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Alternative asset managers and U.S. insurers have come together to create a highly profitable version of pass-the-parcel. Regulators, bank executives, and investors warn that this fast-growing alliance could be the source of the next financial crisis. Are they right? Insurers have plentiful safeguards to stop them going off the rails. The problem comes when the market evolves rapidly but rules that keep it in check do not.

Apollo Global Management and KKR are among the buyout firms that have wedged themselves into the stodgy world of writing policies by buying control of insurers. KKR said on Wednesday it would buy the stake it doesn’t own in Global Atlantic for $2.7 billion. Rival Blackstone recently merged its credit arm with the division that manages investments on behalf of insurers. This trend has helped propel a boom in private credit, the buzzword for loans provided by companies other than banks.

The basic idea is that insurers – and life insurers specifically – are logical owners for financial assets that are hard to sell in a hurry, but which pay a higher return than regular bonds. The industry collects regular premiums but often does not make payments to policyholders for years or even decades. Insurers are therefore less vulnerable than banks to a sudden loss of confidence.

The concept is not new: Warren Buffett’s Berkshire Hathaway has used its insurance premiums to help fund everything from railways to cowboy-boot makers. However, the model is expanding. Investments in alternative asset classes by U.S. life insurers spiked 65% to $334 billion in the five years ending in June 2023, according to the National Association of Insurance Commissioners (NAIC), four times the rate at which their bond holdings expanded.

The prospect of insurance companies buying risky loans or private equity investments has raised eyebrows. Life insurance is known for pointy-headed risk mitigation, not for making speculative punts. Betting on trophy assets like soccer teams, as the investment firm 777 Partners did with England’s Everton FC, could leave an insurer with insufficient funds to pay its policyholders. Rivals in the states where it operates would effectively be on the hook to help make up the shortfall.

What prevents an insurer from going overboard? The answer is a squadron of regulators who dictate the amount of shock-absorbing equity an insurer must keep on standby to offset potential losses in its portfolio – a bit like the work of U.S. bank watchdogs like the Federal Reserve and Federal Deposit Insurance Corp.

But if banking regulation seems byzantine, insurance gives it a run for its money. Insurers are regulated not at a federal level, but by the state in which they reside. Apollo’s affiliate Athene is overseen by regulators in Delaware, New York and Iowa, for example. To ensure consistency, the states outsource much of the work on accounting and capital adequacy to the NAIC, which also checks each state is up to scratch.

The NAIC provides the most important firewall for policyholders. It assigns a risk factor to each asset on an insurer’s balance sheet, which informs how much equity the company should hold. But as well as the NAIC and state regulators, customers are unwittingly relying on ratings agencies too. Assets that carry a stamp from Fitch, S&P Global or their peers automatically slot into a corresponding risk category.

What happens if the ratings agency takes a too-benign view? This is not a theoretical problem: the NAIC has been warning for years about a blind reliance on these third-party analyses. Smaller agencies have sprung up to occupy new and lucrative niches. Many private credit assets, for example, rely on so-called private letter ratings based on confidential data. Assets rated this way roughly doubled in number to 5,580 between 2019 and 2021, while the most active raters were smaller outfits like Kroll, Egan-Jones, and DBRS Morningstar.

Banks and their investors already learned this lesson the hard way, after flawed ratings fueled the U.S. subprime mortgage boom, and almost brought down the global financial system. Insurance watchdogs are also aware of the dangers. They now ask for extra information to support private letter ratings, for example. The NAIC has proposed a system that would allow regulators to challenge a rating that seems way out of whack. But for now, the reliance on ratings remains.

Another risk is that though the market for insurers buying alternative assets has innovated rapidly, the rules governing capital have moved more slowly. One popular novelty is the “rated note feeder”. Imagine an alternative asset manager wants to create a fund holding loans and other assets and bring an insurer along as an investor. If the insurer bought in directly, regulators would view its investment in the fund as equity, which comes with a standard but unattractive 30% capital multiplier.

So instead, the asset manager sets up a new fund, which in turn puts the money into the credit fund. This “feeder” sells bonds to insurers, who thereby take advantage of the lower capital charge that bonds carry over equity. In a worked example last year, the NAIC suggested this alchemy could halve the overall capital charge on the insurer’s investment. If the ratings agency that stamped the bonds is less than scrupulous, the investment is doubly vulnerable.

Given the private nature of private credit, it’s hard to see from the outside how big these risks are, or where they lurk. Loopholes are closing, but this takes time. Besides, even if the share of life insurance assets that are mis-rated or undercapitalized is tiny, smaller insurers could carry more concentrated risk. As the collapse of tech-sector lender SVB Financial showed in March, a relatively modest financial failure can trigger surprisingly large problems. If one insurer dumped illiquid assets in a hurry to raise cash, contagion would spread.

And while policyholders cannot whip their funds out of an insurer as they might with bank deposits, they can still ask for their money back. Penalty fees may discourage withdrawals, but those typically fall to zero over time. The fall of SVB showed how social media can instantly spread anxiety. Like bank depositors, insurance customers are ill-equipped to distinguish the sturdy from the weak.

Big insurers and buyout firms may scoff at these risks. And the likes of Apollo are probably big and sophisticated enough to pick better investments. Nonetheless, bank investors learned this year that if regulators are behind the curve, a too-small-to-scrutinize firm can still prove too big to overlook. Insurers may find the same principle applies.

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