Policyholder Surplus

Policyholder surplus is the difference between an insurance company's assets and its liabilities as measured under the statutory accounting rules used by insurance regulators, principally in the United States. It is the insurer's net worth for regulatory purposes: the resources that remain to protect policyholders after setting aside reserves for all expected claims and other obligations. A larger surplus means a greater capacity to absorb losses that turn out worse than expected and to write new business.

For a mutual insurer, which has no shareholders, the whole of this amount is surplus. For a stock insurer it comprises paid-in capital and surplus together, and is often labelled capital and surplus or surplus as regards policyholders. It corresponds broadly to shareholders' equity in ordinary financial statements, but the figure is usually lower because statutory accounting is deliberately more conservative.

Statutory accounting principles, maintained in the United States by the National Association of Insurance Commissioners, are designed to show whether an insurer could meet its obligations if it stopped writing business. Several features reduce the reported figure compared with general accounting standards. Only admitted assets count: items that cannot readily be turned into cash to pay claims, such as furniture, some software, overdue premium balances and certain deferred tax assets, are excluded. The cost of acquiring policies, chiefly commissions, is charged immediately rather than spread over the policy term, so a fast-growing insurer sees its surplus fall even when the business is profitable. Bonds are generally carried at amortised cost, and reserves are set on prescribed bases.

Surplus changes from year to year with underwriting results, investment income, realised and unrealised investment gains and losses, dividends paid to shareholders or policyholders, and capital contributions. The quality of the liability estimates matters as much as the assets: if claims reserving proves inadequate, later strengthening of reserves comes directly out of surplus.

Surplus sets the scale on which an insurer can operate. Regulators, rating agencies and reinsurers all relate the volume and riskiness of business to it:

• Premium to surplus. The ratio of net written premium to policyholder surplus measures underwriting leverage. A traditional regulatory benchmark treats a ratio above three to one as a warning sign for a property and casualty insurer, though the appropriate level depends on the lines written.
• Reserves to surplus. The ratio of loss reserves to surplus shows how exposed the company is to errors in its reserve estimates, which is most relevant for long-tail liability business.
• Retention limits. Many jurisdictions limit the size of any single risk an insurer may retain to a percentage of its surplus, commonly ten per cent, with the excess to be reinsured.
• Dividend capacity. State laws restrict the dividends an insurer may pay without regulatory approval by reference to its surplus and recent income.

Because writing more premium requires more surplus, industry-wide surplus is watched as an indicator of capacity. After large catastrophe losses or falls in investment markets, surplus shrinks, capacity tightens and prices tend to rise; when surplus is plentiful, competition pushes prices down. This is the underwriting cycle.

Each state sets a fixed minimum capital and surplus for a licence, which varies by line of business. On top of this, the risk-based capital system adopted in the 1990s calculates for each insurer a required amount reflecting its asset risk, underwriting and reserve risk, credit risk and other exposures. The insurer's total adjusted capital, which is essentially its policyholder surplus with some adjustments, is compared with that amount, and the result determines whether the regulator takes no action, requires a corrective plan, may take control of the company, or must do so.

Regulators also apply a series of financial ratio tests to annual statements to identify companies needing closer review, several of which use surplus as the denominator or track its change. Larger insurers assess their own capital adequacy in the Own Risk and Solvency Assessment. In Europe the comparable concept is own funds under Solvency II, measured against the Solvency Capital Requirement and the minimum capital requirement, on a market-consistent rather than a statutory basis.

An insurer whose growth outpaces its surplus has several options. It can raise capital from shareholders or, in the case of a mutual, issue surplus notes, a form of deeply subordinated debt on which payments require the regulator's approval and which statutory accounting counts as surplus rather than as a liability. It can cede more business: a reinsurance cession reduces net premium and reserves and, where the reinsurer pays a ceding commission, restores some of the surplus consumed by acquisition costs, an effect known as surplus relief. A quota share reinsurance treaty is the usual vehicle. It can also slow growth, change its mix of business or reduce investment risk.

Policyholder surplus is an accounting figure and shares the weaknesses of the estimates behind it. Reserves for claims not yet reported, described under incurred but not reported claims, are uncertain, and under-reserving can make surplus look healthy until shortly before a failure. A simple premium-to-surplus ratio ignores differences in the volatility of lines of business, the quality of reinsurance and the riskiness of investments. Analysts therefore read surplus together with the combined ratio, reserve development and risk-based capital results.

• National Association of Insurance Commissioners (NAIC)