SSAP 72: Issuer and Holder Accounting for Surplus Notes

The accounting and reporting of surplus notes for insurance entities is governed by Statutory Accounting Principles (SAP). The guidance is found in Statement of Statutory Accounting Principles (SSAP) No. 41R, which ensures these instruments are accounted for in a way that demonstrates an insurer’s ability to meet policyholder obligations. Surplus notes have unique characteristics that distinguish them from traditional debt or equity, requiring a distinct accounting approach.

Core Concepts of Surplus Notes

A surplus note is a financial instrument issued by an insurance company to raise capital. Also known as capital notes or surplus debentures, these instruments are a form of unsecured debt. Their defining feature is their subordination, meaning they are junior to all other liabilities of the insurer, including obligations to policyholders and general creditors. In the event of liquidation, surplus note holders are paid only after all other debts have been satisfied.

These instruments have a hybrid nature, with features of both debt and equity. Like debt, they have a stated maturity date and a specified interest rate. However, their equity-like characteristics are more pronounced from a regulatory perspective. Any payment of principal or interest requires prior approval from the insurance commissioner of the insurer’s home state. If the regulator does not grant approval, the insurer is not considered to be in default on the obligation.

The function of a surplus note is to increase an insurer’s statutory surplus without diluting ownership. For an insurance company, statutory surplus is a fundamental indicator of its financial strength and capacity to underwrite new business. By issuing a surplus note, an insurer can bolster this metric, which is a component of risk-based capital (RBC) calculations used by regulators to monitor solvency.

Issuer Accounting and Reporting Requirements

For the insurance company that issues a surplus note, the accounting treatment under SAP is distinct from U.S. Generally Accepted Accounting Principles (GAAP). Under SAP, a qualifying surplus note is not reported as a liability. Instead, the proceeds from the issuance are recorded directly in the capital and surplus section, effectively treating the instrument as a form of equity.

This classification is permitted because of the instrument’s deep subordination and the regulatory control over payments. Since the insurer has no unconditional obligation to repay the principal or pay interest without regulatory consent, the instrument is not considered a liability for statutory purposes. The funds raised are viewed as being available to absorb losses and protect policyholders.

An issuing insurer does not accrue interest expense on a surplus note. Interest is recognized as a charge against surplus only when the domiciliary state regulator formally approves the payment and the payment is made. Until both events occur, any unpaid, accumulated interest is disclosed in the notes to the financial statements but not recorded as a liability.

Similarly, the principal amount of the surplus note remains classified as surplus while it is outstanding and is not reclassified as a liability as its maturity date approaches. The reduction of surplus for the repayment of principal occurs only when the state regulator has approved the repayment and the funds have been disbursed to the holder.

Holder Accounting and Reporting Requirements

For the entity that purchases and holds a surplus note, the accounting treatment focuses on the instrument as an investment asset. The holder, which is often another insurance company, initially records the surplus note on its balance sheet at its acquisition cost. The holder reports this investment on its statutory financial statements in accordance with guidance for fixed-income instruments.

The recognition of interest income by the holder follows an accrual basis. The holder recognizes interest income as it is earned over the life of the note based on its stated interest rate. This income is recorded regardless of whether the cash has been received, as long as the income is deemed collectible.

The holder must regularly evaluate the investment for impairment. This involves assessing the financial condition and solvency of the issuing insurer to determine if it is probable that the holder will be unable to collect all amounts due. This analysis considers the issuer’s operating results, capital adequacy, and the likelihood of receiving regulatory approval for payments.

If the holder determines that the surplus note is impaired, it must write down the carrying value of the asset to its estimated fair value. A realized loss is then recognized in its statement of operations. The process of monitoring for and recognizing impairment is a component of investment management for an insurer.

Required Disclosures

Statutory accounting principles mandate specific disclosures for surplus notes to provide transparency to regulators and other users of the financial statements. These disclosures are required for both the company that issues the note and the entity that holds it as an investment.

For the issuer, the disclosures must provide a clear picture of all outstanding surplus notes. The insurer is required to disclose:

• The aggregate amount of all surplus notes included in surplus.
• The key terms for each note, including the original principal amount, interest rate, and maturity date.
• The amount of any interest paid during the reporting period.
• Any unpaid interest that has accumulated but has not yet been approved for payment.

The holder of a surplus note also has specific disclosure obligations. The holder must report:

• The carrying value of the surplus notes it owns, categorized by issuer.
• The terms of the notes held as investments, such as interest rates and maturity dates.
• Information related to impairment.
• Any write-downs or realized losses recognized on surplus notes during the period.