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...objective for insurers, one would expect that for given number of shares to be sold, these firms would price their offerings to maximize proceeds. However, the vast literature on IPO pricing suggests various theories as to why it may be in the issuing firm's best interest to underprice its offering. By examining the initial and long-run stock returns for these conversion IPOs, the existence and degree of underpricing, as characterized by large initial returns, can be determined. It is observed that on average demutualization insurer IPOs post significantly higher first-day returns than nondemutualization insurer IPOs. These gains would accrue to the initial investors and to those policyholders who receive compensation in the form of shares in the newly created stock insurer. Attractive returns are sustained for both groups of insurers during the first few years after IPO.
INTRODUCTION
In the insurance industry, ownership structure changes from mutual to stock have occurred for many years; only in recent demutualizations have insurers systematically issued an initial public offering (IPO) of common stock. A primary objective given by insurers for undergoing a conversion is access to capital. The funds raised by the IPO may be used to help the firm stay competitive or allow the insurer to expand by engaging in new opportunities.
The two main organizational forms in the insurance industry are mutual and stock, which differ in their ownership structure and capital-raising abilities. The policyholders of a mutual insurer collectively own the firm. Ownership rights are granted upon policy purchase and end upon policy termination. Stock insurers have distinct customer and shareholder bases although there could be some overlap of these two groups through separate transactions. A stock insurer can attract capital through a variety of equity and debt offerings whereas a mutual insurer, by statute, is restricted in this aspect. Mutual firms can only increase their capital base through retained earnings or the issuance of surplus notes, a highly subordinated debt security (Dumm and Hoyt, 1999). The desire for both additional capital and future ease of raising funds has induced many mutual insurers, over time, to convert to stock charter (Murray, 1998; Carroll and DeRegnacourt, 2000; Seol, 2001; Boselovic, 2001).
Although not all demutualizations result in an IPO, for a mutual insurer to execute such an offering, it must first convert to stock form. By statute, if a firm fully demutualizes, the mutual's policyholders must be given some form of compensation for this organizational change since they are relinquishing their ownership interests. Typically, these policyholders are given shares in the newly converted firm whereas in some states, they are granted priority subscription rights in the offering. Thus, after the conversion and IPO, insurers could have a significant number of policyholder/shareholders. With the conversion and offering, the insurer simultaneously compensates these policyholders as well as generates new capital. Prior studies document access to capital as a key motivation for undergoing demutualization (McNamara and Rhee, 1992; Cagle, Lippert, and Moore, 1996; Carson, Forster, and McNamara, 1998; Mayers and Smith, 2002, 2004; Remmers, 2003; Viswanathan and Cummins, 2003).
Across various industries, it may be expected that firms that issue offerings aim to maximize their proceeds. A vast literature exists, however, that documents the underpricing of IPOs across industries, characterized by large initial returns (Ibbotson and Ritter, 1995; Ritter and Welch, 2002). These gains, which could have accrued to the issuing firm had it set its offer price higher, would instead be received by the initial stockholders, hence the term underpricing. By examining the returns for insurer demutualization IPOs, it will be investigated whether the performance of these IPOs behaves similarly. This will provide information on how the stock-receiving policyholders fared in the conversion. Large initial stock returns would enrich both these policyholders and initial investors. In addition, sustained positive stock returns suggest a favorable market response to the issue and the firm's prospects. In Akhigbe, Borde, and Madura (1997), seasoned equity and debt offerings by insurers are observed to receive positive market reactions. In this article, the market response to initial equity offerings by insurers will be analyzed.
This article examines the short-run and long-run performance of twenty-four demutualization IPOs that occurred during the period 1986-2001. The starting year represents the time of Unum's demutualization and IPO, deemed to be the pioneer for the wave of conversion IPOs that followed in both the life-health and property-liability industries (Banham, 1998; Carroll and DeRegnacourt, 2000). The ending year coincides with Prudential's December 2001 demutualization, considered to be the final conversion to occur during this wave (Gold, 2002; Stein, 2002). The stock performance for these demutualization IPOs is compared to the performance of ninety-five nondemutualization-related IPOs by insurers over the same time period.
The article is structured as follows. The next section begins with a discussion of the two main methods of insurer conversion to stock form. Also briefly discussed is the IPO process. The following section presents a literature review on IPO underpricing. The theories developed are based on asymmetric information among the stakeholders: the issuing firm, the investment bank/underwriter, and the investors. For conversion IPOs, an additional stakeholder group should be considered, the mutual's policyholders; this leads into a discussion of hypotheses on the underpricing of demutualization IPOs. The data and analysis are then presented with a discussion of the results. Conclusions about insurer underpricing end the article.
INSURERS AND RAISING CAPITAL
The two main methods of conversion to stock charter are full demutualization and partial demutualization, which is also known as mutual holding company (MHC) conversion. As explained in Viswanathan and Cummins (2003), in a full demutualization, typically, a stock insurance company and a stock holding company are formed and the mutual would cease to exist. Compensation must be distributed to eligible policyholders because their membership interests in the mutual have been terminated. This compensation could be in the form of cash, policy credits, or shares in the newly created stock holding company. In several states, a different form of compensation, nontransferable subscription rights, can be granted. In a MHC conversion, both a stock insurance and stock holding company are formed as well as a MHC that is the ultimate parent of this group. Just as in a full demutualization, in this partial demutualization, the insurance contracts transfer to the stock insurer. However, the major difference is here: the membership interests of the policyholders transfer to the MHC. Since the collective ownership of the policyholders has not been extinguished, no compensation is given to them. The intermediate stock holding company could issue an IPO; however, the MHC remains its majority-holding parent.
In a full demutualization, if the converting mutual must distribute compensation to eligible policyholders, the insurer's surplus must be allocated among them. The vast majority of demutualization statutes, rather than prescribe particular formulas on how the surplus should be divided, only require that the allocation be "fair and equitable." Specific formulas, though, have been developed and deemed acceptable to regulators. The commonly used formulas for property-liability and life-health demutualizations are explained in more detail in the Appendix. Both formulas share the feature that the allocation due to a particular policyholder is commensurate to how much the policyholder has contributed to the firm's surplus.
To facilitate the vote on the proposed demutualization, the insurer mails each policyholder the plan of conversion, detailing the benefits of reorganizing to stock form along with financial information about the firm. After policyholders and regulators approve the plan of conversion, the demutualization becomes effective and any planned IPO is executed. For full demutualizations, the offerings typically occur at the time the conversion becomes effective; in MHC conversions, firms have more flexibility on when to issue the IPO (Viswanathan and Cummins, 2003). The insurer, with the aid of its investment bank/underwriter, must decide how many shares to issue beyond the amount it must distribute to policyholders as compensation. Investors would submit their purchase orders to the underwriter. If the offering were oversubscribed, the underwriter, at its discretion, would decide how shares are allocated among the interested investors; however, some demutualization IPOs specify that policyholders are to be given priority in the allocation (Panko, 2000; Aggarwal, Prabhala, and Puri, 2002; Ljungqvist and Wilhelm, 2002).
A market for the firm's stock is created when the IPO is launched and policyholders who received their demutualization compensation in the form of shares would experience the subsequent price changes. In several recent demutualizations, insurers have structured the cash and policy credit compensation option to allow policyholders to benefit from any initial price runup in the stock. In John Hancock's 2000 conversion, policyholders awarded cash or policy credits received an amount based on the greater of the initial stock offer price or the average stock price over the first twenty trading days, subject to a maximum of 120 percent of the offer price. A similar provision, with a 110 percent of offer price maximum, was in force during Anthem Healthcare's 2001 demutualization.
IPOs AND UNDERPRICING
A wealth of research has been devoted to studying IPOs and their subsequent short-run and long-run stock performance. (1) Evidence of large initial returns to IPOs, also known as underpricing, has been extensively documented and observed across time (Ibbotson, 1975; Ritter, 1984; Carter and Manaster, 1990; Ritter, 1991; Cagle and Porter, 1997; Cox and Roden, 1999). Underpricing is calculated as the percentage change from the offer price of the stock to its price at the end of the first trading day (Ibbotson, 1975). An issuing firm sells shares at some predetermined offer price and if there is a strong, positive price change during the first day, that gain would accrue to initial stockholders, those investors who purchased shares at the offer price. The issuing firm would be deemed to have underpriced its IPO because in that first day the market could have borne a higher offer price. It seems puzzling that the issuing firm would not seek to price the issue closer to its true value. The firm would receive the offer price while large initial returns would accrue to the initial investors. The theories discussed below attempt to explain why underpricing is found in a vast majority of IPOs. In this article, just as in other IPO studies, the terms underpricing and initial returns are used interchangeably.
Prior Studies
The basic theme of the various hypotheses explaining underpricing is asymmetric information among the three major stakeholders in an IPO: the issuing company, the investment banker/underwriter, and the investors. Initially suggested by Ibbotson (1975) and expanded on in Tinic (1988), underpricing and the subsequent gains that accrue to investors act as "insurance against legal liability" for both the banker involved in the transaction and the issuing company. When pricing the offering, the banker must invest in information gathering and analysis before establishing the offer price. A strong incentive exists to overprice the offering so that the banker and issuing firm receive the extra proceeds. However, investors in the IPO would subsequently realize a decline in the value of their holdings after the stock begins trading and the price settles toward its true value. Since investors have the right to sue any and all parties who were a party to the offering and signed off on the registration of securities, the financial consequences of such lawsuits as well as the potential damage to reputation could be overwhelming. (2) Thus, firms would rather underprice their issues to guard against such legal proceedings.
Information acquired and produced by the investment banker/underwriter during the IPO creates value. In Baron (1982), the information held by the banker is superior to that of the issuing firm. Because firms cannot perfectly monitor the efforts of the banker, offer prices may be set lower, resulting in underpricing. When firms face greater uncertainty about the value of its issue, the demand for the banker's participation increases. Information asymmetry between the investment banker and the issuing firm is argued to lead to underpricing. However, underpricing is also found in the IPOs for thirty-eight investment banks that went public, suggesting that other factors also influence first-day returns (Muscarella and Vetsuypens, 1989). Both Hanley and Wilhelm (1995) and Aggarwal, Prabhala, and Puri (2002) investigate the allocations of IPOs and observe that institutional investors dominate IPO subscriptions. These authors suggest that these large, influential clients may be favored in these allocations for their contribution to information gathering and possible exchange of private...
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