A brief primer on insurance surplus notes

Dan Bruzzo, CFA | June 21, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Insurance surplus notes are somewhat of a niche structure within the broader investment grade insurance universe, but the segment trades with enough regularity that investors can remain active and target the additional spread opportunities available. Once a temporary funding strategy predominantly utilized by mutual companies in the 90s, these subordinated structures resurfaced over the past decade and have seen enough new issue in the last few years to remain a relevant option for both mutual and public insurance companies seeking to create diversified funding within their capital structures.

While the higher coupon / dollar-price account for a portion of the relative valuation of the older, legacy surplus notes, the bonds still offer attractive spread to senior global notes issued by the large public life insurers (MET, PRU, AFL, LNC, etc). Furthermore, in the low rate environment, the prospect for potential tender offers on some of the older, higher coupon issues, presents additional opportunity for attractive tender offers for holders. The graph below demonstrates that despite the rapid tightening of credit spreads over the past few weeks – and aggregate tightening from the local wides on 01/03/19 – surplus notes have maintained a large aggregate pick to their senior, publicly issued counterparts. At a minimum, these structures provide a means for conservative investors to gain exposure to higher-yielding single-A and AA-rated credits in the long-end of the curve.

Exhibit 1: Insurance surplus notes vs senior life notes – current and year-end

Note: Senior life curve includes index-eligible issues of MET, PRU, AFL and LNC. Source: Bloomberg/TRACE BVAL indications, Amherst Pierpont Securities.

Background on surplus notes

Public and mutual insurance companies utilize surplus notes offerings to diversify capital and attract different types of investors within the public debt markets. Despite their subordinated classifications within the capital structure, in many cases surplus notes are among the only outstanding debt issues for mutual companies. Therefore, they are often only subordinated to insurance company’s policyholders from a priority of payment standpoint. Interestingly for the public insurance companies, since the debt is issued directly out of the insurance operating company, it typically maintains structural seniority to most of the senior unsecured debt issued at the parent company level, though remain subordinated to funding agreement-backed (FA-backed) or  guaranteed investment contract (GIC) structures at the operating company. Furthermore, since large mutual insurance companies are conservatively managed, and typically well-capitalized, these subordinated issues frequently maintain higher ratings than even the senior debt levels of some of the largest and higher-rated public insurance companies.

Surplus notes are technically hybrid capital – but with limitations

Surplus notes are subordinated to policyholders and all other senior debt instruments outstanding at the operating subsidiary. They are classified as hybrid capital since they technically provide for temporary loss absorption to issuers. While the deals are mostly issued as cumulative, both principal and interest payments must be approved by the insurance company’s state regulators. At the regulator’s discretion, those payments can be delayed without triggering an event of default or cross-default provisions. In the event of a delay in interest payment, interest accrues until regulatory approval is reinstated to the issuer to resume the payments. Since the structures first became prominent roughly 30 years ago, there are very few instances where a delay in payment was implemented among IG issuers.

Why surplus notes were originally conceived

Mutual insurance companies are mostly owned by the policyholders themselves. As a result, access to public capital markets was traditionally more limited. This new structure gave non-traditional issuers the opportunity to bolster capital levels and enhance financial flexibility. As with principal and interest payments, the actual issuance must also be approved by the state regulator. The structure was largely dormant for some time, but re-emerged after the financial crisis in 2009 as insurance companies looked to bolster capital ratio levels and instill confidence in the markets. Issuance has since been sporadic, with several prominent deals coming over the past few years.

Exhibit 2: Insurance surplus notes vs senior life notes – current vs early 2016 spread wides

Note: Senior life curve includes index-eligible issues of MET, PRU, AFL, and LNC. Source: Bloomberg/TRACE BVAL indications, Amherst Pierpont Securities

Rating agencies’ approach to surplus notes

Moody’s typically rates surplus notes two notches lower than the operating company’s insurance financial strength (IFS) rating for life insurers, and three notches for property & casualty insurers. S&P also rates two and three notches below the operating company financial strength rating as well. For hybrid treatment, the rating agencies will determine the level of equity credit to the issuer based on the maturity and whether or not the issue is cumulative. However, once the issue is within 20 years to maturity—which is true for many of the original structures from the 90s—Moody’s will automatically treat the issue as 100% debt.