Beginning in January, insurers will be required to file information about the credit ratings of privately issued bonds that they purchase. Regulators are concerned that the ratings may understate the risks associated with the securities.
Regulators will also look into how well the current rating system protects against losses. According to regulatory documents, they will consider changes ranging from requiring multiple ratings for each bond to dropping some rating firms. The regulators are collaborating with the National Association of Insurance Commissioners, a standard-setting organization for the state-regulated insurance industry.
Low interest rates have made it difficult for insurers to profit from certain types of policies and annuities. As a result, many of these companies have been sold to private equity, asset management, and other financial firms. The buyers believe they can turn a healthy profit by leveraging their investment knowledge and operating differences.
According to A.M. Best Co., which rates insurers on their ability to pay claims, newcomers have favored privately placed debt and asset-backed securities, including collateralized loan obligations. Because they are more difficult to sell, these securities typically yield higher returns than traditional corporate bonds and other commonly held investments.
The NAIC is now attempting to determine whether the bonds themselves are riskier than their ratings suggest. If this is the case, insurers may face unexpected investment losses.
Credit-rating agencies play an important role in the insurance industry, which is a major buyer of bonds and loans to businesses and governments. Ratings determine how much capital insurers must set aside in the event that bonds are not repaid.
At times, the relationship between state regulators and rating agencies has been strained. After supposedly safe mortgage-backed bonds lost value during the financial crisis, the NAIC hired financial-modeling experts to assess the securities' risk. Currently, asset manager BlackRock Inc. calculates loss estimates rather than credit-rating firms.
Since the crisis, rating agencies claim to have improved their corporate governance, analysis, and compliance processes. One thing that hasn't changed is the inherent conflict of interest in their business model: In most cases, the firms are compensated by the companies whose bonds they rate. Companies have an incentive to hire the firms with the highest ratings because it means lower borrowing costs.
Regulators are now particularly concerned about the ratings on private securities, which do not trade publicly and are frequently held by a small number of investors. According to the NAIC, more than 5,000 privately rated securities were on insurers' books this year, up from fewer than 2,000 in 2018. This compares to over 300,000 individual securities held by all insurers, totaling trillions of dollars.
Beginning next year, insurers will be required to file reports detailing the private ratings received on new investments, which will apply especially to customized financial instruments. According to the NAIC, private ratings are supposed to be done the same way as public ratings, so it expects to receive reports comparable to what is publicly available on other bonds.
After NAIC staff discovered that firms sometimes gave the same securities widely different ratings, a task force of state regulators at the NAIC announced in December that there would be additional, broader scrutiny on all bond ratings. In some cases, private ratings differed by five notches, indicating that one firm deemed a bond to be of high quality and safe, while another deemed it to be of lower quality and relatively risky. Public ratings fluctuated as well, albeit to a lesser extent. The staff also examined 43 privately rated securities and discovered that the risk was materially higher than the ratings indicated.
"We want more discussion on how we currently rely on ratings firms and whether that framework should be adjusted," said Carrie Mears, an Iowa regulator and vice chair of the NAIC's Valuation of Securities Task Force. More transparency is required because ratings "have such an impact on insurers' capital position," she explained in an interview.
According to a spokesman for S&P Global Ratings, the company is looking forward to "continuing our dialogue with the NAIC in this area."
"We are confident that the NAIC will find our rating criteria robust and our rating analysis thorough in comparison to the other credit-rating firms," said Kevin Duignan, Fitch Ratings' global analytical head.
The American Council of Life Insurers, a major trade group, stated that it is unaware of any issue with rating quality. According to Mike Monahan, director of accounting policy, the trade group supports a "study group to answer any questions, and we look forward to working with this group to see if there are any issues."
In recent years, the NAIC has taken on the responsibility of assessing risk in some obscure investment areas. Its 35-person Securities Valuation Office, for example, analyzes principal protected securities, a complex offering that promises principal protection. Regulators were concerned that raters were overly focused on principal repayment rather than the security's overall performance.
According to Kevin Fry, an Illinois insurance regulator who chairs the securities-valuation task force, regulators will not act too quickly. "We don't want to send markets into a tailspin," he explained.