Swimming Downstream: How a Regional Insurer Buys Others Through Demutualization

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

Donegal Group Inc., a Marietta, Pa.-based regional insurance holding company that owns Donegal Mutual and several other subsidiaries writing property and casualty insurance has been using its own experience in forming a downstream holding company as a manual to gobbling 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 created an agreement under which their premiums, losses and expenses are pooled and each company is allocated a given percentage of the combined underwriting results. The pooling agreement 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 being limited to whatever its own capital and surplus would permit.

“Since 1986, the inter-company pooling agreement has allowed Donegal Mutual and Atlantic States to fulfill their shared objective of growing their premium and surplus. Donegal Group Inc.’s three public stock offerings have provided capital necessary to support growth in Atlantic States’ share of the pooled business over time, and its stockholders, including Donegal Mutual, have benefited as the pool has grown substantially,” Donald H. Nikolaus, president and CEO, said.

The concept worked so well, Donegal Group decided to see how it might work for other mutuals in need. According to Jeffrey D. Miller, senior vice president and chief financial officer for Donegal, until last year, five of Donegal’s acquisitions have involved demutualizations.

There are drawbacks to 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 … It turned into a lengthy negotiation that lasted over two years,” said Fred Dreher of the law firm Duane Morris LLP. Donegal has relied upon Dreher, one of the most prolific legal engineers of demutualizations for its transactions.

When it’s scouting for new acquisitions, Donegal looks only at independent agency system insurers. This is because Donegal is committed to the independent agency distribution channel. Donegal typically rules out carriers underwriting in areas prone to hurricanes (i.e. Florida or Louisiana) or earthquakes (California). It also tends to avoid carriers domiciled in states where the regulators may be “consumer-oriented to a fault.” Finally, it likes carriers in conservative areas.

According to Dreher, Donegal would consider acquiring stock companies but it has not found any it considers potential targets. “Donegal tries to grow both organically and through acquisition. It does not rule out stock companies but it has found a niche with mutuals,” he said.