Why Private Credit Got Entangled With Insurance

Introduction to AI investment research

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Podcast introduction

2:09Bloomberg Audio Studios. Podcasts. Radio. News.

2:29Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, there's a key tenet of finance and investing. And I think it's like essentially the thing that makes finance and investing work. Go on. It is the idea that you can invest in pretty much anything. The world's most stupid thing. I don't care. Dogecoin, whatever. But the key thing is, if you do that and the investment doesn't work out and it goes belly up, you should bear that loss.

3:02Yeah, I think that's right. I would actually. Ideally, by the way, you invest in something that doesn't have negative externalities for other people. But, you know, let's just focus on the loss portion for a second. Yeah, I like this framing. I think the way you could say that financial structures overall, whether we're talking about a bank, whether we're talking about a multi-strategy, multi-platform hedge fund, whether we're talking about whatever, is an exercise in trying to establish this purpose. Right. Because everyone wants to make the investment that they don't bear the loss in.

3:34Right. That's like we and we should all to some extent, we should all be striving for that constantly. You want to build up these things that more or less create that to happen. Principal agent alignment problems and so forth. Right. And so when you get moments in financial history where losses are not purely born by investors. Yeah. People often get very upset. And as you know, 2008 was one of those moments. Right. One of the reasons the 2008 financial crisis was such a huge deal was because we had banks who made a bunch of risky investments and ended up getting effectively bailed out by taxpayers, even though taxpayers arguably were not the ones deciding to invest in synthetic CDOs and things like that.

4:17Even in the absence of bailouts, this always bothers people when someone makes money on a risk. And then someone else holds the bag from the bailout example to people who promoted SPACs and made a lot of money just on the transaction, but didn't participate in the downside. It upsets people. Right. And so all across finance, you see in situations where people are upset when it turns out that the person doesn't have the requisite, quote, skin in the game, unquote. No one wants to be an unwilling bag holder.

4:48That sounds bad. But I want everyone else to be like, we strive.

Private credit and insurance

4:52OK. OK. But wait, the reason I bring up 2008 is because it's actually a very important component of this conversation because we're going to be talking about private credit and private credit to a large extent has grown into this massive industry. And the reason it's grown so much, one of the reasons, is because after 2008, after the banks went belly up and had to be bailed out, et cetera, you had policymakers make an active decision saying that they wanted to move risk out of the regulated banking system into investment vehicles where, if things went wrong, the investment vehicles themselves would bear the losses without having those losses socialized through deposit insurance or taxpayer-funded bailouts and all of that.

5:34And that's what basically happened, right? Yeah, I would say there are sort of in the financial system, we have sort of, I would say, two types of creditors. Like, we're cool with, like, people losing their money when they give money to an institution, they take a risk. But I think there's essentially two types of entities for which we don't find that to be fully acceptable. We don't find it to be fully acceptable when someone deposits their money in a bank. And we, you know, we could say this is a loan, right? But we don't really want to accept that this is a loan.

6:06Like, we don't want people to have the confidence, they're putting money in the bank. I'm not really making a loan to the bank. And then I would say the other category is insurance holders. And we don't really like the idea, you know, as someone who owns a policy, it's a little bit different than a loan. But I think the idea of, like, an insurance holder as a bag holder does not sit well with people on a sort of democratic, sort of societal level. All right. You have totally anticipated the next thing I was going to say, which was we moved risk out of the regulated banking system into private credit.

6:37Yeah. Which seems fine. Yeah, it's great. Like, all right. Risky loans, all that middle company stuff. Deposit holders don't have to worry anymore. Right. Exactly. If risk is now migrating back into another regulated financial industry that we do care about, for the reasons you just stated, which would be insurance, that doesn't seem ideal either, right? Having credit risk migrate out of the banks into private credit and then having private credit migrate into insurers. Yeah. And, you know, like, I think insurers and banks aren't really that different.

7:09It's sort of the differences, the timing and the liquidity with which you can get the money back out of your whether if you're a depositor, can you get your money out on demand? If you're a policy holder, can you get your money out either at a certain time or on an event in which the policy triggers? But fundamentally, I've always thought it's kind of the same different the same business with a different sort of redemption schedule. There are differences between insurers and banks, which we're going to talk about for sure. But one thing I should just say is we have discovered in the course of this podcast that one of the driving forces behind the private credit boom has been its linkages with insurers for some of the reasons that you just said.

7:49So insurers famously have long dated liabilities, right? They have patient capital. They can take in a liquid asset and sit on it for ages and ages and capture that illiquidity premium, that higher yield. So they would seem to be a natural place for private credit to actually end up. But as we mentioned before, it does open up this whole new can of worms about losses and who actually bears those losses. So this is what we're going to be discussing today. The insurance, private equity, private credit nexus in excruciating detail.

8:20And I'm very happy to say that we do, in fact, have the perfect guest. We're going to be speaking with Andrew Granato. He is assistant professor of law at UT Austin, as well as Pranjal Dral. He is a J.D. Ph.D. candidate in financial economics at Yale University. And they just published a really good paper. It is called Private Credit State Backstop, How Private Equity Socializes Risk Through Insurers. Great. So truly the perfect guest. Andrew and Pranjal, thank you so much for coming on All Thoughts. Yeah, thanks for having us. Thanks for having us.

Insurance and private equity relationship

8:49So we know that insurance has teamed up with private equity in various ways. Some private equity firms own insurers outright. Others have like minority investments or like different business relationships. What is the attraction or the allure of insurers for private credit slash PE? Yeah, so you can think of this as being so McKinsey has called us a flywheel. So imagine you have like a private equity firm with three subsidiaries. You have a traditional like buyout subsidiary that buys up companies and uses leverage to do so.

9:22You have a private credit fund, which issues these high risk, high yield loans. And then you also have a life insurance entity. There are theoretically all these different synergies between all of these actors. So if I go and I need to buy some sort of company, well, someone has to issue debt in order for me to be able to do that. Maybe a different part of my PE firm can issue that debt and maybe I can get better terms that way. But then there's also this aspect of, you know, if I have a private credit fund, you know, these are funds where, you know, I have LPs who are constantly, you know, making demands for returns.

9:56But if I have a life insurer, I have these very long dated liabilities where arguably the capital is like what we're told is permanent. So if you can hold these private credit loans that are highly liquid on the balance of the life insurer that you're issuing to other firms in your portfolio, you can imagine that this is like a scenario in which you kind of theoretically get the best of all three worlds. One more way to think about it is that private credit has become a large asset class.

10:26Insurers want access to that private credit. And instead of having an in-house team that just learns how to do private credit investment, they go outsource that to a big PE shop, which has developed this business over two decades in some cases, and essentially outsource and use these economies of scale to outsource part of the lending. So they can still do the, you know, publicly traded sort of boring credit that they've always done and outsource part of the lending to more specialized shops. Well, this sort of realization that these things could merge has just made people an extraordinary amount of money.

11:02It should be noted, you know, one of the most infamous investors of all time, Warren Buffett, utilized this core insight that an insurance, having an insurance arm would be an extraordinary source of patient capital. You know, we talked to like mutual fund managers, and one of the questions we always ask them is like, isn't it tough that at a market drawdown, you can't actually hold it because your clients all move on to the next fund? I mean, this is already for a very long time, just been an extraordinary, fruitful partnership. Yeah, it's not something that's new.

11:33What's new about private equity in the last 15 years or so is the degree to which that they have kind of ramped up the aggression of the investment strategy that they are pursuing with, one, by purchasing these life insurers at such high volumes. Recent estimates have maybe like something like $750 billion or so of life insurance assets kind of within private equity's purview. And then the degree to which they are shifting the portfolios of their life insurance firms. Until quite recently, life insurers were famous for having these, you know, as Roger says, very kind of stodgy, AAA rated AT&T bond portfolios.

12:11And that becomes less and less true across the industry in general. And that's a trend that's being led by private equity, particularly with regard to these like affiliated private credit investments and their other portfolio companies. Yeah. So this is the key thing, I think. So insurance has transformed private credit by supercharging its growth.

Insurance transformation by private credit

12:31But at the same time, insurers themselves are being transformed by private credit. Can you talk about exactly like what does that relationship look like in practice? So you mentioned affiliated assets, which have been in the news recently for reasons we can definitely get into. But if I'm a private credit originator and now I have bought an insurer, what does that relationship look like? Am I dictating that? Am I telling them what they actually need to buy? Am I making polite suggestions?

13:02Am I making sales pitches and saying, well, you got first crack at these very elite, previously exclusive private assets? That's a great question. So as you can imagine, there's a lot of nuance there where certain asset managers. So just to set the stage a bit, Alliance, for example, owns PIMCO and Alliance, the insurer. And this happened in like starting 2000. So the idea of having an asset manager make investments on the behalf of the insurer is not new. The second point there is there's a lot of variation in how that contract works out.

13:33So the most, in our parlance, problematic or concerned we should be is about when the insurer balance sheet is effectively in control of a bigger asset manager. So the idea there would be that the insurer doesn't have as much discretion. They're just at the behest of the broader asset manager. Or you can imagine an insurer goes out shopping. I want the best private credit shop to invest money on my behalf so I can capture the liquidity premium, offer better terms to my policyholders by making more money.

14:08And in that case, there's like a lineup of really sophisticated PE shops that will try to earn that business. And in that case, you can imagine this is called like a third-party agreement where you're outsourcing part of your balance sheet to an asset manager. And that's totally like you can imagine a very competitive marketplace for that service because insurers, as you said, manage large pools of money. So there's like a big spectrum there, one where the insurer has effectively given up full control of the balance sheet, and the other where the insurer is essentially looking for who's going to offer me the best terms to invest my money in this very specific segment.

14:44And you can imagine a spectrum of possible arrangements there. So if I'm an insurer who's owned by a PE shop, I'm paying them management fees as well for those assets, right? That's right. Okay. And so you're paying management fees in both cases, usually. It's just in the third-party context, since you don't own the insurer, you'd imagine the insurer has better bargaining incentives. Exactly. Oh, yeah. And there's also many cases where the insurer, as part of a private equity kind of like sponsored platform, is not just paying out fees for management,

15:16but it's also paying out fees for essentially all sorts of other affiliated services. Like, you know, you could imagine accounting, you can imagine valuation, consulting, all sorts of things. Like IT. Yeah, where like the insurer is kind of like, the balance sheet of the insurer is a holding pen for a lot of the assets, but all of the action is actually outside of the insurer's corporate form and the rest of the kind of fees on there. What if you could use AI to research your investment portfolio and ask,

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16:33Restrictions apply. AI integrations provided by third parties. IBKR does not verify content generated by AI platforms. So there's a lot of noise about AI, but time's too tight for more promises. So let's talk about results. At IBM, we work with our employees to integrate technology right into the systems they need. Now, a global workforce of 300,000 can use AI to fill their HR questions, resolving 94% of common questions. Not noise. Proof of how we can help companies get smarter by putting AI where it actually pays off,

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Competition among insurers

18:10So one of the questions then is, how much competition is there among insurers to gather assets? Because it's like, okay, here is insurance company A and they're going to pay me $5,000 a month for life because I've bought this annuity every month for the rest of my life after I turn X age. And here is another one. But this one is paying all these IT services and all these little things that maybe come out of the return, etc. Does the end market of insurance purchasers have much clarity on what they're buying and the economics of two different policies?

18:48It's a hard empirical question. So there's this thing in finance called the annuity puzzle where, in theory, annuities are the perfect investment, but society as a whole underbuys them. And a lot of finance professors have spent decades puzzling out why that is the case. So we're not going to solve it here. But one of the lessons from that literature is that people are underinvesting annuities because they don't get a good deal. Prices are too high. The policies aren't that good. There's competition, but the end consumer doesn't get a great deal or they at least perceive they're not getting a good deal. So there's always been this concern that, for some reason, the annuity market isn't very competitive.

19:23Now, you might imagine if an insurer is owned by a PE shop and they make a lot of money on the private credit illiquidity and all this, because it's high returning and all this stuff, and they earn fees. So in some ways, a PE shop that owns an insurer might offer better terms to policyholders because they have all these other ways to make money from the business. So we've seen some empirical data that, like, the PE-owned insurance companies compete better in the product market. So you can imagine that consumers might benefit.

19:54The problem there is, of course, that, you know, you might get a good deal in the short run. But, you know, decades down the line, when things come due, there might be problems. If I'm in the market for an annuity, should I or do I have any capacity to take into account credit risk? As someone who grew up or became an adult kind of during the GFC, I was like, I don't know. Like, I'm going to retire in like 20 years. Who knows who's going to be around? To what degree either does that or should that be part of the information that the purchase of the annuity has?

20:25Yeah, so it's very difficult, I think, for retail policyholders to meaningfully grasp, like, the degree of solvency risk that the kind of counterparty annuity provider or life insurance provider has. And so something that we think is really fundamental is that, you know, the investors in, say, a private credit fund, nonprofits, you know, endowments, big institutional investors, pension funds, they're in a very different position than just, like, normal people who, like, don't know about anything, you know, what this insurer is doing with all of the money.

20:58As far as they know, they just bought a life insurance policy. And I'm willing to bet most people haven't even thought about what happens, like, kind of on the other side of that balance sheet. And that asymmetry is what drives a lot of the, like, I think the results that we're going to speak about. Yeah. So, OK, speaking of asymmetry, the McKinsey's of the world out there who will talk about this being a virtuous flywheel where, you know, PE slash PC gets access to these big pools of permanent capital. And then the insurers themselves maybe get access to higher yielding assets that then generate better returns for investors, better products, et cetera.

21:32On the other hand, you also have critics of this practice who will point out that because of the nature of private credit, because these aren't publicly traded bonds with, you know, double A, I guess now, or maybe triple A ratings for some corporates, you don't necessarily have the level of insight into what these things are and what their true riskiness is. Talk to us about what we know about the actual private credit assets on insurer balance sheets and what regulators can actually see and know about these things.

Private credit asset valuation

22:04So this has been a topic of discussion for the last two years. It's almost, I feel like, this almost obsession of how much should we trust private credit valuations. And that's a problem in BDCs, which are like, you know, publicly traded, and you can see the quarterly marks on these loans. And you can see, you know, there's a privately traded BDC and there's a publicly traded BDC, and the public one trades at a discount. So there's always been this concern that the valuations aren't kosher or they're overvalued in some ways. So those same kind of intuitions apply here, except the crucial difference is the regulator, in case the NAIC, which is an association of regulators, essentially has visibility on an insurer's balance sheet, and they look at everything they invest in.

22:48This could be equity, cash, safe bonds, whatever that means, and private credit bonds. And all the insurer regulator sees is the value reported to them, which is usually outsourced to a third party rating agency. And then they see like, this private credit loan is valued, it's like a double A, and then they give you a notch on a scale of one to 10. And you get this picture as an insurer, these private credit assets are X amount of safe, these private credit assets are less safe, and there's like a spectrum.

23:20And then the regulator says, this is a good portfolio, it's safe. And like banks, they have to hold certain amounts of capital against the portfolio, right? Yes, there's a whole risk rating regime through the NAIC that is like somewhat analogous to that of banks. And I think a lot of the concern applies here as well to like, there were concerns in 2008 about what are the incentives of the credit rating providers, the incentives for what are often called private letter ratings and for life insurance are kind of particularly skewed. These are ratings where the rating itself is actually not kind of publicly visible.

23:54So a credit rating agency, someone like Egan Jones might report to the NAIC, you know, here is our rating for this asset. And, you know, how was that rating obtained? Can anybody else like investigate? Is there any sort of track record to compare this against? It's just extremely difficult. And so there's a variety of new empirical literature and economics that's coming out basically every week where people will do various sorts of tests and they'll just continually find overvaluation in a lot of these assets. Since we're talking about 2008 for a second, you know, one of the sub dramas with the bank bailouts was this idea that the bondholders of banks didn't take any haircuts.

24:33And so it was like there were losses at quite substantial losses, but they were all born on the equity side. And we saw like how, you know, the city groups of the world like not lost 95 percent of their money was part of the reason that regulators or policymakers were so reluctant to let some of the bondholders take losses is because you just described the classic normie insurance holding. I'm sure in 2006, you know, it's like, oh, yeah, we have a highly rated bond from a city group in our portfolio. It's like the equivalent of the AT&T bond was part of the concern with bondholder haircuts, essentially, that then it could create an issue with the insurance channel.

25:11Yeah, I think that a lot of the same logic applies what insurance has that banking doesn't have is essentially is a different form of a public backstop that indicates different kinds of agency problems and also a differing way that taxpayers and kind of other like non investor actors can be put on the hook for an insurer's losses. So all of that interacts in like kind of very complex ways with the actual direct capital structure of the insurer, which is partially, you know, these policyholders who are technically, you know, creditors to the insurer.

25:49They show up as liabilities on the insurer balance sheet. And then there's also kind of direct creditors to insurers. They're not covered by the socialized backstop, but there is this kind of like endless relationship that keeps shifting when you have what we call like or what is that an insurance guarantee fund? Yeah. So this is actually the real subject of the paper. As much as we talk about ratings, arbitrage and opacity of private credit assets and things like that, the point that you make is that because of the way that insurers are regulated and I guess administered when they go belly up, although they don't really go through traditional corporate bankruptcy proceedings.

26:29But the way they're dealt with if there's a failure is fundamentally different to the way banks are dealt with in our system. Talk about those differences for us.

Insurance guarantee funds

26:39Yeah. So I think when people think about what is a public backstop look like, if they're familiar with one, they're familiar with federal deposit insurance. And federal deposit insurance is a prefunded risk based system. So if you're a bank and your depositors get federal deposit insurance, every quarter you get an assessment from the FDIC, which basically says you have to cough up some money as a kind of risk premium. The FDIC has a deposit insurance fund, which holds that money. And in the event that a bank ever goes down and payouts ever need to be made to keep depositors whole and to like administer the insolvency of a bank, you know, they spend down that fund.

27:20And in the event that that fund is ever fully depleted, there is the kind of full faith and credit backstop of the United States government. So that would be truly a kind of taxpayer funded bailout. In 2008, we also had, of course, like TARP. So that was, you know, like legislators had to go and vote, say, okay, we're going to individually appropriate money, we're going to appropriate loans, we're going to appropriate all sorts of investments, because like the scale of the problem was just too large to deal with through the FDIC on its own.

27:53Insurers are subject to a different form of public backstop that we argue in the paper is kind of essentially structurally worse. The way that a guarantee fund works is, if a life insurer goes bankrupt, it does not go into bankruptcy, similarly to how a bank does not go into bankruptcy. Instead, the domiciliary state of that insurer takes the lead on a simultaneous insolvency proceeding across every single state.

28:24Insurance is regulated at the state level. There is no kind of federal regulator of insurance. There is no equivalent to the FDIC, you just go into state court, and then we have to resolve this across every state simultaneously. And within every single state, there's a guarantee fund that says, you know, if you are a policyholder of this insurer, we're going to guarantee that you get up to some statutory cap of your money. Similarly to how for the FDIC, you get up to 250K, in theory, potentially it could be far more, but statutorily, you get your first 250K and every account is insured.

29:02It depends on the state law for each individual state coverage, but you can think of it as being roughly 300K. So if I have a life insurance policy that's supposed to pay out for $200,000 when I die and my insurer goes down, I can just keep paying premiums and the policy backstop fund will make sure that I get or that my beneficiary gets 200K in the event that I die and that I've maintained my end of the contract. The way that a guarantee fund pays for this protection in the first instance is by levying an assessment on every surviving insurer in that state.

29:43But this assessment is only levied after the insolvency has already happened. So if I'm the insurer that went down, I've actually contributed $0 of my own. It's very ironic for insurers themselves to not be like paying something towards insuring their own debts. Yes. Yeah. So like you, well, of course, you know, the company has gone down, so it's not a happy ending for them, but like they don't have to cough up anything. Meanwhile, you know, some other random insurer who had nothing to do with this, they have to pay some sort of bill.

30:14And that bill is weighted by the percentage of premiums that they sold in recent years in that line of business. So, you know, the other life insurers in the state of Oregon or whatever, if I have a life insurance policy and I'm in Oregon, like they have to pay up. But then what happens afterwards depends on the state exactly. But in the vast majority of states, you can, as the insurer, get a tax credit against that assessment liability.

30:45And in about 34 states, you get a full tax credit that you can take 20% a year over five years. And then in another 10 states, it's roughly 10 years. It's only about six states where you don't get any tax credit. So, of course, if you have a fully offsetting tax credit, this is economically equivalent to a taxpayer bailout of the insurance policyholders. But nobody ever votes on this. There just happens automatically by operation of law. And the insurer is stuck with losing what we might call like kind of just like time value of money because they have to like float this in the meantime.

31:21But it is a stealth taxpayer bailout. And beyond the sort of structural issues, you might imagine some practical problems with this setup. Number one, the statutory cap in FDIC is $250,000, which is considered a fairly high amount for like just someone having a checking account. In this case, you know, close to $300,000 for life insurance. That's about the 40th percentile of life insurer policies. A lot of policies are way bigger than that. As you can imagine, people who usually buy life insurance are usually richer and they're putting a lot of money into premiums.

31:53So the coverage of this bailout is way lower than sort of bank failure. And the other sort of big concern is that just practically speaking, Iowa and Oregon and New York and Tennessee sort of doing this at the same time is a very challenging task. We haven't really had major insurer failure in this way. Like in 2008, obviously, EDGE was bailed out. So the idea is that... Have we ever had a big insurance failure? Not on this scale. So it's actually it's completely untested to have a large national insurer with assets and something like, you know, the hundreds of billions of dollars range go and solve it in a way that would require administration through the guarantee fund.

32:38So is it fair to say it's like structurally suboptimal on multiple levels? So it's suboptimal in the sense that there is this implicit taxpayer backstop in a way that's a little different from the FDIC. But it's also suboptimal that the backstop isn't actually that good for the policyholders potentially because it's like, all right, if we're going to have a backstop, at least we can rest easy that the policyholders like maybe there's a little bit of misalignment. The backstop encourages the insurer to take undue risk. But look, it's OK. It's good in the end because at least policyholders can sleep easy.

33:12But what you're saying is we don't even have that. We have the taxpayer part and we don't really even have the FDIC equivalent that can make everyone sleep easy. Exactly. And since you're not paying as your solvent, you're paying post insolvency. One more thing that might the regime encourages is as you head into distress, you want to take on more risk. It seems good for an immoral insurer, right? Just a self-irrational insurer. Right. It's like a Holmesian bad man insurer is going to just simply invest more risky things, try to give really good deals to policyholders to make premiums today.

33:48Oh, yeah. You're not paying for it. Because you're not paying for it in the end. So at least in like an equilibrium sense. And, you know, the rivals knowing that one of my rivals is going to go bankrupt soon, they're going to want to pull out. Because with FDIC deposit insurance, they put a cap on how much rates you can offer. Like that's part of that trade so that you can't – a desperate bank can't say, oh, we're paying 15 percent on savings accounts right now. But there's no – in insurance, that mechanism doesn't exist. Exactly.

34:19So there's a lot of noise about AI, but time's too tight for more promises. So let's talk about results. Let's talk about healthcare for a second.

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36:554imprint. 4certain. Wait, so you suggest in the paper that this might be the real reason that private equity slash private credit has been so interested in the insurance space, because it provides them an avenue to basically a socialized backstop, which, you know, makes sense. But I guess I wonder, in the course of your research and actually talking to private equity and private credit, how aware are people of the current regulation scheme for bankrupt failed insurance?

37:26Does it come up a lot? I think one of the main ways that this ends up playing out is that what people are often thinking about is, you know, turning back to the permanent capital angle, am I allowed to just, like, make my investments without somebody yelling at me about them? And one of the reasons why, if you have a life insurer, you can make kind of whatever investments you want without, like, nominally the creditors of your company or the investors in your company coming and yelling at you is because you have... Not having people yell at you is, like, a very underrated incentive in the world, but I think it's one that probably is very important.

38:03Yeah, is that you have this widely dispersed retail base of policyholders, a large fraction of whom are totally insured. And so even you can do whatever you want. And, like, in theory, they shouldn't care because no matter what, they have full coverage. Obviously, that's not true for everyone, but it's just the level of kind of examination that you're going to get from your creditors is so much lower if you are running the private credit through the life insurer balance sheet rather than through kind of a standard private credit fund.

38:38One more point I want to make is that I've spoken to some people who, you know, work in this space. And one thing they say is that, say, there's a good insurance manager and a bad insurance manager. They both use private credit. One of them uses investment-grade private credit on the balance sheet. The other one uses rating-inflated bad private credit. And since the valuation regime is sort of opaque and sort of hard to tell what's, like, a truly good private credit loan versus not, it actually penalizes in equilibrium sort of good asset managers because they might have access to, like, AT&T private credit.

39:13And if they're getting the same ratings from Egan Jones as someone who's investing in, like, a middle market SaaS company in Chicago, obviously those two are extreme examples. They get different notches in the NAIC system. But you can imagine at the margin, the high-quality private credits also suffer just by ratings inflation because you're not just hiding risk. You're also competing in this dynamic market. So the insurer who has access to investment-grade private credit might also suffer. And the design of the guarantee funds actually amplifies this problem because in banking, the assessment premiums that banks pay are risk-weighted.

39:49They're not purely size-weighted. Obviously, size is a major important component of risk. But for guarantee funds, it's purely the premium volume. So you can imagine two identical insurers with the same premium volume, except that one of them, you know, invests very conservatively. The other one invests, you know, like a madman. You know, the expected value of the public backstop is much greater, you know, for one than the other. And so you have this kind of implicit subsidy that is being routed through this, like, underlying backstop. In the event of, like, a failure, like, there is not, you know, as you said, it's only the 40th percentile policyholders.

40:24There are a lot of potential losses. In the literature, in your work, et cetera, is there a certain expectation that there exists in the world certain other implicit backstops that aren't formalized in law for those premium holders? Or could it only be the type of thing where it's like if they're going to get, quote, bailed out, unquote, it would be some sort of tarp-like vote again where politicians would have to stick their necks out? I think that's the exact way to think about it. So this, the 40th percentile person is just by operation of law going to get a bailout.

40:57And then you can imagine politicians, especially local politicians, you might imagine, don't want their state's policyholders to lose out on, you know, people who owe life insurance policies and their insurer goes insolvent are some of the most empathetic people on the planet. So I'm assuming that would be an easy yes at the state level to make them whole. Obviously, it's impossible to, like, predict the future. But it's almost hard to imagine them not getting some protection in the future. There's also the potential, especially in states that actually don't have the tax credit, for a, like, perverse feedback loop.

41:31So if there is a bad macroeconomic environment and some large insurers go down, that levies assessments on other insurers that are already hurting. And that comes at the worst possible time. And if that pushes other insurers into insolvency, you know, then you have this very vicious cycle. That cycle is ameliorated, of course, by the fact that in most states you do have these, like, tax credits. But also, you know, if interest rates are spiking during this time, then you run into kind of more serious time value of money problems with the fact that the tax front has to be taken over five to ten years.

42:06Can we just do a quick history detour for a second? Because hearing you describe this system, it does not sound ideal, to say the least. How did we end up with this particular, like, organizational structure for regulating insurers? So the kind of history of state-based regulation of life insurers goes back to when the Supreme Court had a much kind of stricter interpretation of the Commerce Clause. And so it did, in, like, a famous case in the 1800s, the Supreme Court said that insurance did not constitute commerce for the purposes of the Interstate Commerce Clause.

42:43In the 1940s, the Supreme Court reversed that decision as part of its general trend towards being more permissive of federal regulation. But Congress immediately, like, disclaimed its new power to regulate life insurers in an act called McCarran-Ferguson. And McCarran-Ferguson says that, you know, unless Congress explicitly passes a law that says we're regulating insurers, all other regulatory authority is reserved to the states. So it's just pretty much been like that the whole time.

43:13There are periodic waves in which there's, like, activism for federal insurance regulation, usually because of a wave of insurer insolvencies or some other, like, you know, alleged malfeasance in the industry. And then what will typically happen is that the NAIC, which is the kind of association of state regulators that formerly operates actually through a nonprofit, it's not formally a public entity at all, will act to try to forestall that federal push by kind of doing it on its own.

43:43And that's what happened with guarantee funds in the 1960s and the 1970s. There was a wave of insolvencies and property and casualty insurance, and there were bills introduced in Congress to create a federal backstop that was kind of similar, you know, to the FDIC. And the NAIC and various states quickly responded to create these state-level backstops instead. And one of the interesting ways the NAIC operates is that most states actually defer rulemaking to the NAIC fully into the future.

44:15So I think Indiana is one of these states where they self-incorporate the model law that the NAIC puts out, even prospective changes. Oh, so they just, like, cede control entirely. Yeah. So there are state laws that say if the NAIC says this, it will be automatically incorporated into our own state law, which is, like, a very distinctive arrangement. So it occurs to me there is one – like, so a difference between banks and insurance is that banks have the possibility of correlation on two fronts.

44:46So all the loans – if you're here to say banks make a lot of housing loans, like banks all could go – the loans could all go sour at the same time. But then also their depositor base could be correlated, right? We saw this with SVB, but you could also just imagine in any other environment people get anxious about a bank and they all withdraw their deposits. That can't quite happen the same way with an insurance company, at least if we're talking about vanilla insurance, where you only get paid out either on an event or retirement or something like that and you stagger it. Does that change the dynamics or the fact that insurers could still have correlated failure?

45:21They're all maybe making loans to software companies at the same time, but they don't really have the risk of correlated withdrawals in the same way that a bank would? Great. That's a pitch for our next paper. That's the follow-up that we're going on now. Runs in insurance. You can imagine conceptually there's runs on the asset side of the liability side. I'll speak a little bit about the assets and Andrew is more an expert on the differences in policy and liabilities. But on the asset side, as you said, all of them make loans to Chicago SaaS company in the middle market and then they all go calling back and there's not enough cash flows.

45:56So in that paradigmatic sense, since banking has very good, you know, like on the floor of a bank, there's officials in the federal government that say don't invest in this type of risky asset, usually about credit, but also I'm sure they're thinking about industry risk. Yeah. We're watching your SaaS exposure. Yeah. Something like that. And insurance, since that regime is much weaker because it's dispersed, the NAIC is less, they have way less resources and power than the federal government.

46:26So just on the asset side, the monitoring is much worse. Okay. So you might imagine there's more possibility of correlated exposure than there is in banking. And you can imagine, you know, like the last year or so, a lot of the private credit pain has been due to a very specific kind of exposure. Insurance or something like 15% of the assets are in private credit, 10 to 15, depending on how you measure. And the idea that a third of private credit is the software, it's not a stretch. So you can imagine like, you know, 30% of that 15% is in one industry.

46:57Again, I don't have the specific numbers because they also do infrastructure and all these longer term things. But the idea is like it's more possible in the insurance context of banking. And the liabilities is a completely different answer. Yeah. Liabilities is fascinating. And that's going to be like one of the primary subjects of our next article. So like one preview would be if things depend a lot on the kind of life insurance policy that you hold. So, for example, you could have, let's say, if you hold a whole life policy and you have a cash value reserve account inside of that policy, this is like essentially a tax preferred, you know, kind of a Roth IRA thing that's inside of a life insurance policy.

47:32And you have rights of withdrawal on that account. And so that is demand deposit like. And so if you had a life insurer that had sold a ton of cash value life policies and people tended to store a lot of money in those policies, you know, you can run on that. To be clear, would you say that historically, since these are sort of more exotic flavors of insurance, that regulators have approached this industry as one in which, quote, runs aren't a phenomenon the same way we associate them with banking?

48:05And banking runs is like the primary concern. It drives everything. And in insurance, I do think, you know, kind of per the permanent capital hypothesis, you're structurally. The asset liability mismatch. Yeah. Like you, there are good reasons to think that insurers are structurally less vulnerable to runs on average, but it depends a lot on the nuances. And there have been runs on life insurers before. So executive life in the early 1990s was a life insurer that was really struggling.

48:35And there was a run on the insurer. Now, executive life was, you know, a few billion dollars worth of assets. This is not something that it's going to cause the financial system to collapse. And so I think we've been very lucky that we have not had a situation like that happen with a very large life insurer. Well, OK, speaking of cascading risks, one thing I never understand when it comes to insurance is reinsurance, because it's just like you have the insurers and the reinsurers insure them. And then do you have like re-reinsurers who insure the reinsurers?

49:07I think it's insurance all the way down. But you talk a little bit about this concept in your paper of shadow reinsurance. What exactly is that? Yeah, shadow reinsurance. So if you are an insurer and you would like to transfer some of the risk off of your balance sheet, there are various ways that you can do this. You can re-insure with a totally independent entity. So you'll say, like, you're going to take on these liabilities and I'm going to transfer you these assets.

49:37Or you could do this with a captive, like, subsidiary reinsurer. And that captive subsidiary reinsurer can be anywhere. And so it can have different kind of corporate or state law or tax law that applies to it. So one of the main ways that life insurers, and particularly private equity back to life insurers, like to re-insure, is that they use captives that are in Bermuda or that are in certain states that have tried to compete with Bermuda, like Iowa or Vermont. And these are places where the tax rates are very low.

50:12And also there is no balance sheet visibility into the reinsurance balance sheets through the prism of the primary insurer. So if I were to re-insure all these assets and liabilities, I give up all the stuff off my balance sheet and then it disappears into the reinsurer balance sheet. And on a quarterly level, you could go into the NAIC data and you can see actually at a QSIP level what the life insurer holds in the U.S., that data quality is extremely high. But once that is re-insured into one of these quote unquote shadow re-insurers, you lose all visibility into what's going on.

50:48Hmm. I don't want this to be the typical odd lots episode where we talk about a problem and then just go off agreeing that it can never be solved because part of your paper actually talks about regulatory suggestions for how you might fix some of these issues or at least try to make them better.

Regulatory suggestions for improvement

51:05What do you think can be done here? I think there's a variety of options that the NAIC can undertake, you know, in the first instance, that align the downside risk with the controllers. So you can imagine like step one could be something like valuation based reforms. I think a lot of people agree at this point that the over-optimism in valuation is a structural problem, that private letter ratings are too generous. And that also just that there is an issue with trying to value private credit in the first place because these are non-tradable loans that have these bespoke terms.

51:42And so you can do a Pigouvian tax on opacity itself where you say like, oh, if certain kinds of assets are just structurally hard to value, then we're going to impose a regulatory capital surcharge on that complexity. We're not going to look at any of the individual underlying assets because that's extremely resource intensive to do. That's just not feasible to do, especially if you have, you know, a private equity insurer with billions and billions of dollars of these assets on your balance sheet. But we're just going to just say like, you know what, you're just you're just going to have to pay that surcharge.

52:15You can also move to the guarantee fund level. You can end the tax credits that insurers get for the guarantee funds. You can move to pre-funding. You could essentially you could transform it into a federal deposit insurance like system. And then you can also borrow other ideas from areas in banking. For example, we talk about this this kind of theory in banking law that is, you know, has not actually been operationalized very much, but it's called the source of strength doctrine, where if a bank goes down in theory under the source of strength doctrine, you could go to the affiliates of that bank at a bank holding company and say, look, time to pay up because the rest of us have to pay up.

52:55And so do you. And you could apply a similar concept to an insurance holding group. So you could go to the other affiliates in any insurance group, whether it's private equity or not, and say, you know, you have to be responsible for, you know, X percent of the payouts that have to go from the guarantee fund. And that would align incentives in this insolvency scenario. Source of strength doctrine. Yeah, I like that. That's good. Yeah, that's a good name. It has a sort of like Chinese governmental ring to it.

53:25Yeah, that's right. The intention is stated up front. I just say, it feels like it should be something that's about something bigger than banking regulation. It's like I subscribe to the source of strength doctrine. It's like, oh, it's about banking regulation. All right. Andrew and Pranjal, thank you so much for coming on Odd Law. It's a great paper. Really appreciate you being here. Thank you. Thank you so much. So, Joe, I found that really fascinating.

53:59I do think, like, the relationship between private equity slash private credit and insurance is kind of an underdiscussed one. It's only just starting to get a lot of attention. And again, going back to the whole original impetus for private credit becoming a thing, which was to get some of this risky stuff out of the regulated banking system. It doesn't seem great if it's just landing in another different kind of regulated financial industry. Totally. I mean, on the sort of like, OK, core asset asset liability management.

54:30It's a beautiful synergy. Right. I felt the need multiple times in that conversation to say not all private credit. All right. Not all private credit is bad, but it is a beautiful symmetry. Yeah, that's what I'm saying. You have this sort of pool of they're not depositors. We call them policyholders who really are. They are not expecting to get their money back for a very long time. They can only get their money back on certain rules, et cetera. It truly does solve that. It makes a lot of sense to pair that with certain types of assets whose value emerges because it can be held for a very long time and perhaps held through a drawdown.

55:08So that makes total sense. Of course, though, the question that arises is, well, A, like how much then becomes the sort of quasi regulatory arbitrage? It's sort of a looser environment. How do we even know these are quality assets that will satisfy the policyholders and so forth? And I found that to be very eye opening to sort of like how just loose it all seems. How just sort of like held together by scotch tape. And also this idea that we've never actually had a major insurance failure.

55:38And so you could see that, well, you know, maybe one of the reasons it's all held together with scotch tape is because it's never been an issue before because we haven't had a failure because insurers have been investing in really boring IG rated bonds. But if that's changing, then maybe we need to start thinking harder about this. The one other thing I'll say, we're recording this on July 30th and private credit, it's been in the news, you know, for the past year or so for various reasons. But it's in the news again because we have federal prosecutors apparently investigating Mark Walters, who, in addition to being the owner of the L.A. Dodgers, also has Guggenheim.

56:16And Guggenheim has affiliated insurers, Delaware Life, and I think the other one was called Clear Lake or not Clear Lake, Clear Spring, something clear, clear in a body of water. Yeah. But of course, the irony is that maybe it's not so clear because it put out a revised financial disclosure saying that the number of affiliated assets on its balance sheet. So these are assets that come basically via Guggenheim or that are under common control by Guggenheim. They had reported them previously as something like three to five percent of Delaware Life and Clear or whatever total assets.

56:51And then they went back as a result of this investigation and checked, put out a revised statement. What do you think the proportion of affiliated assets is now? Tell me. Forty percent. There you go. So it moved from three under additional scrutiny. It moved from three to 40 percent. So these are the kind of concerns that I think are starting to bubble up. Totally. But in the meantime, shall we leave it there? Let's leave it there. This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart.

57:22Follow our producers, Kerman Rodriguez at Kerman Armand, Dashiell Bennett at Dashbot, Kale Brooks at Kale Brooks, and Kevin Lozano at Kevin Lloyd Lozano. And for more Odd Lots content, go to Bloomberg.com slash Odd Lots. We have a daily newsletter and all of our episodes. And you can chat about all of these topics 24-7 in our Discord, discord.gg slash Odd Lots. And if you enjoy Odd Lots, if you like it when we talk about insurance regulation, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely

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