism for raising capital is to issue surplus notes, which are deeply subordinated to the insurer's other obligations.

Moreover, because insurance commissioners have the authority to step in and deny payments on them, surplus notes require a higher interest rate to compensate investors for this inherent uncertainty. Nevertheless, policyholders may find considerable comfort in the tendency of mutuals to carry less debt than stock-owned companies.

The difficulties involved in making acquisitions are also often cited by the anti-mutuals camp. Without shares to use as currency, mutuals must pay cash to buy another company. Here again, though, given the number of misguided and overpriced acquisitions in the U.S. p-c market in recent memory, policyholders may prefer their insurers to maintain a consistent identity and not waste precious resources on ventures into unknown territory. Instead, they are likely to prefer cooperative affiliations between mutuals.

Perhaps the most potent protest against mutuals is that they tend not to trim their underwriting activity sufficiently in soft markets. Their original raison d'?tre was to provide capacity to markets that had too little. But when prices softened, they often tried to maintain market share while being slow to recognize claims trends turning against them.

Mutuals could also find themselves unduly exposed from concentration in one business line or in one geographical area while sticking to a very limited mandate. Nowhere is this criticism truer than in medical malpractice coverage, which is heavily populated by companies originally formed by physicians to share their risks when insurance was not available commercially. In the year to June 2003, Standard & Poor's downgraded nine monoline insurers in that business.

In an effort to capture the best of both the mutual and stock worlds, some companies have resorted to a mutual holding structure–in other words, a mutual company that owns stock companies. But the benefits are questionable. Under such an arrangement, the holding company can sell up to 49 percent of its ownership in the stock companies to investors.

This means stockholders are always a minority interest, and there is no chance share prices will be boosted by takeover prospects. Investor interest in such stocks is therefore diminished.

From a ratings perspective, Standard & Poor's wields no prejudice as to whether a mutual- or stock-ownership arrangement is preferable. All other things being equal, a mutual will require relatively more capital to achieve the same ratings footing, given its capital constraints. But, on the other hand, a mutual may be allowed more wiggle room on earnings, as long as those earnings are strong enough to muster sufficient capital growth.

John Iten is a director at Standard & Poor's Ratings Services in New York. Robert Partridge is managing director at Standard & Poor's Ratings Services.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, July 21, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.