Copyright 2011, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Insurance Regulatory and M&A, February 2011
One of Canada's largest property and casualty (P&C) insurance companies, The Economical Mutual Insurance Company, recently announced its intention to demutualize. While a number of life insurance companies (lifecos) have demutualized in the last 20 years in Canada, the demutualization of Economical would be the first modern demutualization of a domestic property and casualty insurer.
Demutualization can offer a number of advantages and benefits to a converted company, especially in a highly fragmented sector like the P&C sector, which industry observers are expecting will experience consolidation. However, while a uniform regime has been established for the demutualization of small and large-cap lifecos, a specific regulatory framework for the demutualization of P&C companies has yet to be introduced. In this bulletin, we provide an overview of the federal demutualization process in Canada and discuss several key topics that will be of interest to a P&C company that is considering converting or to potential acquirors of a mutual P&C company, including the advantages of demutualization, structuring considerations, the current regulatory landscape and policyholder voting and benefit entitlements.
Pursuant to a demutualization, an insurance company owned by its policyholders is converted into a stock company, with the equity in the converted company held by one or more shareholders. As part of the demutualization, eligible policyholders receive benefits in the form of equity or cash or a combination of both. The rights of policyholders as policyholders (i.e., policy values, premiums, coverage and policy dividends) remain unchanged. A highly regulated process, demutualization requires both the approval of at least two-thirds of the eligible policyholders, as well as the approval of the Minister of Finance.
ADVANTAGES OF DEMUTUALIZATION
The strategic advantages of demutualization can include:
- accessing additional capital in different forms and with a greater range of cost alternatives;
- converting to a more flexible corporate structure which could facilitate major acquisitions and business combinations for the converted company, either as an acquiror or a target;
- converting to a holding company structure which would allow the demutualized company to carry on certain activities through unregulated affiliates, which activities could not be carried on by the pre-conversion mutual company, either directly or through directly-held subsidiaries; and
- allowing for stock option plans and other resultsoriented incentive compensation for employees.
From the perspective of eligible policyholders, demutualization unlocks the value of the business for the policyholders and typically entitles them to equity in a more nimble industry operator with greater growth potential.
There are two typical types of demutualization structures. First, a company can convert into a widely held stock company, with the shares of the company traded on a stock exchange post‑conversion. This could occur contemporaneously with an initial public offering (IPO). A variation of this structure involves the establishment of a holding company, which would, on completion of the demutualization, hold all of the shares of the converted company. Eligible policyholders would be entitled to shares in the holding company instead of in the converted company.
The second common type of structure is what is called a sponsored demutualization, whereby a thirdparty acquiror funds the demutualization and acquires a control position in the demutualized company. Unity Life was the first Canadian insurance company in recent times to convert by way of a sponsored demutualization, which was completed in April 2008.
In addition to determining the most appropriate structure for the demutualization, a mutual company intent on converting will also want to carefully consider the following:
- the size of par policyholder surplus post-transaction;
- the division of assets between the par fund and the shareholder fund;
- the future expense allocation methodology between the par fund and the shareholder fund; and
- the converted company's par dividend policy.
REGULATORY PROCESS AND CONSIDERATIONS
Pursuant to the Insurance Companies Act (the Act), demutualization requires the approval of the Minister of Finance (Canada). In order to obtain such an approval, a mutual company is required to submit a conversion proposal to the Office of the Superintendent of Financial Institutions Canada (OSFI) and, if acceptable, OSFI will recommend that the Minister approve it. Once approved by the Minister, the Minister will issue letters patent of conversion to effect the conversion proposal. Prior to the submission of the conversion proposal and any request for approval, the directors of the mutual company are required to call a special meeting of eligible policyholders (as defined in the applicable Regulations) to obtain the approval of such policyholders of the conversion proposal.
The Act contemplates that Regulations will contain specific requirements with respect to the demutualization and the application process. Currently, however, only Regulations with respect to the conversion of lifecos have been enacted, including the Mutual Company (Life Insurance) Conversion Regulations (the Lifeco Conversion Regulations), which were published more than 10 years ago. At this time, there are no Regulations that are directly applicable to the demutualization of P&C companies. Clearly, though, any Regulations that are being or that will be developed with respect to P&C companies (and new Regulations will be required in connection with the proposed demutualization of Economical) will establish a similar framework to that employed for lifecos and should require the submission of similar information, tailored as appropriate to the P&C sector.
In addition to providing for a definition of "eligible policyholders", the Lifeco Conversion Regulations set out requirements for the calculation of the value of the converting company and rules for the selection of an eligibility date. These Regulations also itemize in detail the components of an applicant's conversion proposal, the materials to be submitted to OSFI in addition to the conversion proposal, such as certain expert opinions, and the contents of the notice of the special meeting to be mailed to eligible policyholders. OSFI has supplemented the Regulations with some guidance notes relating to the expert opinions and reports to be included in the applicant's conversion proposal and the financial statements to be included in the notice to policyholders. OSFI has not, at this time, published any guidance, general or otherwise, with respect to the demutualization of P&C companies.
In the absence of Regulations and related OSFI guidance governing P&C companies, any P&C company seeking approval to demutualize will have to work closely with OSFI to determine the exact steps to be followed and information to be provided to OSFI and to policyholders, eligible or otherwise. According to the press release issued by Economical, it has had, and is continuing, consultations with OSFI and will enter into consultations with the Department of Finance to identify the "most effective route to demutualization".
Other regulatory considerations will apply to P&C companies seeking to demutualize. If the demutualization is sponsored, additional approvals will be required under the Act in connection with any post-conversion (or contemporaneous) acquisition of control of a demutualized company. Similarly, required approvals under the Competition Act will also have to be considered. If the converting company has operations outside Canada, regulatory requirements in foreign jurisdictions with respect to the completion of the conversion may also apply. Further, where the demutualization involves an IPO, the demutualizing company will have to comply with applicable provincial securities laws and potentially the securities laws of foreign jurisdictions where eligible policyholders may reside.
The demutualization approval process can take several months from the date that the mutual company submits its application to OSFI and, depending on the complexity of the conversion proposal, could take up to 12 months or longer to complete. The key steps include preparing the application materials, co‑ordinating the expert opinions required to be submitted as part of the application, responding to OSFI's questions, updating address information for eligible policyholders, preparing the mail‑out to eligible policyholders, dealing with policyholder queries and concerns and holding the annual meeting.
As noted above, where the demutualization involves a change of control, submissions under the Competition Act and dealings with the Competition Commissioner will also have to be factored into timing. Developing a strategy for an IPO, if applicable, also typically requires a significant amount of time and resources.
The Act provides that any conversion proposal must be submitted to a meeting of eligible policyholders. The term "eligible policyholder" is defined in the Regulations, not the Act, and in respect of the demutualization of a lifeco, "eligible policyholder" is essentially a holder of a voting policy as of a date specified by the company in accordance with the Lifeco Conversion Regulations. If Regulations are introduced for the demutualization of P&C companies, the same definition may be adopted, although the Department of Finance has previously proposed that, subject to certain exclusions (e.g., short duration policies), the right to vote be extended to all policyholders of mutual P&C companies.
The rationale given for this proposal was that some mutual P&C companies have a small number of voting policyholders and this narrow voting base could ultimately have a negative impact on governance matters.
In some other jurisdictions that provide for the demutualization of P&C companies, the definition of eligible policyholders includes all individuals who held policies at any time during a prescribed period prior to the demutualization, which in some cases can be as long as three years.
In general, with respect to voting policyholders, each policyholder who holds one or more policies that entitle that policyholder to vote is entitled to a single vote regardless of the number of policies held. Further, each voting policyholder ranks equally with each other voting policyholder. For example, each voting policyholder will cast a single vote in a single pool of votes for the election of directors. However, there are several exceptions to this general concept, including where the result of a vote could affect one class of voting policyholders differently.
A mutual company can take steps to increase or decrease the number of voting policyholders. For example, the bylaws of a company can be amended to remove a voting right that had been granted by bylaw. Any amendments to bylaws would of course require a policyholder vote. Additional methods to remove a voting right would be available where the consent of the particular policyholder was obtained. The terms of a policy could be amended to remove a voting right (for policies other than participating policies) or to remove the right to participate in profits from a participating policy. Whether or not the policy could be amended unilaterally would have to be considered. Similarly, a company could also grant a voting right by amending its bylaws or by amending a policy.
ALLOCATION OF DEMUTUALIZATION BENEFITS
With respect to the benefits to be distributed to eligible policyholders, policyholders can receive equity in the demutualized company, or its holding company, cash or a combination of equity and cash. In addition, the demutualizing company could also offer benefits such as policy enhancements and premium reductions. OSFI will consider and approve the demutualization entitlements that a mutual company proposes to provide to eligible policyholders as set out in the applicant's conversion proposal. As is the case with mutual lifecos, it is expected that a mutal P&C company will be required to submit an opinion from a valuation expert that benefits provided are appropriate substitutes for mutual ownership rights.
OSFI's application process for lifecos also requires that, as part of the application process, an applicant must submit a description of the measures to be taken by the demutualizing company in the two years following the demutualization, to ensure that eligible policyholders who receive equity will be able to sell those shares on a public market. Further, an opinion from a financial market expert must also be submitted stating that the measures are adequate. Satisfying this requirement may present challenges in this era of market uncertainty.
The Act itself does not prescribe to whom benefits must be paid in connection with a conversion. Requirements with respect to benefits are set out in the applicable Regulations and, in the case of the conversion of lifecos, the Lifeco Conversion Regulations provide that all benefits in respect of a demutualization must be allocated to eligible policyholders, who, as noted above, must hold policies entitling them to vote. In fact, the conversion proposal has to include a statement to this effect. Further, the Lifeco Conversion Regulations require that all or most of the benefits must be provided to policyholders who are entitled to participate in profit distributions.
In the Canadian lifeco demutualizations, demutualization entitlements were determined by a methodology, approved by an independent actuary and OSFI, that took into account attributes such as policy longevity and surrender value. Clearly, a somewhat different approach will be required for mutual P&C companies, and we expect that considerable effort is currently being invested in establishing an appropriate approach for Economical. In some other jurisdictions, P&C demutualization benefits are tied to the aggregate premiums paid by a policyholder over a defined period, which is three years in certain cases.
The Act also contemplates restrictions to be set out in the Regulations restricting the payment of demutualization benefits to directors, officers and employees of the demutualizing company (except in their capacity as eligible policyholders). The Lifeco Conversion Regulations strictly prohibit any such payment.
We expect that the framework that will be established for the demutualization of mutual P&Cs will be very similar, in form and process, to the current framework that applies to lifecos. As Economical proceeds with its demutualization plan, OSFI and the Department of Finance will no doubt be publishing guidance that sheds light on their specific expectations with respect to the demutualization of mutual P&C companies. Presumably, Regulations tailored to mutual P&C companies will also be tabled to allow for the demutualization of Economical and other P&C companies. A separate bulletin will be issued and circulated once any new guidance or draft legislation is published.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.