Odd Lots - Why Private Credit Got Entangled With Insurance

Episode Date: July 31, 2026

Insurers have quietly become a major driver of the private credit boom, with numerous private equity shops striking deals with insurance companies or buying them outright. But the entanglement with private credit is also changing the insurance industry itself, raising a number of questions about risk and regulation. Today we speak to Andrew Granato and Pranjal Drall, authors of a new paper, “Private Credit's State Backstop: How Private Equity Socializes Risk Through Insurers," examining the relationship between private credit and insurance. Granato (an assistant professor at the UT Austin Law School) and Drall (JD-PhD student in Financial Economics at Yale) talk to us about how PE got so interested in insurance in the first place, how both sides benefit from the relationship, and why taxpayers might ultimately be on the hook. Read more:Blue Owl Surges as Leaders Stress It’s More Than a Direct LenderAres $29 Billion Private Credit Fund Sees Uptick in Non-Accruals Only Bloomberg - Business News, Stock Markets, Finance, Breaking & World News subscribers can get the Odd Lots newsletter in their inbox each week, plus unlimited access to the site and app. Subscribe at  bloomberg.com/subscriptions/oddlots Subscribe to the Odd Lots NewsletterJoin the conversation: discord.gg/oddlotsSee omnystudio.com/listener for privacy information.

Start your day with Marketplace Morning Report and me, Kimberly Adams. In 10 minutes or less, I'll explain the day's economic news, why it matters, and what it means for the way you live and work. Tune in each weekday morning for independent award-winning journalism that brings clarity to the economy. Listen to Marketplace Morning Report on your favorite podcast app. Bloomberg Audio Studios, Podcasts Radio News. Hello and welcome to another episode of the Oddlots podcast. I'm Tracy Alloway. And I'm Joe Wisenthal. Joe, there's a key tenant 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 bell. up, you should bear that loss. Yeah, 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, like, 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, right? 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. Totally. Even 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. That sounds bad. But I want everyone else to be like, we strive. Okay, okay, 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, etc., you had policy makers making 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. And 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. Like 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 at 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. Yeah. Which seems fine. Yeah, it's great. Like, all right. Risky loans, all that middle company. 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. It'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 policyholder, 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, is kind of 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.

So 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. Great. The insurance, private equity, private credit nexus in excruciating detail. And I'm very happy to say that we do in fact have the perfect guess. We're going to be speaking with Andrew Granato. He is

assistant professor of law at UT Austin, as well as Prongjold Draal. He is a JD PhD 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 Pranchal, thank you so much for coming on all thoughts. Yeah, thanks for having us. Thanks for having us. So 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. You 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 an assertive company, well, someone has to issue debt in order for me to be able to do that, maybe a different part of, my P.E. firm can issue that debt. 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. But 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 two 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. Insurers warrant 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 B 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 outsourced 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. It should be noted, you know, one of the most infamous investors of all time, Warren Buffett, utilize this core insight that an insurance. it's having an insurance arm would be an extraordinary source of patient capital.

And we talked to mutual fund managers. And one of the questions we always asked them is like, isn't it tough that at a market drawdown, you can't actually hold it because your clients, I'll move on to the next fund? I mean, this has already for a very long time just been an extraordinary fruitful partnership. Yeah. It's not something that's new. What'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 of so of life insurance assets, kind of within private equities 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 Prontor says, very kind of stodgy, AAA-rated AT&T bond portfolios, 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. But 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? Am I making sales pitches and saying, well, you got first crack at these very elite previously exclusive private. 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 siege of it, 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. So 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.

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 make. capture the liquidated premium, offer better terms to my policyholders by making more money. And in that case, you know, there's like a lineup of really sophisticated P.E. shops that will, like, try to earn that business. And in that case, you can imagine the, this called like a third-party agreement where you're outsourcing party of 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. And 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 you're, 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, but it's also paying out fees for essentially all sorts of other affiliated services. Like, like, you know, you could imagine accounting, you can imagine valuation, consulting, all sorts of things where... Like IT. Yeah. 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,

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and all these little things that maybe like come out of the return, et cetera. Does the end market of insurance purchasers have much clarity on what they're buying and the economic of two different policies. It's a hard empirical question. Yeah. So there's a thing called in finance called the annuity puzzle, where in theory, annuities are the perfect investment, but society as a whole underbys 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 to invest in annuities because they don't get a good deal. Prices are too high. The policies aren't that good. There's competition, but there's 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 N.O.D. market isn't very competitive.

Now, you might imagine if an insurer is owned by a P.E. shop, and they make a lot of money on the private credit in liquidity and all this, you know, because it's high returning and all this stuff. And they earn fees. So in some ways, a P.E. 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 P.E-owned insurance companies compete better in the part market. So you can imagine that consumers might benefit.

The problem there is, of course, that, you know, you might get a good deal on 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 for 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 buy, the purchase of the annuity has? Yeah.

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. As far as they know, they just bought a life insurance policy. And I'm willing to about 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, think the results that we're going to speak about.

Yeah. So, okay, 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, etc. On 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 public. 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. So this has been a topic of discussion for the last two years, almost I feel like this almost obsession of how much should we trust? private credit valuations. And this is 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 the public 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 NIC, which is an association of regulators, essentially has visibility on an insurer's balance sheet, and they look at everything they invest in. This 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 1 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. And 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. 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 to 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. So 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? 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. And so he 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% 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? Yeah, 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 implicates 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. They 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. But 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. Yeah. So I think when people think about what does 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 FDI. I see 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, you know, the insolvency of a bank, you know, they spend down that fund. And 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, like, 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. Insurers 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 fond of. 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 unsolvency proceeding across every single state. Insurance 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 the FDIC, you get up to 250K, in theory, potentially it could be far more. But statutorily, you get your first 250K in every account is insured.

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. But this assessment is only levied after the insolvency has already happened. So if I'm the insurer that went down, I've actually contributed zero dollars of my own. It's very ironic for insurers themselves to not be

like paying something towards insuring their own deaths. Yes. Yeah. So like you, well, of course, you know, the company's 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. And 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. And 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 it kind of just like time value of money because they have to like float this in the meantime.

But 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 $250K,000, which is considered a fairly high amount for, like, just someone having a checking account. In this case, you know, close to $300K 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. So the coverage of this bailout is, right? 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 the scale. So it's actually, it's completely untested to have a level. 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 funds.

So is it fair to say it's like structurally suboptimal on multiple levels? So it's suboptimal in this 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 is like maybe there's a little bit of misalignment. The backstop encourages the insurer to take undue risk. But look, it's okay. It's good in the end because at least policyholders can sleep easy.

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 you're solvent, you're paying post-insolvency. One more thing that 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-irational insurer. Right.

It's like a homesy and bad man insurer is going to just simply invest more risky things, try to give really good deals with policyholders to make premiums today. Oh, yeah. You're not paying for it. Because you're not paying for it in the end. So at least in like a 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% on savings accounts right now. But there's no, in insurance, that mechanism doesn't exist. Exactly. Canadian women are looking for more. More out of themselves, their businesses, their elected leaders, and the world are out of them. And that's why we're thrilled to introduce the Honest Talk podcast.

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Stories that move markets. Chair Powell opened the door to this first interest rate cut. Impact politics, change businesses. This is a really stunning development for the AI world and how you think about your bottom line. Listen to the big take from Bloomberg News every weekday afternoon on the IHeart radio app, Apple Podcasts, or wherever you get your podcasts. 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 old. aware are people of the current regulation scheme for bankrupt failed insurance? Does 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. Yeah, 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. One more point I want to make is that I've spoken to some people who, you know, work in the space. and one thing they say is that, say, there's a good insurance manager and a bad insurance manager that 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 an equilibrium sort of good asset managers because they might have access to like AT&T private credit. And 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 NIC 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 get 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. They're not purely sized-weight. 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. There 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.

And then you can imagine politicians, especially local partitions, you might imagine, don't want their state's policyholders to lose out on, you know, people who are life insurance policies and their insurer goes insolvent are some of the most sympathetic 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 break 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 perverse feedback loop. So 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 a 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 10 years. Can 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 18, the Supreme Court said that insurance did not constitute commerce for the purposes of the interstate commerce clause. In 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, were regulating insurers, all other regulatory authority is reserved to the states.

So it's just pretty much been like that the whole time. There are periodic waves in which there's activism for federal insurance regulation, usually because of a wave of insurances 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 formally operates actually through a nonprofit. It's not formally a public entity at all will act to try to forstall that federal push by kind of doing it on its own. And 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 to the FDIC. And the NAC and various states quickly received. responded to create these state-level backstops instead. And one of the interesting ways the NIC operates is that most states actually defer rulemaking to the NIC fully into the future. So I think Indiana is one of these states where they self-incorporate the model law that the NIC puts out, even prospective changes.

Oh, so they just like see control entirely. Yeah. So there are state laws that say if the NIC 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's one, like, so a difference between banks and insurance is that banks have the possibility of correlation on two fronts. So all the loan, if you hit the sick 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? They'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 led? Great.

That's a pitch for our next paper. That's the follow-up that we're running on now. So you can imagine, conceptually, there's runs on the asset side of the liability side. I'll speak a labor about the assets, and Andrew is more an expert on the differences in policies and liabilities. But on the asset side, as you said, all of them make loans to Chicago's SaaS company in the middle market, and then they all go calling back and there's no, you know, there's not enough cash flows.

So in that paradigmatic sense, since bank. banking has very good, you know, like on the floor of a bank, there's officials on 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 or something like that. 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.

So just on the asset side, the monitoring is much worse. 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 pay in has been due to a very specific kind of exposure. Insurers are 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 a software is not a stretch. So you can imagine, like, you know, 30% of that 15% is in one industry.

Now, again, 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. 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. Yeah. 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 rough-examines, IRA thing that's inside of a life insurance policy and 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 tend 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? And 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, it's 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. And 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, okay, speaking of cascading risks, one thing I know.

never understand when it comes to insurance is reinsurance. Because it's just like you have the insurers, then the reinsurers insure them. And then do you have like re-reinsurers who insure the reinsurers? 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 reinsure 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. Or you could do this with a captive, like subsidiary reinsurer. And that

captive subsidiary reinsurer can be anywhere. And so we 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 reinsure, 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. And also there is no balance sheet visibility into the reinsurance balance sheets through the prism of the primary insurer. So if I were to reinsure 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 reinsured into one of these, quote unquote, shadow reinsurers, you lose all visibility into what's going on. I don't want this to be the typical Oddlots 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. What do you think can be done here? I think there's a variety of options that the NAC 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 and 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. And 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 back 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 going to have to pay that surcharge.

You 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. 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 kind of theory in banking law that has not actually been operationalized very much, but it's called a 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

in a bank holding company and say, look, time to pay up, because the rest of us have to pay up and 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. Yeah, it'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 Prongall, thank you so much for coming on Ozla. It's great paper. really appreciate you being here. Thank you. Thanks so much. So, Joe, I found that really fascinating. I do think like the relationship between private equity slash private credit and insurance is kind of an under discussed 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. of regulated financial industry. Totally. I mean, on the sort of like, okay, core asset liability management, it'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, but it is a beautiful symmetry, right? That's what I'm saying. You have this sort of cool 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. So 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 this 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. And 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 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.

And Guggenheim has affiliated insurers, Delaware, 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 3 to 5 percent of Delaware life and clear

whatever total assets. And 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. 40%. There you go. So you move from three, under additional scrutiny, it moved from three to 40%. 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 Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Allaway. And I'm Joe Wisenthall. You can follow me at the stalwart. Follow our producers, Carmen Rodriguez at Carmen Armid. Dashel Bennett at DashBot. Kale Brooks at Kail Brooks and

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