Definition of Insurance Surplus

Most insurance policyholders don’t like paying for insurance, but they want their insurance company available when they have a claim. An insurance policy is only good if it can be backed up. That’s why the solvency of an insurance company is so important.

An insurance company needs a surplus to maintain this solvency. But what is an insurance surplus, and how important is it?

When an insurance company has more assets than liabilities, they have a surplus. The insurance industry aims to have a sound ratio of premiums written to its surplus.

According to the National Association of Insurance Commissioners (NAIC), if an insurance company doesn’t have at least the minimum surplus each state's department of insurance requires, they are in danger of insolvency. This is particularly possible if catastrophes strike policyholders. The more claims against the insurance company, the more a surplus is drained. If the insurer doesn't have an adequate surplus, insolvency is possible.

Reserves are the financial liabilities the insurance company possesses. There are two types of financial liabilities: One is loss reserves, and the other is unearned premium reserves from various insurance products.

Loss reserves are based on claims. When insurance agents report a claim, funds are set aside in a reserve to pay the claim. This is an insurance regulation every insurance company must follow.

Premium reserves are funds paid by a policyholder for insurance coverage that has yet to be used because the policy has yet to expire. An insurance regulation is in place to ensure a hold on these funds.

Insurance coverage is only available if the insurance market is solvent. That’s why an insurance company is careful with how it places risks. It doesn't want to insure activities and property that are overly vulnerable to loss. For instance, some insurance companies in North America are so particular about their underwriting that they won’t insure or they limit the number of policies they sell in areas susceptible to catastrophes, like hurricanes.

But beyond underwriting high-risk properties or activities, an insurance company carries a policyholder surplus for day-to-day insurance claims. An insurance regulation requires that an insurance company must have a minimum surplus in its home state before selling insurance coverage. The insurance commissioners for the state's department of insurance monitor this. If a surplus is weak and liabilities are high, it could lead to lower ratings or insolvency.

This surplus is not fungible. For instance, it can't be transferred from one insurance company to another insurance industry member.

Because policyholders prepay premiums, insurance companies can invest those funds. The interest from these investments helps fund a surplus.

Investment is necessary to generate a surplus beyond premiums. The insurance industry profits don’t usually come from underwriting. Instead, the income generated comes from investments that are used to offset underwriting losses.

For instance, the Rocky Mountain Insurance Information Association states that the average yearly vehicle insurance premium is over a thousand dollars, but if you have a car accident and total your car, the loss could be upward of $10,000. Then, you might need to add any hospital costs or liability costs if you were at fault.

In other words, you received more money than you paid. That’s why an insurance company will invest premiums to help pay claims.

The insurance industry must maintain a surplus of funds to protect the policyholder. If catastrophes or other accidents occur, you need your insurance to be available. Without an insurance surplus, this may not be possible.

But what if an insurance company doesn't have enough surplus and goes insolvent? Fortunately, there are state guaranty funds to protect policyholders from insolvent insurance companies. These funds are a pool of funds that are available for policyholders. The funds come from assessments levied against the insurance industry.