What it means
An insurer collects premiums today and pays claims later, so it holds large reserves (money set aside for future claims). Surplus is what is left after counting every reserve and other liability against the company's approved assets.
It plays the role that shareholders' equity plays in an ordinary company. Regulators watch surplus closely because it is the buffer that absorbs shocks, and they require insurers to file regular reports on it.
A catastrophe, a run of larger claims or a fall in investment values all eat into it. If surplus becomes too thin, the regulator can restrict new business or take control of the company.
Insurers use surplus to decide how much business they can write. A common check is the ratio of annual premiums to surplus, which shows how much risk is being supported by each dollar of cushion.
Rating agencies and regulators look at that ratio when judging financial strength. Insurance accounting differs from ordinary company accounting.
Only certain assets are "admitted", meaning counted for regulatory purposes, and some items such as furniture or overdue receivables may be excluded. This is why statutory surplus can be lower than the equity shown in published accounts.
Buyers of insurance, brokers and investors read surplus as a measure of safety, and it is usually the first number they look at in an insurer's statutory filing. A large and growing surplus signals that the insurer can pay claims and expand, while a shrinking one is a warning sign.
Surplus also links to how insurers price and grow. A company with a strong cushion can accept more risk, write more policies and weather a bad year without raising prices sharply.
A company with a thin cushion must be selective, buy more reinsurance or raise fresh capital from its owners.
In practice
Real-world examples.
Example
A regulator reviews a small property insurer after a severe storm season. Claims have reduced surplus sharply, so the regulator asks the company to stop writing new policies until it raises more capital. The owners inject funds and the surplus is rebuilt over the following year.
Example
A broker choosing an insurer for a client's large commercial policy, such as cover for a factory with $50,000,000 of equipment, compares policyholder surplus across candidates. The broker favours the company with a bigger cushion relative to premiums. The extra safety is worth a slightly higher price to the client.
Example
An investor analysing an insurance company's accounts notes that surplus has grown for five years while premiums have grown more slowly. That suggests the company is becoming more conservative. The investor takes this as a sign of financial discipline rather than slow growth.
Formula
Calculation
Policyholder surplus = admitted assets - total liabilities
Premium-to-surplus ratio = net written premium / policyholder surplus
Suppose an insurer has admitted assets of $520,000,000 and total liabilities of $400,000,000, including claim reserves.
Policyholder surplus = 520,000,000 - 400,000,000 = $120,000,000.
If it writes net premiums of $240,000,000 a year, the premium-to-surplus ratio = 240,000,000 / 120,000,000 = 2.0.
A ratio of 2.0 means $2 of premium is supported by every $1 of surplus. If the insurer then paid a $20,000,000 dividend to its owners, surplus would fall to 100,000,000 and the ratio would rise to 240,000,000 / 100,000,000 = 2.4.Case study
Seen in the real world.
Summit Harbour Insurance is a fictional property insurer. After two heavy claim years, its policyholder surplus falls from $90,000,000 to $60,000,000 while premiums stay at $150,000,000. The premium-to-surplus ratio therefore rises from 1.67 to 2.5, which draws attention in this illustrative scenario from the regulator and the rating agencies alike.
The board responds by buying more reinsurance (insurance for insurers) to cover larger claims, by pausing growth in its riskiest region and by pausing owner dividends until the cushion is rebuilt. It also reviews prices on policies that have produced poor results.
Over the next two years, with better pricing and fewer severe claims, surplus rebuilds to $85,000,000. The ratio improves to 1.76, and the regulator ends its closer monitoring.
Watch out
Common mistakes.
- Treating surplus as spare cash. It is a regulatory cushion that is largely tied up supporting existing policies, and paying it out too freely weakens the insurer.
- Equating it with shareholders' equity in ordinary accounts. The two can differ because of statutory accounting rules.
- Looking at the amount without the premium written. A large surplus can still be thin if the insurer writes a huge volume of business.
Questions
People also ask.
Is a bigger surplus always better?
Usually it signals strength, but an excess can mean the company is using its capital inefficiently and giving owners a lower return than it could.
Who sets the minimum?
Insurance regulators set required capital levels, and rating agencies apply their own tests as well, so an insurer usually aims to hold more than the legal minimum.
How can surplus fall?
Large claims, falling investment values, dividends to owners or under-reserving that is later corrected can all reduce it.
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