Surplus Notes Remain an Attractive Source of Statutory Capital For U.S. Insurers

Morningstar DBRS published a commentary discussing the issuance use of surplus notes by U.S. insurers.

Key highlights:
-- Surplus notes allow U.S. insurers to raise capital that is treated as equity for statutory purposes while maintaining the tax efficiency and cost of capital advantages of fixed-income debt instruments.
-- Surplus notes can be assigned a relatively high credit rating when there is no other more senior capital instruments issued by an insurance operating company.
-- In distress situations, surplus note notching is likely to be increased, to that of a hybrid instrument or even higher, should there be an increased plausibility of a regulatory halt on interest or principal payments or worsening expectations for recovery.

"Since they are issued at the operating company (OpCo) level, surplus notes may be assigned a credit rating as high as one notch below an insurer's Financial Strength Rating, provided that they meet certain criteria," said Patrick Douville, Vice President, North American Insurance Credit Ratings. "Assuming an insurance group uses a standard holding company (HoldCo)/OpCo structure, and as long as no other more senior capital instruments exist at the OpCo, surplus notes can therefore be rated higher than subordinated debt or even senior debt issued at the HoldCo level."