The growing cost and shrinking availability of whole account and net quota share capacity for some insurers is leading to heightened demand for alternative capital solutions including surplus notes, The Insurer can reveal.

Surplus note v2

Sources said the capacity issue is most noticeable where there is cat exposure as reinsurers continue to retrench, but is also being seen in more casualty-focused situations.

The growing demand to issue surplus notes is thought to be attracting interest from a number of specialist investors including funds such as Twelve Capital and in some cases large insurers including those in the life space seeking diversifying risk.

Boutique investment banking and advisory firms such as Stonybrook are understood to be active in the space to bring the solutions to insurer clients, as are the corporate finance arms of intermediaries such as Acrisure Re.

Multiple market sources have highlighted a retrenchment by a number of reinsurers from proportional business that is having a significant impact on cedants, especially those with meaningful cat exposure that rely on quota share support as part of their capital stack.

Public statements on quota share appetite have not been widespread, but Munich Re on its second quarter earnings call revealed that it reduced its proportional property writings at mid-year renewals.

The reinsurance giant’s CEO Joachim Wenning said that after factoring in conservative inflation assumptions the company had concluded that pricing had moved negatively, prompting it to reduce its exposures, particularly in the US.

Munich Re also said it had written no new casualty quota share business, although it had increased its support for some cedants already in its portfolio.

The comments are in line with market intelligence as several sources have alluded to retrenchment at others such as Swiss Re, while a number of reinsurers are only prepared to offer capacity at onerous prices.

In the US, the shift in reinsurer sentiment is seen as having the biggest impact on smaller specialty insurers that tend to utilise proportional treaties more, and those regional or single-state carriers with cat exposure, some of which are relatively thinly capitalised and heavily reliant on net quota share protection.

“Any big user of quota share is impacted by this,” said a senior executive from an investment bank focusing on the sector.

They noted that the smallest mutuals tend to rely on reinsurance capacity from a small number of providers such as Wisconsin Re or Guy Carpenter’s RAP (regional accounts program) facility, while large nationwides would simply retain more in response to limited quota share availability.

“But those in the middle have very real decisions to make and they’re all playing chicken right now with the reinsurance market,” said a source.

In addition to cat-exposed companies, demand is coming from non-standard auto companies and mutuals with meaningful auto books, both areas that typically are significant users of quota share capacity.

The surplus note solution

Multiple sources have said that buyers are looking in particular to the surplus note market as an alternative to quota share reinsurance.

Although surplus notes are debt instruments and share similarities with corporate bonds offering a coupon with a maturity date, they are treated under statutory accounting principles as equity and are considered as part of an insurer’s total adjusted capital under the state regulatory system in the US.

Rating agencies are typically aligned with the regulatory view of surplus notes, although AM Best and Demotech do have a different view on the amount of debt that can form part of a capital structure.


According to banking sources, there is a relatively narrow pool of potential investors that will consider surplus notes for insurance companies, especially for Southeast risk, where the MGA-carrier model is prevalent among small, regional or single-state carriers.

“You’re merging together two business models: you’ve got a fee model, and you’ve got an insurance balance sheet. So you’ve got to be sophisticated enough that you can understand what the insurance risk is and not all debt providers are comfortable with that, because it’s not their area of expertise,” said one executive.

Surplus notes are relatively common as part of a carrier’s capital stack in markets such as Florida.

Indeed sources have said there are a number of examples of Florida and other Southeast firms looking to raise funds via surplus notes to inject capital.

They are thought to include Florida Peninsula, which is understood to be looking to raise capital and has been linked with Stonybrook in the process. Stonybrook has previously raised surplus note funding for a number of cat-exposed coastal operators, including Florida Peninsula.

Investor base

More broadly, investors in surplus notes fall into three groups: private equity houses that have specifically raised a fund to do credit or debt facilities; fund managers, including those involved in ILS; and trade insurance carriers that have the capabilities to do capital markets transactions as well.

Life insurance mutuals are also thought to represent a big investor base for surplus notes.

Bain Capital is an example of a private equity firm linked with a move to target the space. Earlier this year the firm appointed former National Association of Mutual Insurance Companies CEO Chuck Chamness as a senior advisor.

Other private equity names linked with surplus notes appetite include Bridgepoint Group and Centerbridge Partners.

Meanwhile, KKR-backed Kilter Finance – a specialist lender providing flexible capital to the insurance industry – has also been mentioned in dispatches, although its focus is more on the life and annuities segment.

Credit or debt-focused funds tend to have a lower return profile than typical private equity investments but are seen as being less risky, at least in theory.

Stonybrook Capital CEO Joe Scheerer told this publication that risk-adjusted returns on surplus notes could be measured in the 40s.

“There is a high degree of certainty that you will get your money back and when you marry high single-digit interest rates with that high degree of credit quality, you find yourself with some of the best risk-adjusted returns in the market.

“This is especially true in today’s choppy equity markets – both public and private,” he added.

ILS funds active in the space include Twelve Capital, with Hudson Structured Capital Management also previously involved, although sources said its appetite at least for coastal exposure is likely to have dimmed after taking heavy losses on its investments in Southern Fidelity and Weston.

Other active players are thought to include Cohen & Co.

Sources said large mutuals sometimes look to invest a surplus note into a carrier they may be interested in acquiring but that isn’t for sale.

“The note is a way to build a strategy relationship with a group in which you have an M&A interest and see where it goes over time,” said one source.

The reciprocal benefit

Sources pointed to strong demand for surplus notes to initially capitalise the flurry of reciprocal exchanges that have launched to target coastal homeowners and other cat-exposed business in the last couple of years.

Recent examples include Cajun Underwriters, SageSure-sponsored SureChoice Underwriters Reciprocal Exchange, Kin Interinsurance Network, Trusted Resource Underwriters Exchange, Tower Hill Insurance Exchange and American Mobile Insurance Exchange.

Reciprocals are similar to mutual companies in that the policyholders own the entity, with the platform manager an attorney-in-fact (AIF). That AIF is frequently owned by the reciprocal’s sponsors.

One key advantage reciprocals have over traditional insurers or MGAs is they are not exposed to any balance sheet risk themselves.

“The reciprocal exchange is where the classic surplus note is best served, because of the tax advantages and the way you can recycle within the reciprocal,” said a source.

In reciprocal exchanges, however, surplus notes have to come from third-party investors otherwise the owners of the AIF will have to consolidate the results of the reciprocal.

Investor appetite and buyer economics

Investor appetite for surplus notes is likely to be fuelled – at least in part – by a desire for diversification away from volatile equity and fixed income markets.

With regulators approving interest rates on surplus notes, sources said the going rate now is in the high single digits of interest on the coupon.

“If you can get 7, 8 or 9 points of interest from a 150-year-old mutual that’s been through world wars and great depressions, then why wouldn’t you put $20mn into that?” said Stonybrook’s Scheerer.

For issuers of surplus notes the economics may look attractive compared to the cost of a quota share, even if that capacity is available.

In simple terms, the cost of capital associated with a quota share is a carrier’s net premiums to surplus ratio times the margin in the quota share contract.

So if the margin is 6 percent and an insurer is writing a two-to-one net then the cost of capital is around 12 percent.

With some quota shares with reinsurers in areas like non-standard auto building in higher margins of say 8 points, if the cedant has a more levered premium to surplus ratio that could be equivalent to paying 24 points.