Private credit ratings let insurers dress up risk, lower capital

U.S. life insurers have found a loophole in state capital regulations, and they are driving a truck through it. The Financial Times reports that insurers are commissioning private credit ratings—grades that never see public scrutiny—on assets like structured credit and private placements, then using those ratings to lower the statutory capital they must hold. The practice is not illegal, but it is exactly the kind of regulatory arbitrage that turns a balance sheet into a bomb with a long fuse.

The mechanics are simple. State insurance regulators rely on credit ratings to determine risk-based capital charges. A bond rated investment-grade requires less capital than one rated junk. Insurers have figured out that if they cannot get a favorable public rating from S&P or Moody's, they can pay for a private rating from a firm that has every incentive to be generous. The regulator accepts the private rating, the capital charge falls, and the insurer can lever up further into illiquid credit.

This is not new. The Federal Reserve flagged the issue in research on insurer risk-taking in alternative assets more than five years ago. The National Association of Insurance Commissioners has debated reforms repeatedly. Nothing has stuck. Meanwhile, life insurers have quadrupled their holdings of private credit since 2010, much of it sitting in statutory filings with ratings the market never sees.

The comparison to the air taxi story from The Verge is unintentional but instructive. Electric vertical takeoff and landing aircraft are stuck in certification limbo because the FAA will not bless a new category of vehicle until every failure mode is modeled. Insurers face no such standard. They are allowed to self-certify risk as long as they pay a ratings firm to countersign the paperwork.

The risk is not immediate. Life insurers are long-duration, stable-funded, and less prone to runs than banks. But capital rules exist for tail events, and private ratings are designed to make tail risk disappear from the spreadsheet without making it disappear from the portfolio. If credit spreads blow out or liquidity vanishes in private markets, the gap between reported capital and real loss-absorption capacity will show up all at once.

Regulators know this. The question is whether they act before the next stress test is administered by the market.