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A battle for the soul of mutuals

With Scottish Amicable planning a flotation, Peter Rodgers asks if insurers are going the way of building societies
If ever there were an example in a single organisation of both the benefits and the drawbacks of mutual ownership it is Scottish Amicable, which announced last month that it planned to float on the Stock Exchange, provoking a pair of rival bids from Abbey National and the Pru.

Now that building societies are moving towards extinction, it is a serious issue whether the insurers are heading the same way. Do they deserve to disappear? Or would the economy and the financial services sector benefit from the continued existence of mutual ownership in this specialised area?

It is clear from ScotAm's accounts that the most important financial characteristic of most mutual insurers is that they do not build large reserves, because they distribute profits as they go. The only free reserves they accumulate are their working capital, so when they demutualise there is no enormous windfall to hand back to their mutual owners. This distinguishes them from building societies, which have built valuable surpluses which allow large distributions of cash or shares to members.

Since they distribute their profits as they go, life insurers remain close to the 19th century principles of mutuality. The businesses are run largely for the benefit of members, who are also the customers. Indeed, managements are required to consider the interests of all their stakeholders, including employees.

In a conventional insurance company, 10 per cent of the profits of the life funds go to outside shareholders. This may explain why mutuals appear more often at the top of policyholder performance tables than shareholder- owned life insurance companies.

In contrast, building societies have long since forgotten the ideal of mutuality, the last glimmerings of which disappeared in the early 1980s when mortgage rationing was abolished. Until then, membership of a society at least assured a preferential place in the queue for a mortgage, and the rates were cheaper than those charged by banks.

Some of the societies that remain have suddenly realised that they have lost touch with the original concept of mutuality, and have begun to distribute profits as they go, by charging less for mortgages and paying more for deposits than banks. But they are probably too late to stop the wave of demutualisation sweeping through the industry.

However, the mutual insurers' advantage - their ability to distribute most of their profits as they go - is also their Achilles' heel. Despite not paying dividends, their growth can easily be restricted by their lack of capital.

They can take a decision to build up higher reserves. But to do so they must pay less of their profit to policyholders, so they drop down the performance league tables and find it hard to win new business. There are ways in which mutuals can raise outside loan capital, but their flexibility is restricted, compared with the freedom of conventional companies to raise cash from shareholders.

If mutuals outgrow their capital by taking on too much new business, it creates a vicious circle. If the capital is insufficient, prudence dictates that less of the money under management is invested in equities, because of their greater volatility. Yet over a long period, equities bring higher returns than anything else, so the performance of the funds falls off and it is again harder to sell new policies and win new business.

This is a dilemma all too familiar to ScotAm and in the past to others such as Scottish Equitable and London Life. The solution is usually to demutualise and invite new owners to inject more capital into the business. Another option, the one the Pru has suggested to ScotAm, is to stop taking new business altogether, so working capital is no longer needed and can be distributed to policyholders.

Another disadvantage of mutuality that is clearly displayed by the ScotAm affair is the lack of corporate governance pressures on management, at least compared with conventional companies. ScotAm would never have been able to spend last week ignoring the Abbey and Pru offers if it had been a conventional company with institutional investors, governed by the rules of the Stock Exchange and the Takeover Panel.

It is curious that the whip hand in the ScotAm auction could be held by three trusts that specialise in investing in second-hand endowment policies. They have enough ScotAm policies to call a special general meeting to force a vote against management, exactly the kind of pressure conventional companies often find themselves under during bids.

The final and perhaps most serious criticism of mutual insurers is to do with the nature of the products they sell. The endowment insurance policy is probably one of the most one-sided contracts ever written.

For a start, it is several years - and as many as 10 for some companies - before investors receive back all their cash if they surrender their policies. This is a result of high fees and commissions and early surrender penalties. And while the main advantage of a mutual is that profits are distributed as bonuses, the way it is done is open to question. Annual and terminal bonuses are at the discretion of the insurer. The terminal bonus on a long-term policy can be as high as 250 per cent, but is never guaranteed, so there is huge scope for massaging the results.

This means, incidentally, that any promises by bidders for ScotAm to add a chunk of money to the terminal bonus are almost meaningless, since there is nothing to stop the company adjusting downwards the rest of the terminal bonus when the time comes.

Does it matter for the econ-omy if these mutuals disappear? Probably not a great deal. The advantages in efficiency and in investment performance of mutuals are noticeable, but not large enough to have a serious impact. And shareholder-owned companies do have the benefit of being able to grow faster, because of their easier access to capital.

For customers of the life insurance industry, being a policy-holder in a mutual means you own part of the company. The effect is that your investments are weighted towards the life insurance industry itself. This is no bad thing given the bid premiums that are emerging for life insurers, but it will not always be an advantage.

While it is certainly hard to feel any sentimental attachment to mutual building societies, since they behave exactly like banks, mutual insurers nevertheless remain very different.

First, the windfalls for members on demutualisation are much smaller, so in theory there is less incentive for members to vote them out of existence.

Second, though the list of drawbacks to mutuality may look longer than the list of advantages, a well-run mutual such as Standard Life or Scottish Widows does bring significant advantages to its members, compared with a shareholder-owned company. This is an area of commercial life where mutuality should be encouraged, because it really does mean something.