Investing Reserves and Surplus

The assets of an insurance company are segregated into reserves and surplus.

Reserves

Reserves are those assets that are required by the Insurance Commissioner to be set aside to administer and pay potential claims arising from the policies issued by the company and currently in force.

Because the assets in reserves may be required to pay claims, the Insurance Commissioner will impose "permitted asset rules" on the reserve assets so that they are conservatively invested.

Some jurisdictions have liberal permitted asset rules, and allow a substantial percentage of the reserves to be invested in things like real estate or stock. This gives the company the greatest latitude to attempt to make investment profits with its reserves.

Other jurisdictions have more conservative rules and restrict the reserves to cash and equivalents, treasury bonds, and the like. This necessarily limits the ability of the company to generate returns from its returns; however, the potential for investment losses is of course much less.

The amount of reserves that a captive is required to have is usually set with the guidance of an actuary, although the Insurance Commissioner may participate in setting or reviewing the amount of reserves that the company keeps.

Surplus

Surplus are those assets of the insurance company that are not reserves, and are basically "stand by" assets that are available to back any future policies that the company might underwrite. Another way to look at surplus is that it represents the capacity of the insurance company to take on new business.

The permitted asset rules typically do not apply to surplus, meaning that the surplus can be invested in any investment that is otherwise legal and prudent for the insurance company to invest in.

Surplus is typically created either by capitalizing the insurance company or by retaining underwriting profits within the captive.

Investing for a Captive Insurance Company

Because a captive insurance company is basically treated as a "C" corporation, investment income is taxed at corporate rates. Thus, investment strategies for a captive insurance company must look to tax efficiency.

Another factor is that the captive should try invest in a contrary sectors to what the owner's other businesses are in. For instance, if the owner's other businesses are in real estate development, then the captive should not invest in real estate oriented investments. That way if the owner's other businesses run into economic trouble and need the captive to pay claims, the value of the captive's investments will not be simultaneously depressed because of the downturn in the real estate markets.

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