How Adjusted Surplus Works

One indicator of an insurance company's financial health is adjusted surplus. It's the statutory surplus that's been adjusted to account for the likelihood of asset value declines. The statutory surplus—owners' equity or net worth—is the excess of assets over liabilities as determined by state insurance regulators' accounting treatment of assets and liabilities. The National Association of Insurance Commissioners (NAIC) requires all insurance companies to keep reserves as a buffer against potential losses.

The insurance company adds the asset valuation and the interest maintenance reserve to the statutory surplus to arrive at an adjusted surplus. Like the asset valuation reserve, the interest maintenance reserve is a fixed amount that insurance companies must keep on hand to protect against a possible loss in the value of their assets due to an increase in interest rates. The company sets these funds aside to protect itself from insolvency and the possibility of not paying its customers' claims. When an insurance company makes a profit in its investment portfolio, the adjusted surplus increases.

If you own an insurance firm, you must know that the NAIC heavily regulates such companies, and financial statements are no exception. This means your company must adhere to NAIC-established Statutory Accounting Principles (SAP). These regulatory guidelines apply to all insurance companies and are not limited to those on the stock exchange.

Adjusted Surplus Example

Assume you own an insurance company. In that case, your company will have to reserve a certain amount of cash—let's say $500,000—in case a year comes where you must make several payouts. The adjusted surplus of your insurance company is basically what's left over after you subtract your company's assets (cash and accounts receivable) from its liabilities (usually accounts payable, etc.). In this case, your assets amount to $1,000,000 and your liabilities $400,000. Your adjusted surplus is $600,000, $100,000 over your goal.

The adjustable surplus of your insurance will grow from yearly operating gains and profits from its investment portfolio, where you can then put the money into the reserves account. So in case a natural disaster like Hurricane Katrina in New Orleans occurs, and your company has to pay billions of dollars of claims, the adjusted surplus is going to handle the payouts. If this happens, your insurance company will most likely raise premiums by the following year so you can build up your reserves again. The higher your insurance company's adjusted surplus, the better its financial health.

This shows that if your company has a weak adjustable surplus, there could be problems in case of a big financial hit or a decline in the value of assets. Because all insurance companies must have a healthy adjusted surplus, your company will do all it can to bounce back if it ever records high payouts that affect its reserve. On the other hand, a year with more gains or profit to your company's portfolio would mean an increase in the value of its adjusted surplus.