AM Best: Surplus notes more attractive for P&C carriers amid hard reinsurance market

By Isha Marathe

March 21 - (The Insurer) - Surplus notes have increased 8% to 9% in the property casualty insurance segment since 2022, totaling $16.8 billion for the U.S.-domiciled P&C segment as of Q3 2024, an AM Best report said.

In 2023 and 2024, 46 companies entered or reentered the surplus notes market across the P&C, life/annuity and health insurance segments. Doing so has been costlier than previous years as the average interest rate of surplus notes exceeded 7% in each of the last two years, with the divergence in rates widening between unaffiliated and affiliated notes, the report showed.

"The need for financial flexibility is driven by several factors," AM Best said.

"Financial losses, primarily generated on the underwriting side, slowed down the expectation of capital growth."

Of the 80 companies that have grown surplus notes outstanding by more than 50% since the end of 2022, those in the P&C industry have reported aggregated pretax operating losses in both 2023 and 2022, as well as through third quarter 2024.

The median ratio of surplus notes to capital and surplus for companies with notes outstanding is 26% for P&C companies, the report showed.

"These losses create a need for bolstering capital cushions and additionally, loss affected insurers are the ones most likely to face reinsurance rate increases and increases in attachment points which causes the need for even more capital," AM Best said.

Surplus notes have provided capacity for continued premium growth as operating losses have impeded capital growth.

AM Best said that it can be difficult to obtain the necessary P&C reinsurance limits at reasonable rates.

"When considering a surplus note, some companies find that in addition to more traditional results of increasing capital and enhancing financial flexibility, higher capital reduced the need for reinsurance. Surplus notes can partially fill the capacity created by rising secondary perils and social inflation amid the need for increased riskadjusted-capital," the report said.

The interest rates on surplus notes can be partially offset by investing proceeds in investment grade fixed income where yields on new issuances are relatively high.

AM Best views notes issued to affiliated parties more favorably, because affiliated companies may have more flexibility to adjust the terms of the notes if conditions warrant. Over 35% of notes outstanding for P&C line are affiliated.

The rating agency said that some companies may find surplus notes can provide a better economic solution compared to additional reinsurance when companies are seeking to support groHoweverwth. But it said that the benefits of surplus notes should not be overstated.

"(S)urplus notes are not a replacement for reinsurance and insurers need to perform appropriate risk/reward analysis to find optimal capital raising strategies," AM Best said.

"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."

Additionally, companies that rely heavily on surplus notes may be viewed as having a weaker balance sheet profile, especially if the terms of the notes create a burden on earnings and management’s intent behind surplus note funds is also reviewed, AM Best said.