Policyholder Surplus: What it is, How it Works

What Is a Policyholder Surplus?

A policyholder surplus is the assets of a policyholder-owned insurance company (also called a mutual insurance company) minus its liabilities. Policyholder surplus is one indicator of an insurance company’s financial health. It gives an insurance company another source of funds, in addition to its reserves and reinsurance, in the event the company must pay a higher than expected amount of claims. When an insurance company is publicly owned, its assets minus its liabilities are called shareholders’ equity rather than policyholder surplus.

Understanding Policyholder Surplus

Policyholder surplus is one metric that insurance rating companies use when developing the simple letter ratings ranging from A++ to F. Consumers can turn to these ratings for help in choosing an insurance company because they indicate the strength of an insurer financially. It’s important for consumers to choose an insurer that can afford to pay its policyholders’ claims under varying circumstances, even if a widespread disaster like a severe storm means that thousands of policyholders are simultaneously filing claims.

Policyholder surplus is also a component of various other calculations that ratings companies use to evaluate insurance companies' financial strength. These calculations include ratios such as reserve development to policyholder surplus, loss to policyholder surplus, net liabilities to policyholder surplus, and net premiums written to policyholder surplus, among others. Calculations involving policyholder surplus are also used by state insurance regulators to determine which insurers might need their attention due to financial weakness or over-reliance on reinsurance. For publicly-traded insurance companies, the same calculations can be performed by substituting shareholders’ equity for policyholder surplus.

Interpreting the results of these calculations requires specialized knowledge, not just common sense. For example, insurance company examiners will consider the company’s change in policyholder surplus from year to year as one component of assessing whether the insurer is becoming financially stronger, weaker, or staying about the same. While it might seem like a significant increase in policyholder surplus from one year to the next would always be a good sign, it could sometimes indicate that the insurer is on the verge of insolvency.

Policyholder Surplus Creates Competitiveness

When the insurance industry is flush with policyholder surplus, the insurance marketplace becomes more competitive. Fueled by lower premiums, relaxed underwriting, and expanded coverage across the industry, carriers begin to compete more. This is called a soft market. Historically, soft markets are temporary. Lower premium prices reduce underwriting profits, and the industry’s return on average net worth begins to deteriorate. The industry also attracts less capital. As liabilities begin to chip away at policyholder surplus, insurance companies are forced to raise premium prices, underwriting tightens, and coverage is restricted. Then, the soft market becomes a hard market.