Private credit – a public issue for insurance

Over the last 25 years, private credit funds’ assets under management have grown from over $0.2bn to $2.5tn and the global insurance industry is one of the largest investors, reflecting a 9.8% share in the investor base. These investments can offer higher yields, greater diversification and long‑dated cash‑flow characteristics which align well with liability profiles. But the Prudential Regulation Authority (PRA)  is concerned that insurers could underestimate their exposure to this market, which could have a systemic impacts across the financial sector.

These concerns have grown from high-profile market events, bringing greater scrutiny over synthetic securitisation, special purpose vehicles (SPVs) and private credit funds. One of the most pressing concerns is transparency around the underlying loans, drawing parallels to the 2008 sub‑prime crisis, which materially impacted insurers. 

Improving transparency will be no mean feat as there isn’t a one size fits all approach to private credit. Some insurers write predominantly long‑tail liabilities while others have short‑tail profiles. Some maintain in‑house investment expertise, while others outsource entirely to asset managers. In some instances, insurers underwrite insurance risks that are likely to be magnified in the event of a private credit market disturbance. Regardless of the approach, insurers need to review their current risk management approach to identify and mitigate risks associated with private credit.

Managing credit risk

Insurers may either invest in private credit directly, or delegate the role to asset managers, with varying degrees of transparency and different implications for credit risk.  

Those investing directly need to assess the quality of loans, and evaluate the risk of default – taking into account liability duration, risk appetite and diversification strategies. Firms need significant technical expertise to balance these elements, but in practice due to the fast growth of this market, teams’ capabilities might not have grown at the same pace, exposing firms to  greater risks around mispricing, overly optimistic assumptions, overvalued assets, or underestimated probability of default.

For insurers that delegate their investment management, the weakest link is the strength and structure of the manager’s mandate. Strong transparency and reporting are essential to reduce unknowingly exposures to funds with underlying assets that aren’t fully understood by the insurers. It’s also essential to mitigate concentration risk – where the asset manager invests across multiple vehicles with overlapping exposure to private credit.

These issues need senior oversight, and key questions for Boards and Chief Risk officers include:

• Does your investment team has sufficient expertise in private credit and the key investment sectors involved?
• Are credit and loan‑assessment processes robust enough to identify valuation and default risks?
• Does the Board fully understand the firm’s exposure to private credit? 
• Does your asset manager provide adequate transparency on underlying positions, and is their mandate strong enough?
• Have you developed and undertaken stress‑test scenarios including sector‑wide or systemic default events?
• Have you considered concentration and refinancing risk within the private credit portfolios?
• Have you considered default risk and recovery timelines into your assumptions for managing credit risk?
• Do you have appropriate policies in place to manage and mitigate sector concentration arising from private credit?

Managing liquidity risk 

Liquidity is a key concern for the PRA and recent market events outline the risks. Insurers must ensure their investment maturity profile aligns with expected liability cash flows, but liquidity over private credit loans may vary. Some may be wrapped into fund structures, reducing both transparency and liquidity. Others may be easily transferable on paper but rely on market confidence to realise their value.  

Financial shocks can trigger redemption restrictions and limit an insurer’s ability to liquidate positions when liabilities materialise. In these instances, insurers may need to realise assets at a loss; liquidate alternative assets (potentially jeopardising liquidity buffers). This may result in negative impacts on their capital position.

Given the relative novelty of certain fund structures and limited transparency, firms need to fully understand the liquidity characteristics of each private credit holding. It’s also essential to embed recovery strategies to address borrower defaults and understand the impact of low liquidity on regulatory capital and solvency.

Firms need to consider:

• Are liquidity risks for private credit holdings appropriately assessed and monitored?
• How would redemption restrictions or market illiquidity affect your liquidity coverage?
• Have you incorporated systemic private credit stress test scenarios into your capital modelling?
• Have you considered eligibility of these funds as collateral for liquidity funding purposes?
• Do you have a strategy in place to recover distressed assets?
• Have you tested for mismatches between cash flows from private credit and insurance liabilities?  

Managing underwriting risks  

Looking beyond investment management, insurers also face underwriting exposures linked to private credit, primarily though financial lines products – such as professional indemnity, or directors' and officers’ insurance.  

In a systemic event, investors may not understand their underwriting risk due to poor transparency, complex private credit products, limited understanding of securitisation and the various roles market participants undertake. As such, investors could claim against alleged misselling, inadequate disclosure or imprudent asset valuation. Share prices could drop rapidly and shareholders may pursue action against firms participating in, or structuring, private credit transactions.

Key considerations for underwriting and claims teams include:

• Do underwriters fully understand private credit market dynamics and exposures?
• Do they receive sufficient information to assess risks and adjust policy terms appropriately?
• Have associated underwriting risks been reflected in reserving and internal models modelling?
• Do the claims teams understand the mechanics of private credit structures and the controls expected of market participants?
• Do you have access to third‑party experts able to support valuation challenges in claims or litigation?

Strengthening the control environment

Firms that fully understand their private credit exposures are best placed to maintain resilience and navigate systemic issues across the market. To achieve that, insurers need to strengthen their internal knowledge of the market, governance and oversight processes, and key activities include:

• reviewing current investment, underwriting and claims teams to ensure the right blend of skills – providing additional training as needed
• assessing whether oversight of fund managers is robust, granular and transparent to identify material risks
• carrying out a comprehensive assessment of liquidity and credit risk to identify key risks and implement additional controls, where appropriate
• performing due diligence into robustness of funds governance, dependence on borrowers’ ability to refinance, borrowers’ incentives to invest and exit strategy etc
• exploring additional stress test scenario to reflect private credit risk, including systemic factors and the risk of contagion.  

Early action is essential to maintain resilience, instil confidence in the market, and give regulators and clients assurance that the associated risks are being managed appropriately. For further information on private credit risks across the insurance sector, contact Blandine Arzur-Kean or Rebecca Deane.