A.M. Best Special Report: Surplus Notes Issuance Showed Growing Investor Appetite in 2013

The FINANCIAL — OLDWICK — While P/C companies had the highest number of surplus notes outstanding at 681 as of year-end 2013, the total amount of $15.8 billion is only 2.4% of the sector’s capital and surplus. On the other hand, life companies had 221 surplus notes outstanding representing $25.2 billion, which accounts for 7.8% of its sector’s capital and surplus, and health companies had 224 surplus notes outstanding for a total of $2.3 billion or 1.2% of this sector’s capital and surplus, according to A.M. Best Company, one of the world’s oldest and most authoritative insurance rating and information sources.

Surplus notes are considered investment-grade notes generally issued directly by insurance operating companies and subordinate to policyholder claims. Like straight debt, most surplus notes offer a stated maturity date and a periodic coupon (fixed or floating). However, principal and interest payments require prior approval from state regulators, who must review the insurance companies’ policyholders’ claims and other liabilities. If they find that the insurance company has sufficient funds, they will approve the payment. If the regulators believe the payment could potentially put policyholders and the company at risk, they may make the company defer the scheduled payment to the surplus note holders. Regulators tend to treat these surplus notes as capital rather than borrowing for statutory purposes.

Since 2000, average coupon rates on surplus notes issued generally have been between 5% and 6%, which may explain why investors have increased appetites for surplus notes. Interest rates were fairly steady from 2000 to 2007; however, after 2007, Treasury and LIBOR rates plummeted and have yet to return to pre-2007 levels. During this period, surplus note yields remained fairly stable around 5%, with notes issued in 2011 and 2013 averaging just above 4%. Investors in surplus notes need to have additional yields to offset the possibility of regulatory action, which could lead to loss of interest and/or principal, according to A.M. Best Company.