Much has been made lately of insurers’ exposures to private credit. Some commentators are starting to wonder whether the situation could pose a systemic risk to the sector, though most in the market would fiercely object to that idea.
What is clear is that regulations have made insurers a natural home for private credit risk and hence any nervous regulators ought to reflect on their part in creating this situation when planning their next set of rules.
The way the capital rules work for insurers and banks means it is more efficient for insurers to fund private credit lending and naturally the market has found vehicles to make that happen. Notably for example, Ares’ UK direct lending CLO earlier this year was specifically structured to have matching adjustment compatibility to fit the requirements of UK insurers.
The first element of the picture is that private credit has been able to compete with banks for deals because Basel capital rules have forced banks to pull back from lending or seek to share the risk of their loan books with external investors.
For particular high yielding credits to live outside the banking system is probably a good thing, but the competition with private credit has intensified lately higher and higher up the credit curve, including incursions into investment grade lending. Banks can and do still provide senior funding to credit funds, normally on the basis of a diversified pool of risks.
However, at the same time, European insurers seeking to optimise their returns on capital have been pushed to offer senior funding in private markets by Solvency II, which makes it inefficient to gain exposure to corporate and consumer debt by buying public ABS and CLOs.
That has left them to deploy a substantial portion of capital into private credit. Most of that is in investment grade exposures, but the scale of the likely losses in the cases of First Brands and Tricolor has left some to reflect on underwriting standards in the US and to a lesser extent in Europe.
Again, there are lots of reasons to think those are idiosyncratic cases, with allegations of fraud as well as sector-specific headwinds. In addition, banks, as well as private credit funds, provided capital to both companies.
However, given the private nature of the market, applying thorough scrutiny from an external perspective is difficult.
The merits of rebalancing the amount of capital flowing into public markets played only a limited part in the recent debate on reforming Europe’s securitization market, with the European Commission more focused on galvanising growth.
And the reforms won’t solely lead to more public deals. Synthetic securitizations to achieve significant risk transfer — a private market but visible to regulators — could grow as a result of the bank capital rule changes.
But given every transaction is signed off by the regulator, that market is subject to a much closer regulatory eye than unregulated private credit.
Perhaps, increased transparency could be a welcome ancillary benefit of the reforms. Warren Buffet famously said that only when the tide goes out do you discover who's been swimming naked. The regulators must seek clearer waters so that when the time comes, there are no nasty surprises.