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This document was prepared by the staff of the Parliamentary Research Branch to provide Canadian Parliamentarians with plain language background and analysis of proposed government legislation. Legislative summaries are not government documents. They have no official legal status and do not constitute legal advice or opinion. Please note, the Legislative Summary describes the bill as of the date shown at the beginning of the document. For the latest published version of the bill, please consult the parliamentary internet site at www.parl.gc.ca.

LS-329E

TABLE OF CONTENTS

BACKGROUND

   A. Life Insurance Companies – Legislative Framework

      1. Mutual Stock Life Insurance Companies: Statutory Considerations

      2. Policyholder and Shareholder Status under The Insurance Company Act

   B. The Quebec Experience

      1. Financing

      2. The Laurentian Mutual Insurance Company

   C. Mutual Insurance Companies outside Canada

BILL C-59

   A. Description

   B. International Considerations

BILL C-59:  AN ACT TO AMEND THE INSURANCE
COMPANIES ACT - THE ISSUES [NOTES]

BACKGROUND

On 1 December 1998, Secretary of State Jim Peterson (International Financial Institutions) tabled Bill C-59, outlining the framework under which large and federally regulated mutual life insurance companies could demutualize, provided their eligible policy holders approved. Demutualization is a process by which mutual insurance companies are converted to public stock companies.

According to its 1997-98 Annual Report, the Office of the Superintendent of Financial Institutions (OSFI) regulates 57 Canadian-owned life insurance companies and 72 foreign-owned life insurance companies. Of the 57 Canadian-owned companies, the following six are mutual insurance companies: Manulife, Sun Life, Canada Life, Mutual Life, Toronto Life and Equitable Life. A mutual life insurance company is a company with no common shareholders and for which all members of the board of directors are elected by the policyholders. A mutual company has no access to common stock.

The provisions of Bill C-59 would be accessible to these six insurance companies but not to the foreign-owned mutuals that operate in Canada, the provincially regulated mutuals, or the mutual property and casualty companies. Procedures for demutualization of this last group are expected some time next year.

Demutualization has been an issue under discussion since the 1992 reform of the legislation respecting federally regulated financial institutions in Canada.

In August 1998, the Department of Finance released a consultation paper entitled Demutualization Regime for Canadian Life Insurance Companies, which identified six proposed elements:

1. Status of policyholders’ benefits and coverage would have to be unchanged after demutualization.

2. The total value of the company would have to be allocated to eligible policyholders, who would be those: (i) who had applied for policies before the company announced its intention to demutualize; or (ii) who held voting policies. There would be procedures enabling those who had let their policies lapse before eligibility day to reinstate those policies.

3. Management would not receive shares or stock options for at least one year after the shares had been listed on a recognized stock exchange in Canada.

4. OSFI would monitor the conversion process, the information to be sent to policyholders, and each step of the demutualization process. Once a demutualization process had been approved by eligible policyholders, the Minister of Finance would have to approve or disapprove of the application for demutualization.

5. No special tax treatment was proposed for the demutualization benefits to be received by policyholders.

6. After demutualization, participating policyholders would retain their rights to vote and make proposals at meetings of policyholders and shareholders of the converted insurance company; participating policyholders would have the statutory right to elect at least one-third of the board of directors of the converted company.

The demutualization process would involve: board authorization, preparation of documentation, OSFI review of documentation and authorization to proceed, the holding of a special meeting to consider demutualization (at least two-thirds of eligible policyholders who cast votes in person or by proxy would have to approve demutualization for it to proceed), and application for ministerial approval.

Critical to the process is the information that would have to be provided to policyholders. Why would it be in their interests to approve? Why would the company want to demutualize? What would be the value of the benefits from demutualization to those policyholders? The company actuary and an independent actuary would be asked to provide an opinion on matters such as the method used to apportion the value of the company and the financial strength and viability of the company after demutualization. Further, an independent valuation expert would be asked for an opinion on the value placed on the company.

Finally a converted company would be authorized to set up a regulated holding company of which the converted company would be a subsidiary, to achieve the same organizational structure options as existing stock insurance companies.

Several stock companies became mutual companies during the 1960s, following amendments to the insurance companies legislation to protect against foreign takeover.* At that time, only two mutual companies held 95% of the total assets of the then seven Canadian mutuals under federal jurisdiction; they were Mutual of Canada (founded as a mutual in 1870) and the North American Life Insurance Company (founded as a stock company in 1881 but mutual since 1931). There were 32 insurance companies under federal jurisdiction at that time.

In 1957, in response to concerns over possible transfers of assets to foreign ownership (section 91, Canadian and British Insurance Companies Act) a new federal Act included a part on mutualization of Canadian stock companies. During the 11 years following, Canada Life, Sun Life, Equitable, Confederation and Manufacturers all mutualized. Proposed amendments to restrict foreign ownership were presented in 1964. Further, in 1973, the Foreign Investment Act included provisions to control foreign ownership.

Access to capital is the major reason for conversion to a stock company. In the United States, many demutualizations were brought on by financial problems. In some cases, it happens that management does not wish to retain the mutual form, preferring forms of compensation comparable to stock option plans in some private companies. The need for regulations can differ depending on the situation of the mutuals and on the reasons for the push to transform. In every case, regulatory measures should be fair and equitable. An evaluation of the situation and ministerial authorization should provide an assurance of democratic conditions for initiating the process.

The business of life insurance companies has changed dramatically over time. The Senate Banking Committee was told by the CEO of Sun Life, that when Sun Life began, 100% of its business was life insurance. In 1962, when Sun Life completed mutualization, the percentage was roughly 50%. Today, "protection," defined as individual and group life insurance and all forms of health and disability insurance, makes up about 13% of the company’s business. The other 87% consists of investment management, retirement savings, mutual funds and various forms of guaranteed accumulations. The main source of a mutual company’s capital is the accumulation of surplus from premiums paid by policyholders. Overall, Canadian companies earn almost a third of their income from premiums paid by insured persons in other countries.

The various Canadian mutual life insurance companies favour different ways of gaining access to capital markets, depending on their competitive position and strategic planning. They can simply demutualize; they can also reorganize and make use of strategic alliances, partnership agreements and mergers. From a global market point of view, companies should have some latitude. In every case, they must respect the legislative and regulatory frameworks of the countries in which they operate. Canadian legislation has provided for mutualization only since the 1960s. The legislation on financial institutions and providing for the first time for conversion of mutual companies came into force on 1 June 1992. The Department of Finance discussion paper of 21 May 1992 was based on this legislation.

Further specific information on the legislative framework applying to life insurance companies is given below. In the conversion of mutual insurance companies, the major topic is the right to the surplus or, more precisely, to the distributable surplus.

   A. Life Insurance Companies – Legislative Framework

      1. Mutual Stock Life Insurance Companies: Statutory Considerations

There is no unique theoretical basis for allocating voting rights in a mutual company and there is some debate about who is entitled to the surplus. Some argue that it belongs to all who ever contributed to it (i.e., all policyholders who ever purchased a policy); others argue that it belongs to participating policyholders only. Others suggest that a cut-off is necessary; that is, the surplus should belong to all current policyholders within a specified period. Others feel the surplus belongs to the "company" and has been generated over its operating history.

For a company with capital problems, right to the surplus is only an academic question. For those with a significant surplus, however, it is a matter of serious concern. It is useful at this point to see how the Insurance Companies Act treats shareholders and policyholders.

According to the Act, a stock company is:

1. an incorporated company with share capital;

2. controlled by an elected board of directors.

The directors of a company with common shares and policyholders entitled to vote shall determine the number of directors, or the minimum and maximum number of directors to be elected by the policyholders (section 73).

A mutual company is an incorporated company with no shares that permit the holder to:

1. vote at meetings of the company, or

2. receive any of the remaining property of the company on dissolution (section 63).

Sections 226 to 236 of the Act deal with the conversion of a stock company to a mutual company. The directors must first submit the plan for approval by the shareholders and policyholders and policyholders entitled to vote (section 228(1)). A mutualization proposal dealing with the terms and means of effecting the conversion must then be submitted to the Minister. Of note, each share of a company making a mutualization proposal carries the right to vote on the proposal, whether or not it otherwise carries the right to vote (section 228(2)). Once the proposal is approved by the Minister, the Superintendent monitors the process. The statute provides considerable detail on the mutualization process.

Section 237 deals with the conversion of a mutual company into a company with common shares. The details are left to the regulations.

      2. Policyholder and Shareholder Status under The Insurance Company Act

A life insurance policy is a contract whereby an insurer agrees to pay a designated recipient a specified sum of money on the occurrence of a certain event. The three basic plans are term, whole life and endowment insurance. With term, a fixed sum is payable if the insured dies within a specified period; with whole life, the sum is payable on death whenever it may occur. For endowment insurance, the insured receives a fixed sum at the end of a specified period if he or she is still alive; otherwise a designated recipient receives the amount at the time of the insured’s death.

For a life insurance company to generate a surplus, it must take in more revenues from premiums and earnings on the money it invests than it pays out to the beneficiaries of insurance policies. If such a surplus is generated, the insurance company must then decide whether to distribute it in some form or to retain it for future investment. Entitlement to the surplus will depend on the form of the company (whether it is a mutual or a stock company) and on the nature of the policy (whether it is participating or non-participating, as defined below).

a) As used in the financial sense, stock is a certificate showing ownership in a corporation. Stock is divided by type into various classes, such as common or ordinary and preferred (sections 64 and 65). Common shareholders possess an ownership interest in the equity of a stock corporation, which can be bought and sold. Such shareholders may receive dividends and/or capital gains and are entitled to participate on a pro-rata basis in any distribution of assets of the corporation in the case of a winding-up or dissolution.

When they buy a participating policy, policyholders acquire, along with specified benefits, certain rights that are not transferable. These include: the right to borrow against the cash value of the policy; the right to dividends, if and when such dividends are declared by the board of directors; and, on a winding up in the case of an insolvency, the right to rank ahead of any creditors of the company and also to rank ahead of shareholders in a stock life company. A non-participating policy gives the holder no right to participate in the distribution of the surplus.

b) Voting rights of common shareholders and policyholders entitled to vote:

one share – one vote (sec. 67, sec. 152);

one policyholder entitled to vote – one vote (sec. 153, sec. 154).

c) Common shareholders and policyholders are entitled to vote to elect the directors of a stock company (sections 50 and 173); policyholders are entitled to vote to elect the directors of a mutual company.

d) Shareholders or policyholders entitled to vote at the annual meetings may submit proposals for consideration at the annual meeting (sections 147 and 198).

e) The directors shall submit by-laws regulating the affairs of the company for shareholder and policyholder approval (sections 50 and 197).

f) Shareholders and/or policyholders entitled to vote may requisition the directors to call a meeting of shareholders and policyholders for the purposes stated in the requisition (section 159).

g) There are various rules with respect to non-residents and non-citizens. At least one half of the directors of a company that is the subsidiary of a foreign institution, and at least three quarters of the directors of any other company, must be resident Canadians at the time of appointment or election (section 167).

A mutual company, however, is a resident if its head office and chief place of business are situated in Canada and at least three quarters of its board of directors and each committee of its directors are Canadian citizens ordinarily resident in Canada. There are no restrictions on the distribution of par policies – the persons who vote for the directors (section 427(5)). For stock companies, on the other hand, non-residents may not acquire more than 25% of the voting rights (section 429). The Minister may waive this restriction for any company that has been converted from a mutual to a stock company (section 429(6)), but may not do so for existing stock companies. Some have expressed the view that it is important that the Minister apply this power of exemption liberally.

h) Shareholders and policyholders entitled to vote must approve any proposal to transfer all, or substantially all, of the company’s policies; to reinsure all, or substantially all, of the risks undertaken; or to sell all, or substantially all, of the assets (section 257). In this case, each share of a company carries the right to vote in respect of a proposed agreement, whether or not the share otherwise carries the right to vote (section 257(2)). Only policyholders entitled to vote have the right to vote on the proposed agreement.

i) Some would argue that, after a mutual reorganization has taken place, the resulting entities, the company and the stock insurance company, can still be considered together as a mutual company (that is, an entity controlled by the policyholders); in other words, that any entity in which the policyholders have more than 50% of the voting rights can be considered a mutual. This is clearly very important for regulators who are called upon to determine whether a specific firm can be considered to be widely held – a determination needed, for example, if the Minister is to waive the public holding requirement (sections 411 and 414 of the Insurance Companies Act). This is clearly a legal issue and beyond the scope of this study.

j) A company with participating policies must maintain accounts separate from those maintained in respect of other policies (section 456). In addition, there are rules for allocating income and expenses to the participating accounts (sections 457 and 458). Provision is also made for stock companies to make a payment to their shareholders from a participating account (section 461). Finally, the company may pay a dividend, bonus or other benefit to participating policyholders (section. 464).

In summary, while there are similarities between the treatment of shareholders and policyholders entitled to vote, and more specifically participating policyholders, there are also important legal differences. While the shareholders of a stock corporation clearly own title to the corporation – with the right to sell that title – the participating policyholders participate only while their policies are in good standing and are unable to transfer any of their "ownership interests." In addition, while the voting power of a shareholder is proportionate to his or her share of the outstanding shares of the company, each participating shareholder has one vote, regardless of the number or size of participating policies.

As mentioned above, one theory holds that no identifiable person or persons own a mutual company – that the company is, in effect, a self-sustaining entity with capital that has been built up over time as the accumulated difference between premiums received and interest earned, on the one hand, and amounts paid out as expenses taxes, or to policyholders, on the other. Contributions to surplus can be attributed to all prior generations of participating policyholders as well as to all other policyholders who made any contribution whatsoever to company surplus. This theory presents rather serious problems to a policymaker who is concerned with mutual conversion and distribution of a significant amount surplus.

For all practical purposes, neither shareholders in large corporations nor policyholders in large mutual companies have available any practical mechanism for playing a meaningful role in the selection of management or participating in corporate governance matters generally. The boards of directors of both types of large organizations are largely self-perpetuating bodies who make decisions with very little shareholder/policyholder influence.

The government, in its discussion paper on conversion of mutual insurance companies of 21 May 1992, adopted the approach that a mutual conversion proposal must be approved by current policyholders of a mutual company who are entitled to vote at a meeting called to consider the proposal. Further, the entire amount of the distributable surplus (to be determined) must be allocated to a stated group of eligible policyholders – excluding non participating and non-voting policyholders. And the terms of the common shares issued to eligible policyholders must include a pre-emptive right to acquire any common shares issued by the company within two years following the conversion. Implicitly, then, the government was working on the basis that current "eligible" policyholders own the company.

   B. The Quebec Experience

The origins of life and health insurance companies in Quebec are fraternal benefit societies and the co-operative movement, which has been called "an economic system whereby individuals are part of democratic associations they own equally and, where individuals obtain goods and services they need at cost prices." These origins characterize Quebec companies and help explain the philosophical differences behind their decisions to reorganize. Some authors feel that they also explain the differences between Quebec life and health insurance companies and their anglophone counterparts. The fraternal benefit societies and the co-operative movements often developed in reaction to the excesses of capitalism and are based on solidarity and mutual assistance, a point of view that seems to have been accepted by the Quebec National Assembly. On the other hand, American legislators have always been convinced that mutual companies are capitalist in nature.

It should be borne in mind that, although there are differences in the products offered by mutual insurance companies and stock insurance companies (see section A. above on statutory considerations), the main differences between them have to do with voting rights and the level of dividend participation provided for the contract obtained through purchase of an insurance policy.

Since 1985, several groups have examined the possibility of implementing a common legislative framework. A proposal for doing so made in Quebec in 1987 was not implemented. A common view among these groups was that a "case by case" approach was preferable in view of the complexity of this issue, the wide variety of types of policies, and the wide range of internal rules for each company.

Given this background, we now go on to consider questions of access to capital.

      1. Financing

The financing of mutual companies can be problematic. Since such companies do not have access to risk capital financing, they must resort to internal financing by means of corporate debt, unsecured bonds and notes. Quebec companies that have demutualized include the Laurentian Mutual Insurance Company (1988). The Laurentian model has served essentially as a basis for the eight private bills on reorganization of mutual companies in Quebec.

In addition, foreign control of mutual companies exerted pressure on the government to act. This required actuarial rules to be accepted, and capital requirements to be established. There are, however, still few precise criteria for the changing nature of demutualizing companies.

A Quebec parliamentary committee on the financing of mutual companies sat during March 1991. The Garneau report tabled at that time discussed the various means of financing available to mutual companies. These included: preferred shares, unsecured bonds, notes, downstream holding and demutualization. Downstream holding (see the section on the Laurentian Mutual Insurance Company, below) was considered to be the most effective of these. The Garneau report also came down in favour of organizing a market for unsecured bonds and notes, for capitalization purposes. The use of preferred shares was found to be very rare, despite tax incentives for such use introduced in 1984 The report also recommended the use of debt as a financial instrument, in order to avoid conflict-of-interest problems.

As mentioned, some federally chartered insurance companies must overcome their problems of financing and access to capital. So-called pure demutualization is not a solution preferred by all companies, given the associated takeover risk. Companies must have alternatives available if they are to convert. The next section examines some legislative frameworks in greater detail.

      2. The Laurentian Mutual Insurance Company

In 1988, the Laurentian Mutual Insurance Company began its reorganization. To achieve a conversion that respected and retained its mutual nature, it first created a public financing vehicle, the Laurentian Group Corporation, in 1985. Then, by means of legislation (Quebec’s Bill 206, 17 June 1988), the Laurentian Mutual Insurance Company was empowered to split into two entities: a mutual company, and a share company that also acted as a public financing vehicle. To this end, and following a motion by the board of directors, a committee of experts was given responsibility for:

confirming the fair market value of the Laurentian Mutual Insurance Company in the context of its conversion to a share company (the Laurentian Life Insurance Company) and a mutual management corporation. [translation]

This committee submitted its report on 21 September 1988. In order to carry out its mandate, the committee first discussed the respective rights of insured persons, members of the mutual company, and members of the management corporation, as well as the rights of participating policyholders, as distinct from those of preferred shareholders. Defining these rights made it possible to distribute the surplus, which was to be considered in the calculation of the market value of the Laurentian Mutual Insurance Company according to the method selected and the value of common shares to be issued to the management corporation. The report concluded that, as set out, the conversion process was successful in that the rights of members, insured persons or participating policyholders were not altered; the necessary steps for protecting the rights of insured persons, members and participating policyholders were minimized; the provisions for future payments were appropriate; and the divided forecast was realistic.

At the third and last legislative stage, the legal structure of the Laurentian Group Corporation was converted so that it would include insurance activities downstream of it, as well as activities common to the Laurentian Life Insurance Company and other subsidiaries of the Corporation.

The case of the Laurentian Mutual Insurance Company illustrates that it is possible for a mutual company to convert in order to gain access to the capital market, while still respecting the principle of mutuality. Quebec’s An Act Respecting Laurentian Mutual Insurance (Bill 206), is a result of the decision by the Quebec National Assembly to adopt a case-by-case approach in reorganization decisions. In Quebec, eight private pieces of legislation essentially identical to this Act reflect the same approach.

Several points must be considered when a company demutualizes: fair treatment of its assets; the requirement that managers submit to the discipline of the marketplace; and the possibility of foreign takeover. In the case of the Laurentian Mutual Insurance Company, the possibility of a takeover by shareholders was narrowly avoided. Since companies most often mutualize in order to avoid foreign takeovers, it would be somewhat ironic if demutualization increased a company’s exposure to them. The next section discusses the foreign experience.

   C. Mutual Insurance Companies outside Canada

In demutualizations in other countries, the importance of determining ownership of the surplus has been paramount. Various forms of transformation have been successful.

The legislation in the United States has dealt with demutualization for a long time. However, there are differences among the States. Some States permit mutuals to convert. During the fifties, the "Williams model," based on Wisconsin legislation which is 100 years old, was adopted by 18 states. Twenty other States permit conversion of mutuals but use different models. Finally, four States totally forbid conversion of life insurance mutuals while ten States have no relevant legislation at all.

The Canadian legislation is in some respects similar to the American, particularly that in New York State. Before the 1980s, New York State forbade any mutual conversion. Today, its law considers various forms of conversion, (such as a form for companies with no outside capital and a form for small companies). In addition, there is always the right of the Superintendent to approve a particular form of conversion on a case-by-case basis.

In 1986, Union Mutual successfully demutualized. Other attempts in the United States were not as encouraging, however. The basic motivation for Union Mutual was access to capital, but fiscal disincentives resulting from American fiscal reforms reinforced the drive for other companies to demutualize. During the last decade, a number of companies (mainly life insurance) attempted conversion because of concerns about their financial situation.

There have been significant structural changes in the insurance industry. In 1960, there were five mutuals among the 10 largest American financial institutions (in terms of capital). By 1985, however, only two of the 10 largest institutions were mutuals. In Canada, the reverse phenomenon is seen; most mutuals are among the largest Canadian life insurance companies.

Above all, the chances for successful transformation of a company are related to its initial health and to the motives for transformation. Whatever the legislative or fiscal context, success in transformation is more likely for a healthy company than for an unhealthy one. When a company has difficulties, access to capital becomes critical to the ongoing operations.

BILL C-59

   A. Description

Bill C-59 is a short bill containing ten technical amendments to the Insurance Companies Act (ICA). The amendments are designed to ensure that, in a demutualization process, policyholders would be kept fully informed, given adequate time to study the issue, and be fairly treated.

Clause 1, a proposed amendment to section 142(1)(d) of the Insurance Companies Act, deals with the power of directors of a mutual company to fix the date for determining who would be deemed a policyholder for purposes of demutualization.

Clause 2, which would replace section 143(1)(b) of the ICA and would amend 143(1)(c), deals with the number of days before a meeting dealing with demutualization in which a notice of the meeting would have to be sent out.

Clause 3, which would replace section 149(1.2) of the ICA, deals with when shareholders’ and policyholders’ lists would have to be prepared for a meeting of the company.

Clause 4 would add four definitions to section 236(1) of the ICA including: "conversion proposal" (to convert a mutual company into a company with common shares); "converting company" (as defined by the regulations); "eligible policyholder" (as defined by the regulations); and "letters patent of conversion" (letters of patent issued under 237(1)(b) of the ICA).

Clause 5, which would replace section 237(1), 237(2)(a) and (b), would amend 237(2), and would replace 237(3) of the ICA, deals with the information to be provided in a demutualization application; the value established for the converting company; the information to be sent out to policyholders by the converting company; the whole process of informing policyholders about conversion; the compensation or issuing of shares or options to the directors and management of a converting company; and when a notice of a special meeting would have to be sent to policyholders in order to allow them to consider the conversion proposal. Basically, the Superintendent of Financial Institutions would be given the power to oversee these matters and to give direction to management.

Clause 6 would replace section 237.1 of the ICA to state when the company ceased to be a mutual company.

Clause 7 would replace section 407(4) of the ICA to impose a widely held ownership requirement on the converted company (essentially to specify that no person, or group of persons acting together, could own more than 10% of the outstanding voting shares of the converted company).

Clause 8 would amend section 462 of the Act to permit transfers to be made from a participating account in order to enable demutualization to proceed.

Clause 9, which would amend section 587.1 of the ICA, deals with a foreign company that changed its chief agent or the address of its chief agent; this is not a demutualization issue.

According to clause 10, this bill would come into force on a date established by the Governor in Council

   B. International Considerations

Canadian insurance companies are international organizations, selling policies around the world. For example, the four big mutual companies (Manulife, Sun Life, Canada Life and Mutual Life) have hundreds of thousands of policyholders in the United States. This means that a mutual company considering undertaking conversion would be communicating with participating policyholders around the globe.

In the United States, insurance companies are regulated at the state level. Because Canadian companies have chosen to use Michigan as their port of entry for transacting insurance business in the United States, the Commissioner of Insurance of the State of Michigan has a strong interest in the process of demutualization of these four companies. He has expressed concern about the regulations that would limit the allocation of the value of the company to voting policyholders only. In Michigan, all policyholders, participating as well as non-participating, are members of a mutual company, and as such have the right to vote. The Commissioner has also indicated that it could be unfair to exclude all non-voting policyholders from the proceeds of conversion. These are issues that will have to be worked out with the Michigan regulator.

* Pages 3 to 13 are taken from the Twenty-Second Report (Report on Conversion of Mutual Companies in Canada), Standing Senate Committee on Banking, Trade and Commerce, June 1992.