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Surplus Notes

a particular kind of borrowing which allows the company to record all or a portion of the proceeds from such borrowing as an increase in surplus funds, rather than as an increase in liabilities.

The repayment of the funds borrowed usually is restricted until such time as repayment can be made without decreasing surplus below prescribed levels. Payment of periodic interest and repayment of principal typically require the prior contemporaneous approval of the insurance commissioner.

Only surplus notes that have been approved as to form and content by the insurer’s domiciliary commissioner and contain the following provisions are permitted to be reported as surplus and not debt:
• subordination to policyholders;
• subordination to claimant and beneficiary claims;
• subordination to all other classes of creditors and
other than surplus note holders;
• interest payments and principal repayments require the prior approval of the commissioner of the domiciliary jurisdiction.

Discount or premium, if any, is reported as a direct deduction from or addition to the face amount of the note and amortized in conjunction with the recognition of interest expense. Approved principal repayments are reclassified from surplus to liabilities as of the date of approval by the domiciliary commissioner.



Definition of Surplus

Excess of a company’s net worth over the par or
stated value of its capital stock.

* surplus = admitted assets - (liabilities and capital stock)

Surplus represents the excess of contributed capital over the par or stated value of capital stock and the cumulative effect of operations on the company and changes in the valuation of various assets and liabilities for statutory accounting purposes.



Special Surplus Funds

• are portions of surplus allocated or appropriated for a specific purpose.
•Special surplus funds usually are allocated voluntarily but also may be required by an insurance regulator.
•Such special purpose funds are not available for the payment of dividends to stockholders or policyholders.
•These special allocations are for voluntary or general contingency purposes and do not substitute for amounts that should have been established as liabilities.
•The transaction to establish these funds is reported as a transfer from unassigned surplus to special surplus.



Special Surplus Funds - Examples?

• Group Contingency Reserve.
• Group Annuity Contingency Reserve
• Participation in Separate Accounts.
• Guaranty Fund.
• Mortality Fluctuation Reserve.
• Contingency Reserve for Large Risks.
• Special Contingency Reserve.


Treasury Stock

is capital stock of the company that has been issued and reacquired by the company and not yet canceled. If no resale is intended, the stock generally is retired or canceled. Treasury stock held by the company is carried at the company’s cost to acquire such shares and is shown on a separate line as a deduction from surplus. Treasury shares generally do not have voting
or dividend rights.


Need For Surplus

• serves as the cushion of safety against adverse events and provides assurance that the company can meet its obligations, given such uncertainties as asset risk, underwriting risk, off-balance sheet risk, and general business risk. Surplus is available to carry the company through times of financial difficulties and to support the growth of the company.


Need for Surplus

Impairment of Surplus

generally occurs when the company’s admitted assets minus the sum of its liabilities and capital stock is less than the minimum surplus required by law.


Capital and Surplus Account

presents a summary of the changes in capital and surplus that have occurred during the accounting period, including changes relating to:
• Net income
• Unrealized capital gains and losses
• Unrealized foreign exchange rate fluctuations
• Deferred income tax
• Nonadmitted assets and related items
• Liability for reinsurance in unauthorized companies
• Reserve on account of change in valuation basis
• Asset valuation reserve (AVR)
• Treasury stock
• Surplus contributed to or withdrawn from Separate Accounts
• Other changes in surplus in Separate Accounts Statement
• Surplus notes
• Changes in accounting principles
• Capital accounts
• Surplus adjustments, including changes resulting from certain reinsurance transactions

* • Dividends to stockholders: stockholders are a return of profit or ownership and are reported directly in surplus. * When dividends are declared, unassigned funds (surplus) is charged, and the corresponding amount is established as a liability until disbursed.



* Restatement of gross paid-in and contributed surplus and unassigned funds (surplus) under a quasi-reorganization is permitted only if the restatement is approved in writing by the domiciliary regulator and an 80% or greater change in the ultimate ownership of the insurer has occurred within the six-month period prior to approval of the restatement, and either:

• A new business plan has been adopted that results in substantive change in the operations and business mix of the insurer and the situation or circumstances that gave rise to the negative unassigned funds will not be part of the ongoing operations,
• The insurer is a shell company with no existing operations, inforce policies or outstanding




a. Total adjusted capital (TAC)
b. Authorized control level (ACL)

* •Plan Level RBC 200-150
between 200-150 percent or those companies between 250-200 percent which exhibit a significant downward trend in that ratio are required to submit a detailed 5-year financial plan to regulators.The plan reviews the causes of the decline in surplus, proposes corrective actions, and outlines anticipated results.

•Action Level RBC. 150-100 % RBC plan and corrective orders required. subject to a detailed regulatory investigation. Also, an order is issued specifying corrective actions that the commissioner will require the company to take to increase its ratio of TAC to RBC.

•RBC Authorized Control Level. 100-70% at the discretion of the domiciliary regulator, be placed under supervision

•Mandatory Control Level RBC.


Management of Surplus

management may decide to increase surplus to:

To determine the optimal amount of surplus, management must determine the interests of policyholders, stockholders, board of directors, regulators, and rating agencies.

management may decide to increase surplus to:
• Satisfy minimum surplus for a new line of business or to meet new RBC requirements
• Build up benchmark surplus for a new line of business or to absorb fluctuations in investments where asset and liability mismatches may occur
• Take advantage of large scale investment opportunities, such as private placements, which may coincide with the company’s long term investment policy
• Obtain a higher rating from industry rating organizations and thereby enhance the company’s marketing posture.


Perspectives On Capital and Surplus

A logical first step toward understanding the capital and surplus accounts of a life and health insurance company and the related financial reporting considerations is to review the manner in which different interested parties view the end result of the accounting process for capital and surplus transactions, for example, the adequacy of the resulting balances.

*Key interested parties include:
• Policyholders
• Agents
• Stockholders
• Insurance regulators
• Rating agencies
• Management


Perspectives On Capital and Surplus


* Regulators also may restrict the amount and/or source of stockholder dividend payments and may place various restrictions on an insurer’s investment activities that are derived from or as a result of capital and surplus balances.


Corporate Form of Organization:
Stock and Mutual

two principal forms of corporate organization in the life and health insurance industry are

A. Stock Companies: *Stock life insurance companies are capitalized initially by the sale of capital stock.

1. Financing by Sale of Capital Stock
2. Owned by Stockholders
3. Advantages over Mutual - the flexibility in raising additional capital.
4. Disadvantages over Mutual - the need to reward investors with an adequate return on capital and balance the interests of such investors with those of policyholders in the ongoing management of the company. Such shares of capital stock, or of the insurer’s parent or ultimate holding company, may be publicly traded and, indirectly, may subject the insurance company to additional financial reporting and regulatory requirements.

B. Mutual Companies: *Mutual life insurance companies are organized for the benefit of, and are essentially owned by, their policyholders. There is no capital stock.

1. No Capital Stock
2. Owned by Policyholders
3. Advantages over Stock - there is no conflict between the needs and desires of policyholders and stockholders and no need to provide a return to stockholders, in theory, permitting insurance to be provided to policyholders at a lower net cost.
4. Disadvantages over Stock - limitations on access to capital and lack of stock to use as an acquisition currency.

Stock life insurance companies are capitalized initially by the sale of capital stock.

Mutual life insurance companies are organized for the benefit of, and are essentially owned by, their policyholders. There is no capital stock.


Capital Stock and Gross Paid-In and Contributed Surplus

* The value of the capital stock shown in the stock life insurance company’s statutory basis balance sheet equals the par value per share multiplied by the number of issued shares. In the case of no-par stock, the stated value per share is used (or liquidation value, for no-par preferred capital stock).

* Thus, paid-in and contributed surplus is distinguished from other forms of surplus such as unassigned surplus and special surplus funds (allocations of funds that have accumulated through the operation of the business and which are intended to cover fluctuations in asset values, expenses, and morbidity and mortality costs).



Unassigned Surplus

• *represents the undistributed and unappropriated amount of surplus at the balance sheet date.

• unassigned surplus can be either a positive or a negative number
• Dividends to stockholders generally are declared from unassigned surplus

• extraordinary Dividends:
A dividend or distribution is considered extraordinary if the fair market value of all dividends or distributions paid within the preceding 12 months exceeds, depending on jurisdiction, either the greater or lesser of (a) 10 percent of the insurer’s surplus at the end of the previous calendar year or (b) the insurer’s net income for the previous calendar year.


Dividends to Stockholders

* Dividends to stockholders are a return of profit or ownership and are reported directly in surplus. When dividends are declared, unassigned funds (surplus) is charged, and the corresponding amount is established as a liability until disbursed.


Other Surplus Considerations

Levels of Capital and Surplus

For life and health insurers, the RBC formula focuses on four general risk components

• Asset impairment risk (C-1 component)
• Insurance or pricing risk (C-2 component)
• Interest rate risk (disintermediation risk; C-3 component)
• General business risk (C-4 component)