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A De-Mutual Understanding, Forged By Duane Morris Partner

By Gina Passarella
December 9, 2008
The Legal Intelligencer

Deal Makers

In the mid-1980s, Duane Morris corporate partner Frederick W. Dreher was working on ways to help a mutual insurance company client raise capital. And with no stock to sell, a downstream holding company was the answer.

When Donegal Mutual Insurance Co. President and Chief Executive Officer Donald H. Nikolaus heard what the company had done, he was interested for himself and called to see who the attorney was that handled the deal.

Dreher has represented Donegal ever since and helped the insurance company create its own downstream holding company, Donegal Group Inc., in 1986.

Since that time, Dreher and Nikolaus have completed six or seven demutualizations as Donegal looks to use the acquisition structure as a way to grow in existing and new markets.

The company basically identifies a mutual, or member-owned, insurance company in a market it wants to enter and then works to create an affiliation. In the meantime, Dreher and his team work with the state's insurance department and the new company to prepare for a demutualization. Donegal pays the members, or policyholders, of the target company for their stake in the mutual company and infuses new capital surplus into what is usually a much smaller insurance company that Donegal would then own.

"It's not a process for the faint of heart," Nikolaus said. "You have to have people that are skilled at doing it legally."

Donegal's latest deal that closed Dec. 1 was with Wisconsin-based Sheboygan Falls Mutual Insurance Company . Even though Donegal has done several demutualization deals in the past, this one proved to have its challenges.

It was the first demutualization Wisconsin had ever seen and the state's demutualization statute, according to Dreher, was not very clear.

As a policyholder in a mutual company, a person has two different interests — that as a covered insured and that as a part owner in the company, he said. There are no rights to possession of that ownership, however, until something like a demutualization occurred, he said.

Under the Wisconsin statute, if a company wanted to go through a demutualization, it had to give the policyholders stock in the new company. Dreher said that didn't work for Donegal because the company didn't want to put money down and not own anything.

He said it took a lot of meetings with the state's Office of the Commissioner of Insurance to come to a mutual (no pun intended) agreement and get the office to see the benefits of policyholders being paid a one-time payment for their ownership in the mutual company.

"That's why the deal took two years," Dreher said.

Nikolaus said the deals require the acquiring company be fair to the policyholders given the heavy involvement by state insurance departments. He said companies have to be very transparent and develop good relationships with these departments.

Nikolaus said Donegal has entered into both demutualization and stock deals but generally focuses on demutualizations. Dreher said that while the deals are tougher to do because of regulatory concerns and a longer lead time, the benefits of demutualizations are often greater than stock deals. He said the deals allow companies to do extended due diligence through the sometimes years-long affiliation as well as help the smaller company become more financially stable before acquiring it onto their balance sheets.

Nikolaus said the company has developed a skill in doing demutualizations and said there are plenty of targets for this type of acquisition given the hundreds of smaller mutual insurance companies across the country.

One of the main ways to stay competitive in the insurance industry, Dreher said, is to be able to offer policyholders individual rates and premiums specific to their needs. That means a lot of needed technology, which he said many of the smaller companies can't always afford. That can make demutualizations an attractive solution, he said.

For Donegal, the process is a plus because it still has a mutual company of its own, Donegal Mutual. That is the company that affiliates with potential acquisition targets. The targets often need an infusion of cash, so Donegal uses its mutual company to help accomplish that goal and then the acquisition is done under the holding company umbrella.

Nikolaus said Donegal plans on continuing its expansion efforts, bad economy or not. He said he would like to think the company is well positioned to weather the financial meltdown. Nikolaus joked that he sees cornfields outside his office window in Marietta, Pa., in Lancaster County, pointing to the conservative nature of the company.

Dreher said this type of economy creates opportunities for conservative companies like Donegal. Many mutual companies that weren't as conservative in the past few years are taking hits on their capital surplus right now and could be in need of a deal like this.

Deal Details

As part of the deal worked out with Wisconsin's insurance commissioner, the department created an independent board to determine the worth of Sheboygan Falls. It valued the company at about $7.2 million.

Donegal paid Sheboygan about $12 million, which included a surplus contribution of $8.5 million to support future growth of the company. Nikolaus said the money was to restore Sheboygan's capital surplus since it would be Sheboygan that would actually pay out the $7.2 million to the shareholders. Dreher said on average the policyholders would get about $300. He said that while it isn't much, it's like found money because many of the policyholders didn't even know they had a stake in the company.

Current policyholders and those who had been policyholders within the last five years will receive a check. The percentage is based on the amount of premiums a policyholder paid over the term of his policy compared to the total amount of premiums paid to the company in a given period of time.

Sheboygan will continue to operate under its existing name, although the term "mutual" will no longer be a part of it.

Most of the work on Duane Morris' end of these deals is done through its corporate department, Dreher said. Some tax work is involved as well as employment issues when Donegal suggests the acquired company change its employee benefits structure.

Anne E. Ross , a partner with Foley & Lardner in Madison, Wis., represented Sheboygan in the deal. She was not immediately available for comment by press time.

This article originally appeared in The Legal Intelligencer and is republished here with permission from law.com.