The Long and Short
Updated primer on insurance surplus notes
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. This material does not constitute research.
Insurance company surplus notes offer a way for investors to target higher ratings while potentially adding spread over comparable or lower-rated senior unsecured notes issued by public insurance companies. While the spread between surplus notes and senior, publicly issued benchmarks has compressed over the years, these structures still allow conservative investors to get exposure to higher-rated credits in the long-end of the curve, without conceding much spread. Issuance has been relatively dormant over the past couple of years but there seems opportunity for the primary market to open up again, and new surplus issuers often come in waves.
There are a total 63 bonds each with $300 million or more par value classified as investment grade insurance surplus notes currently outstanding in the market, making it a niche in the broader insurance sector. With few exceptions, these bonds are typically issued as 144a private placements, leaving them outside the investment grade index. There have only been two issuers since late 2022: MUTOMA 64s in January 2024 and FARMER 64s in October 2024.
While the primary market has been quiet, secondary market liquidity in surplus notes has recently been ebbing and flowing, mostly in conjunction with 30-year US Treasury rates. When 30-year Treasuries get close to 5%, it seems to draw long-end buyers into the market looking for very high-quality paper that can potentially yield over 6%. Those types of trading environments typically lend themselves to more active surplus note buying.
Although it has been several months since the market has seen one, a new issue insurance surplus note would likely be well-received. From 2017 through 2021, there were waves of issuance that saw as many five to six borrowers in a given year. Given the attractiveness to total yield buyers, index eligibility is by no means mandatory. That could potentially broaden the field of borrowers to those wishing to issue in sizes below $300 million when primary liquidity picks back up again.
Exhibit 1: Insurance surplus note credit curve and senior unsecured life curve
Source: Santander US Capital Markets LLC, Bloomberg/TRACE g-spread indications
Background on surplus notes
Public and mutual insurance companies use surplus notes to diversify capital and attract different types of investors within the public debt markets. Despite their subordinated classification 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 the insurance company’s policyholders for priority of payment. 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 remaining 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.
Exhibit 2: Universe of life insurance surplus notes (3-year maturity or more)
Source: Santander US Capital Markets LLC, Bloomberg/TRACE pricing indications
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 to 35 years ago, there are very few instances where a delay in payment was ever implemented among investment grade issuers.
Exhibit 3. Universe of P&C Insurance Surplus Notes (>3 yr maturity)
Source: Santander US Capital Markets LLC, Bloomberg/TRACE pricing indications
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 older, original structures—Moody’s will automatically treat the issue as 100% debt.
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