This has been a difficult period for the insurance industry. Insurers endured investment portfolio losses, declining investment income and an active 2008 Atlantic hurricane season. The industry faces an uncertain regulatory future, including the implementation of Europe's Solvency II, proposed federal regulatory legislation and more rigorous analysis from the rating agencies. Many insurance companies are trading at reduced valuations, often below book value and at all-time lows. At the same time, companies have reduced their takeover defenses in response to governance initiatives. These conditions, coupled with recent and proposed legislative changes, create opportunities for both strategic buyers and activist investors in the insurance sector. Companies targeted for hostile activity suffer management distraction, defense costs and a potential talent exodus, even if the activity is ultimately unsuccessful. In the current environment, insurance companies cannot simply rely on insurance regulatory mechanisms for protection. They should be evaluating their defensive posture and developing a proactive strategy for dealing with the possibility of hostile activity.

Merger and acquisition activity in the insurance sector was restrained in 2008 and early 2009 by depressed equity markets, expensive debt markets and capital constraints. As financial markets recover, insurance companies, particularly property and casualty companies, can be expected to seek acquisitions to access new capital, achieve premium growth and economies of scale, and create diversification. In addition, although there may be fewer activist funds, those that remain are increasingly targeting high-profile companies and demanding improved profitability. Recent amendments to Delaware law allow corporations to permit reimbursement of shareholder expenses incurred in conducting proxy contests and permit shareholders to include their nominees in the corporation's proxy statement. These changes, combined with proposed changes in the federal proxy rules to provide proxy access to shareholders nominating directors, may be expected to increase the number of proxy contests in the future.

The recent contested battle for IPC Holdings Ltd., a property catastrophe reinsurer, illustrates that a determined and well-capitalized strategic bidder can successfully pursue an insurance industry target. On March 1, IPC entered into a $900 million stock deal with Max Capital Group Ltd., a diversified specialty insurance and reinsurance company. IPC agreed to exchange 0.6429 IPC shares, valued at $16.34, for each Max Capital share. The amalgamation agreement had a "force the vote" provision, allowing the board of each party to change its recommendation but requiring the agreement to go to a shareholder vote, if a party received a "Superior Proposal." On March 31, Validus Holdings Ltd., a short-tail reinsurer, proposed an amalgamation with IPC in which 1.2037 Validus shares would be exchanged for each IPC share, a $1.68 billion deal, with a value of $29.98 per IPC share. On April 7, IPC announced that the Validus proposal was not a "Superior Proposal" and reaffirmed its support for the Max Capital transaction.

Validus was not to be deterred. It commenced litigation in Bermuda challenging the Max Capital deal and mounted a strategic assault on IPC. Validus solicited proxies from IPC shareholders to vote against the Max Capital deal, commenced an exchange offer for at least 90% of IPC's shares to be followed by an amalgamation and filed an application with the Bermuda courts to convene an IPC shareholder meeting to vote on a scheme of arrangement. Validus also revised its bid several times, adding a cash component. In response on June 4, IPC declared a cash dividend of $1.50 per share payable currently and $1.00 per share payable at the Max Capital closing. By the time of the IPC shareholder meeting on June 12, the Validus proposal had been revised to 1.1234 Validus shares, plus $3.75 in cash, for each IPC share, valued at $30.67 per share. The IPC shareholders overwhelmingly voted against the Max Capital deal, and the agreement was terminated.

Validus then commenced a shareholder solicitation to compel a special meeting of IPC shareholders to replace the IPC board. On July 1, Flagstone Reinsurance Holdings Ltd., a property and casualty reinsurer and insurer, offered to exchange 2.638 Flagstone shares and $5.50 in cash for each IPC share.

On July 9, IPC agreed to a $1.6 billion deal with Validus at a price of 0.9727 Validus shares, plus $7.50 in cash, for each IPC share, valued at $29.48 per share. Validus agreed, subject to certain limitations, to pay the $50 million breakup fee to Max Capital and gave up the right to terminate the agreement if IPC suffered large catastrophe losses prior to closing, a right that Max Capital had in its agreement.

The Validus-IPC-Max Capital situation is notable on many levels -- the aggressive strategy, including the use of untested structures under Bermuda law; the overwhelming IPC shareholder vote against the Max Capital deal; the need to supplement the deals with cash; the absence of protection against Atlantic hurricane season losses in the final Validus-IPC deal; and the multiplicity of bidders, which indicates more deals in the industry are likely.

The dramatic impact of activism in the insurance industry is evident in the recent events at Kingsway Financial Services Inc., a Canadian specialty insurance provider that reported significant losses in 2008. In November 2008, Joseph Stillwell, a 9% shareholder, demanded that Kingsway call a special meeting to remove two directors -- the nonexecutive chair, and the president and CEO -- and replace them with two Stillwell nominees in order to accelerate changes to Kingsway's business strategy. Kingsway called the special shareholder meeting for Feb. 10, 2009. In January 2009, Kingsway and Stillwell reached a compromise -- Stillwell could nominate two directors but couldn't seek control of the company for three years, and the president and CEO would resign from the board. The agreement, and consequent change in the board, resulted in an overhaul of Kingsway's strategy and management team. In February, Kingsway announced a major cost-cutting plan, and in April and May, the president and CEO as well as the CFO were replaced.

As the Validus-IPC transaction and the Kingsway contest reveal, regulatory and tax barriers (such as insurance holding company change-in-control statutory limits and tax-related ownership limits used by Bermuda companies, typically set at 10%) are not a deterrent to determined bidders willing to pay the requisite purchase price and aggressive activist investors. As insurance company valuations remain low and managements grapple with capital and underwriting issues, insurance companies should consider how to best protect against bottom-feeding acquirers and short-term activist investors.

First, companies should analyze their financial and strategic posture, including a review of their strategic plan, capital position, rating agency views and analyst reports, as well as the status of other industry participants. In particular, companies should identify operational goals, future capital requirements, ability to access the reinsurance and capital markets, and likely suitors and acquisition targets.

Next, companies should analyze their structural defenses, including a review of applicable state regulations, charter and bylaw limitations on share acquisitions or voting, and the desirability of adopting a shareholder rights plan. Companies should specifically evaluate their vulnerability to proxy contests by reviewing their charter and bylaw provisions governing the nomination, election and replacement of directors, and action by shareholders. However, before amending their organizational documents, companies need to consider the corporate governance policies of the proxy advisory services, such as RiskMetrics Group Inc. and Glass, Lewis & Co. LLC, which are increasingly influential with institutional investors.

Finally, companies should address their shareholder base by reviewing shareholder lists, Schedule 13D and 13G filings, and filings with insurance regulators. They should begin a dialogue with their activist and institutional investors to identify concerns before they become issues. Although it may be impossible to avoid hostile activity entirely, given the confluence of recent events, insurance companies should be proactive in strategically assessing and reducing their vulnerability.

Lois F. Herzeca is a corporate partner resident in Gibson, Dunn & Crutcher LLP's New York office. Her broad practice includes mergers and acquisitions, capital markets transactions, corporate governance counseling and joint ventures, with a particular specialty in insurance transactional matters.