AM Best, a global credit rating agency specialising in the insurance sector, has released a new report shedding light on a significant trend in the US property/casualty (P&C) and health insurance markets.
According to their findings in the Special Report, “Hard Reinsurance Market Makes Surplus Notes Attractive for Some,” surplus notes are increasingly being utilised by insurers to achieve greater financial flexibility in response to the ongoing challenges in the reinsurance market and elevated interest rates.
AM Best’s report indicates that, while the overall growth in surplus notes has been relatively moderate since 2022, the P&C and health segments have experienced an 8-9% increase in surplus notes outstanding, which is notably higher than the less than 4% increase in the life/annuity (L&A) segment.
By the third quarter of 2024, the US-domiciled P&C segment had accumulated $16.8 billion in surplus notes, while the L&A segment had surpassed $51 billion. AM Best notes that the surge in surplus note issuance is largely concentrated within personal property and standard auto/home composites, areas that have faced significant challenges in recent years due to market volatility.
“Operating losses since 2022 have created a need for insurers to bolster capital cushions,” commented Jason Hopper, Associate Director, Industry Research and Analytics, AM Best. “Loss-affected insurers are most likely to face increases in reinsurance rates and attachment points, which then causes the need for them to raise even more capital.”
The rise in surplus note usage is largely attributed to insurers seeking greater capital flexibility amidst a hardening reinsurance market.
“Beyond the more-traditional results of increasing capital and enhancing financial flexibility by way of issuing surplus notes, the higher capital can also reduce the need for reinsurance,” added Hopper.
In recent years, P&C lines have been particularly affected by rising reinsurance pricing and underwriting losses. These factors have led many insurers to turn to surplus notes as an alternative means of strengthening their capital position and ensuring continued business growth.
As AM Best points out, surplus notes allow insurers to raise the necessary capital without the immediate need for reinsurance, providing a viable option to bridge the gap in their capital reserves.
Despite the benefits of surplus notes, AM Best stresses that they should not be considered a replacement for traditional reinsurance.
The agency emphasises that insurers must carefully assess the risks and rewards associated with surplus note issuance as part of their overall capital-raising strategy.
“The ability of a company to issue surplus notes is viewed as a sign of financial flexibility, but excessive reliance on surplus notes may result in negative assessment of capital quality,” said Doniella Pliss, Director, AM Best.
AM Best further explains that the interest rates on surplus notes, which have remained high in recent years, can be somewhat offset by investing the proceeds in investment-grade fixed income securities.
This strategy can help insurers mitigate the impact of the interest expenses associated with issuing surplus notes. Additionally, writing more business with the support of surplus notes can generate further earnings, further alleviating the costs linked to interest.
The report also notes a continuing trend in the issuance of surplus notes to affiliated companies. AM Best views this practice more favourably, as affiliated parties have greater flexibility to adjust the terms of the notes should market conditions change.
In fact, more than 90% of surplus notes issued by health insurers are to affiliated companies, offering them a greater degree of control over the terms of the notes if needed.
However, AM Best strongly cautions against excessive reliance on surplus notes. While they can enhance capital flexibility, surplus notes should not replace reinsurance, especially as the market for reinsurance remains challenging. Insurers must maintain a balanced approach to capital raising to avoid compromising the quality of their capital base.
According to AM Best, a company’s ability to issue surplus notes reflects its financial flexibility, but too much dependence on this tool may negatively impact the overall assessment of its financial stability.
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