U.S. life insurers may need to hold as much as $4.5 billion more regulatory capital each year for their growing private credit portfolios, according to a new study by Columbia Business School professors Xuelin Li, Samgmin S. Oh, and Giacomo Ricciardi.
According to the professors, that’s because the private ratings used for private credit investments “systematically understate credit risk,” allowing insurers to hold less capital against potential losses.
Privately rated holdings of U.S. life insurers have grown from $46 billion to $481 billion in carrying value and from 1.5 percent to 12 percent of insurers’ bond portfolios during that time, the study said. Such assets are primarily structured credit securities and syndicated bank loans that often lack transparent market prices and instead are valued by brokers or the insurers themselves.
Unlike public ratings, which are issued by agencies such as Moody's, S&P Global Ratings, and Fitch, private ratings are disclosed only to the issuer and a limited set of investors, typically subject to confidentiality restrictions, the study explained. “While the rating still determines its holder’s regulatory capital, whether it accurately conveys information about credit risk becomes less clear in the absence of market discipline,” it said.
The study echoes a recent IMF report that raised concerns about the rapid growth of smaller firms that issue private letter ratings. While the three major rating agencies rated roughly 1,000 private securities in both 2019 and 2023, specialized firms rated about 7,000 in 2023, up from roughly 2,000 four years earlier, according to the IMF.
When privately rated bonds were compared with publicly rated bonds that have the same rating, the Columbia professors found the privately rated ones were “twice as likely to impair yet are downgraded less often.” If privately rated bonds carried capital charges consistent with comparable publicly rated bonds, insurers would need to hold an estimated $4.5 billion more regulatory capital each year, the researchers calculated.
One reason for the growth is a National Association of Insurance Commissioners’ 2021 regulatory change, which would have required most insurers to increase regulatory capital by about 20 percent. The study argues that some insurers responded by relying more heavily on private ratings since higher ratings reduce the amount of capital insurers must hold.
Because higher ratings require insurers to hold less capital, insurers have incentives both to obtain more favorable ratings and to avoid subsequent downgrades. “When a bond moves from the regulator’s in-house channel into the private channel, it is upgraded more than four times as often as it is downgraded,” the study found.
The Columbia professors’ analysis was based on annual insurance company filings to the NAIC that disclose their bond holdings and state whether they are privately rated or not, a requirement since 2018.
“This matters because private ratings concentrate among the largest, high-yield-exposed insurers and in their most opaque holdings, so inaccurate ratings conceal tail risk in the segment with the largest systemic footprint,” they concluded. Ultimately, they said, “the unrecognized credit losses fall on the annuity and life claims it has promised to honor.” In other words, if assets perform worse than their ratings suggest, insurers ultimately must absorb those losses while still meeting obligations to policyholders.
