Insurance company premium writings are limited by the surplus on its balance sheet, and is determined by calculating the Risk Based Capital ratio, and also the Best Capital Adequacy Ratio. When that limit is reached, an insurer can do one of the following: stop writing new business, increase its capital, or buy surplus relief through quota share reinsurance.

Insurers have several options to maintain a conservative leverage ratio and still write new business.

SURPLUS NOTE

A surplus note is a type of debt instrument issued to an insurance company under the regulations of the insurer’s domiciliary state. The proceeds are included in the surplus account of the issuer rather than being treated as a liability.

Pros

1. This is the main capital raise option for mutual insurance companies because they cannot access equity markets.

2. Interest and principal payments can be deferred and accrued.

3. Equity ownership of stock insurers is not diluted.

Cons

1. Surplus note holders are last in line to make a claim on the company’s assets in a default scenario.

2. Interest and principal payments are subject to regulatory approval. Interest continues to accrue, but the note holder has no recourse for late payment.

3. Loan covenants are minimal.

QUOTA SHARE REINSURANCE

A quota share contract indemnifies the ceding company for an established percentage of loss on each risk covered in the contract in consideration of the same percentage of the premium paid to the reinsurer. Surplus relief occurs under statutory accounting rules as the premium, assets and liabilities are transferred to the balance sheet of the reinsurer, leaving the insurer’s surplus unchanged or increased.

Pros

1. There are many reinsurers interested in writing quota share business, and there is a lot of capacity in the market.

2. Quota share contracts are easy to arrange. Contract language is fairly standard throughout the industry; contracts can be negotiated and executed cheaply and quickly.

3. No regulatory approval is required to buy quota share.

Cons

1. Reinsurer keeps underwriting profits of the ceded premium.

2. Reinsurers charge a margin to write this reinsurance. The margin cost may not be as competitive as the interest rate payable on a loan.

3. Excessive use of reinsurance can have negative implications with rating agencies.

LOAN/DEBT

The preferred loan structuring puts the loan obligation on the insurance holding company balance sheet with the loan proceeds directly infused onto the insurance company subsidiary balance sheet. Debt repayment comes from the holding company using dividends upstreamed from the operating entity. To avoid regulatory limitations on dividend payments, many holding companies set up an MGA subsidiary and use the MGA cash flows for debt service.

Pros

1. Usually no regulatory approval required.

2. Investors prefer this option over surplus notes because interest and principal payments cannot be deferred by regulators.

3. Insurance company balance sheet remains clean of debt.

4. Transaction fees are modest.

Cons

1. Loan covenants can have adverse consequences if interest and principal payments are not paid on time. 
2. Smaller insurers may have difficulty finding investors interested in a small transaction. 
3. The MGA may not generate sufficient cash flow to cover projected debt service.

Bonus Tip: Use a Reinsurance Brokerage Sharing Agreement to Increase Surplus

Depending on how much you spend on reinsurance, a brokerage-sharing agreement with your reinsurance broker can immediately drop cash into your surplus account and reduce your net reinsurance cost.

To employ the best solution to reduce your leverage and keep writing business, you need the right experience and expertise.