The Long and Short
NATMUT surplus notes offer attractive spread
Dan Bruzzo, CFA | January 28, 2022
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 company surplus notes offer an attractive means for investors to target higher ratings while still adding spread over comparable, lower-rated notes issued at the senior unsecured level. Surplus notes have maintained a large aggregate pick to their senior, publicly issued counterparts. While that spread has compressed over the past several years with increased risk appetite and price discovery in this segment, these structures allow conservative investors to gain exposure to higher-rated credits in the long-end of the curve, without conceding much spread. Although the higher coupon / dollar-price often accounts for a portion of the relative valuation of legacy surplus notes, more recent issues still offer attractive spread to often lower-rated senior global notes issued by the large public insurers.
This structure is mostly utilized in the life insurance subgroup. Although technically a multi-line operator, Nationwide Financial Services (NATMUT) is one of the few property and casualty (P&C) insurance companies to issue this type of debt at the subordinated level from its core P&C operating subsidiary (Nationwide Mutual Insurance Co.). Therefore, investors can achieve single-A ratings versus the BBB-rated debt issued at the parent company level. In the case of NATMUT, there is only one debt tranche that is senior to the surplus notes in the capital structure – a very rare single issue of senior opco debt rated A2/A and issued out of an intermediate holding company with a senior guarantee. Otherwise, the surplus notes are only subordinated to insurance policy holders. NATMUT is a highly stable credit in the broad insurance segment, with strong capitalization and a solid suite of businesses across its core P&C operating segment and diversified life insurance operations.
Exhibit 1. NATMUT Senior/Subordinated Debt Curve
5 million NATMUT 4.35% 04/30/50 @ +170/30-year, G+169, 3.78%, $109.77
Issuer: Nationwide Mutual Insurance Co. (NATMUT)
Amount Outstanding: $1.35 billion
Payment Rank: Subordinated (Surplus Notes)
Subordinated Ratings: A3/A-
Insurance Financial Strength Rating: A1/A+
Private Placement 144/A
Exhibit 2. AA/A rated Surplus Notes vs Senior Parent Company Life Insurance Paper
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.
Primer 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.
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.