Cross post from The Institutional Risk Analyst....

April 3, 2025 | In the this issue of The Institutional Risk Analyst, we feature a guest post from our old pal Nom de Plumber, a senior risk manager on Wall Street who loves to send us little missives from the world of private equity, credit and, of late, insurance.  Is the flow of toxic waste pouring from busted private equity portfolios into credit trades a threat to insurance companies? Yup. Does the National Association of Insurance Commissioners (NAIC) even care? Hard to say....

Risk and PE-Affiliated insurer Funding Agreements

By Nom de Plumber

It is more than a little odd that Wall Street decided to launch retail credit strategies at a time when the bloom was clearly off the rose on the original credit trade. What was that trade? Insurers controlled by the likes Apollo Global (APO) bought retail annuities for mom & dad and funded them with a variety of credit strategies, including illiquid private equity assets, commercial real estate and even residential mortgages.

More recently, as the flood of annuity assets has dried up, Wall Street has decided to finance the credit trade by selling equity slices in these remarkable opportunities to retail investors and also by issuing funding agreement-backed notes (FABN) via captive insurers to investors and other insurers. Most of the major Wall Street purveyors of ETFs and mutual funds, of note, have set up new rackets to sell subprime toxic waste in credit to retail investors.

In the US, the SEC, the National Association of Insurance Comissioners (NAIC), other regulators and even the rating agencies, have not said a word of late. That is not the case in the UK and other markets, however, where sales of credit exposures and FABNs to pensions and banks is causing rising official concern. Why are FABN’s and similar securities a problem for insurance companies? Because some of the biggest players in private equity are unloading their mistakes unto the shoulders of investors, including insurers, and running for the door.

The unfolding credit train wreck in the world of private equity is episodic in nature and, like commercial real estate, only gets better with time. This mess has already caused the shares of the major credit shops to sell off sharply from the highs of mid-2024. The chart for APO and its peers looks a lot like the charts for the large banks. This is fortuitous since the banks have facilitated the bubble in private credit and will likely face considerable blowback when the proverbial bubble bursts.

Private equity funds are cashing out their illiquid equity stakes in moribund portfolio companies, by piling new debts atop unpaid debts. Lenders have enabled them to own their long-stuck portfolio companies, with almost no money down, a Heads-I-Win/Tails-You-Lose bets.  How does this work?

A private equity fund seeks to buy and privatize undervalued public companies, using mostly high-leverage buyout loans from banks, plus thin slivers of General and Limited Partner equity. Ideally, with operational improvements and higher market valuation multiples, the fund can later sell such portfolio companies back to public ownership (IPO), perhaps within five years or so, thereby repaying those bank loans and earning a large profit on that partner equity. But this model has broken down since 2021, when the Fed began to raise interest rates.

General Partners control the private equity fund, and charge asset management fees to the passive Limited Partners. However, because many private equity funds have been unable to sell such portfolio companies for as much or as soon as expected, the assets are impaired. Economic stresses (higher interest rates, inflation, new competition, geopolitical shocks, etc.) have caused persistent operational and financial under-performance, preventing sufficient IPO sale proceeds to repay both the initial buyout loans and the partner equity.

In desperation, the private equity funds have resorted to borrowing even more money, from either banks or private credit providers, to recover as much of those stale General and Limited Partner equity stakes as possible. This surreptitious maneuver leaves both the banks and private credit providers holding the entire bag, with scant means or buffer to prevent default losses.  Lending money to borrowers with scant skin in the game rarely ends well.

Despite all of this self-dealing by the General Partners of private equity funds, neither the regulators nor the ratings community are saying a word. Fitch ratings wrote in a missive: “The increase in FABN issuance is not expected to affect issuer ratings due to their modest size relative to total liabilities and the limited impact on key ratios such as statutory operating leverage.” This is the essence of rating-agency and regulatory arbitrage. Pari-passu additional leverage dilutes the protection of other creditors.  Bad.

“The FABNs issued by the sponsoring life insurance company are considered equal to that of general account policyholder obligations., and as such, FABNs are assigned a rating aligned with the Insurer Financial Strength (IFS) rating of the life insurer issuing the FABN securing the notes,“ Fitch confides. Notes tied to funding agreements skyrocketed last year, reaching $58.55 billion, about 70% more than in 2023. Last year's total nearly matched the record $58.75 billion issued in 2021, Fitch notes.

Why are FABNs a problem for insurers? Like the securities-lending SPVs which blew up ABCP conduits, SIVs, and insurers like American International Group (AIG) in 2008/2009, the underlying credit is doubtful at best.  There is no such thing as risk-free matched funding for risky assets.  Yet for some reason, Fitch, other rating agencies and the banks are fully on board with enabling and financing this dubious racket. 

Fitch writes: “Insurers writing FABNs benefit by investing the proceeds in higher-yielding assets that are typically both cash flow and duration matched to the FABN." But not everyone thinks that FABNs are a good thing. Almost a decade ago, a paper prepared by a Fed researcher noted that these securities increase the level of connectedness and thus correlation between insurers and the financial. Markets. That is bad. Insurers are not supposed to be correlated to the financial markets, right?

Stéphane Verani, Principal Economist in the Systemic Financial Institutions and Markets section of the Federal Reserve Board, noted in a 2015 presentation to the NAIC that FABNs increase the connection between insurers and financial sector and that maturity and liquidity transformation increases vulnerabilities. He noted, significantly, that these vulnerabilities are amplified as FABN maturity shortens:

• Shocks to insurers or institutional investors could trigger a run

• Initial withdrawals could cause a panic, and more withdrawals

• The effect of the run depends on the availability of liquidity

• Illiquidity at an insurer could lead to delays in payments

• Delays could cause a panic in short-term funding markets

How does this growing investor fascination with FABNs end? Low-beta insurers with book value, held-to-maturity portfolios will be forced to redeem rancid FABNs when the underlying credit rolls over. Defaults in the more risky FABNs may then cause a cascade of sales by investors.

Banks, credit managers and dealers who have created and sold this high-beta toxic waste for their PE manager clients will suddenly find themselves in the crosshairs as politicians react to losses in pensions and other regulated, "low-risk" institutions. And, as in 2007, the PE managers and investment bankers who created this mess will simply fade into the woodwork.  

https://www.rcwhalen.com/inflated