Rising interest rates and a firm reinsurance market are prompting more US insurers to consider surplus notes as a tool for capital management, according to a new report by AM Best.
With increased pricing across several property/casualty lines and operating losses affecting capital growth, some insurers are evaluating surplus notes to improve financial flexibility and meet regulatory requirements.
While the total growth in surplus notes has remained modest over the last two years, the P&C and health sectors have seen an increase of 8% to 9% since 2022. In comparison, life/annuity (L/A) companies reported growth of less than 4% over the same period.
AM Best data shows US-domiciled P&C insurers held US$16.8 billion in surplus notes as of third-quarter 2024. L/A insurers carried more than US$51 billion, driven in part by the sector’s need for higher levels of capital due to scale. Fifteen companies account for roughly 75% of L/A surplus note balances, many of which are mutual insurers.
Despite the size of outstanding surplus notes in the L/A sector, the ratio of surplus notes to capital and surplus (C&S) is lower than other lines – 18% for L/A versus 26% for P&C and 46% for health, which holds the largest proportion of affiliated notes.
In 2024, central banks worldwide adopted a cautious stance on interest rate adjustments amid economic uncertainties. The Federal Reserve maintained its key interest rate at 4.5% in December, reflecting concerns over persistent inflation and global economic challenges.
Meanwhile, projections indicate a cautious approach among central banks regarding interest rate adjustments in 2025. The Fed notes that markets anticipate potential rate cuts by the end of 2025, contingent on economic indicators such as inflation and employment.
These interest rate trends have significant implications for the reinsurance industry. Elevated interest rates in 2024 contributed to improved investment income for reinsurers, enhancing overall profitability.
Despite a decline in risk-adjusted prices during the January 2025 renewals, the sector is projected to maintain strong profitability, with combined ratios expected to hover around 90% and return on equity anticipated to be slightly lower at 17%, down from 19% in 2024.
The increase in surplus notes has been partly driven by underwriting losses, which have limited capital growth. According to AM Best, nearly 80 insurers have grown their surplus notes outstanding by more than 50% since year-end 2022.
Most of these companies are in the P&C and health segments and reported aggregate pretax operating losses in 2022, 2023, and through the third quarter of 2024.
These losses, combined with higher reinsurance pricing and changes in attachment points, are fueling demand for capital relief – particularly among insurers with less than US$500 million in direct premiums written.
Many are also concentrated in health, personal property, and auto/home, with provider-owned health plans seeing margin pressure in Medicare Advantage and Managed Medicaid.
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