Swimming Downstream: How a Regional Insurer Buy Others Through Demutualization

Donegal Group’s Strategy Has Helped It Grow From Writing in 1 State to 19 in 20 Years

Even in a good economy, mutual insurers face challenges trying to raise the capital they need to grow since they don’t have any stock to sell. But one insurer has figured out a way to overcome this disadvantage.

Donegal Group Inc. is a Marietta, Pennsylvania-based insurance holding company that owns Donegal Mutual and several other subsidiaries writing property/ casualty in the Mid-Atlantic, Southeastern and Midwestern regions. Donegal executives have been using their own success as a mutual that formed a downstream holding company to gobble up smaller, sometimes troubled regional mutual insurers. The strategy unfolds in two steps: first it affiliates with the targeted mutual; then it begins the process of demutualizing it. The strategy has worked a half dozen times in the past 20 years.

It all began in 1986, when Donegal Mutual saw other mutual companies were forming downstream holding companies. It formed Donegal Group Inc. and completed a stock offering, with Donegal Mutual retaining a majority interest. In the same year, it formed Atlantic States Insurance Co. as a wholly-owned subsidiary. Atlantic States and Donegal Mutual then agreed to pool their premiums, losses and expenses with each company allocated a given percentage of the combined underwriting results. The pooling produces more stable underwriting results for each company and spreads the risk of loss. Each company has at its disposal the capacity of the entire pool, rather than only what its own surplus would permit.

The concept worked so well, Donegal Group decided to see how it might work for other mutuals in need. According to Jeffrey D. Miller, chief financial officer for Donegal, a number of its acquisitions have involved demutualizations: Southern Insurance Co. of Virginia (1988); Pioneer Insurance Co. of Ohio (demutualized in 1993 and subsequently merged into another subsidiary); Delaware Atlantic Insurance Co. (demutualized in 1994 and subsequently merged into another subsidiary); Pioneer Insurance Co. of New York (demutualized in 1998 and subsequently merged into another subsidiary) and Le Mars Insurance Co. (2004).

Now one more can be added to the list. Donegal’s most recent acquisition in Wisconsin provides a glimpse into how the strategy is implemented.

Sheboygan Falls Mutual Insurance was founded in 1899, the same year Donegal was, and has been writing mostly personal lines in Wisconsin since then. In 2007, it wrote direct premium of $9.2 million. While the rural insurer had survived a long time, the board of directors recognized that the company faced problems. Its automation systems were antiquated; it lacked a clear line of succession for senior management, and it was not as efficient as it should be. Worst of all, it lacked access to capital to fix its problems.

The insurer needed help and it just so happened that there was an insurer interested in helping. But in exchange, Sheboygan Falls would have to give up its identity as an insurer owned by its policyholders.

In late 2006, Sheboygan Falls welcomed the offer of a pooling arrangement with Donegal Mutual similar to the one with Atlantic States. This first step buoyed Sheboygan Falls but Donegal made it known that the affiliation would be terminated unless Sheboygan Falls converted from a mutual to a stock company, with all of its stock purchased by Donegal Mutual. An independent appraiser warned that if it lost its affiliation with Donegal this “could reasonably be expected to have significant adverse consequences for the financial health of, and future prospects for, Sheboygan Falls.”

So the process moved forward. Donegal gained control of the insurer on June 7, and also bought a $3.5 million surplus note issued by Sheboygan. In April 2008, the company decided to pursue demutualization.

There were a few obstacles, however. Since it was a mutual, all policyholders would have to be compensated for the sale of the company to Donegal and Wisconsin regulators had never dealt with a demutualization.

The Sheboygan Falls case illustrates one of the drawbacks of the demutualization process— it’s not quick. “For example, in Wisconsin, the insurance department never experienced a demutualization. The statutes weren’t clear and the regulators had a number of questions about what we will do – or not do – for Sheboygan Falls. It turned into a lengthy negotiation that lasted over two years,” recalled Fred Dreher of the Philadelphia-based law firm Duane Morris LLP. For its transactions, Donegal has relied upon Dreher, one of the leading demutualizations lawyers.

Initially, Wisconsin regulators were leery of the transaction but, according to Dreher, they became more comfortable after speaking with other states and coming to understand Donegal’s track record.

Sheboygan Falls was eventually valued at $7.2 million, which translated into about $300 for each policyholder. “It’s not a fortune but it is found money for the insureds,” Dreher said.

On Nov. 11, 2008, Wisconsin Insurance Commissioner Sean Dilweg gave final approval to the conversion. About a month later, Donegal Group Inc. bought all of the capital stock of Sheboygan Falls for about $12 million, a sum that included a surplus contribution of $8.5 million to support the future premium growth of Sheboygan Falls.

In the end, according to Dreher, the demutualization saved a company that may have been headed for conservatorship or liquidation; something no insurance department wanted to face.

When it’s scouting for new acquisitions, Donegal looks only at independent agency system insurers. Dreher says this is because Donegal is committed to the independent agency distribution channel.

Topics Carriers Wisconsin