Insurance investment analysts are wondering whether some of the assets going into the life insurance and annuity pie crusts are overrated.
The analysts work for the Capital Markets Bureau, a National Association of Insurance Commissioners team that helps state insurance regulators understand insurance companies' investments.
The analysts have noted in a new report that "private letter ratings," or custom assessments of securities by credit rating providers, seem to be a lot higher than the grades the same securities would get from the NAIC's own Securities Valuation Office.
Because the private letter ratings are so much higher than SVO ratings, using them without any adjustments can "potentially lead to the undercapitalization of insurance companies," the analysts warn.
What it means: Grade inflation could make your clients' life insurance policies and annuity contracts a little less secure than they look.
The pies: Life insurance policies and annuity contracts are, in effect, pie crusts made out of legal contracts. In the United States, the fillings traditionally have consisted mainly of high-grade corporate bonds, mortgages, mortgage-backed securities and a smattering of other types of assets, such as private debt, private equity stakes and securities backed by everything from automobile loans to credit card debts.
The ratings: The United States leaves regulation of the business of insurance to state insurance regulators. The NAIC is a Kansas City, Missouri-based group that helps states share regulatory resources.
States gauge insurance companies' financial health by asking them to calculate "risk-based capital ratios."
When an insurer adds assets to the capital total used in the RBC ratio math, the insurer is supposed to adjust for each asset's level of risk by applying a value reduction, or "charge," that reflects what the NAIC believes to be the asset's level of risk.
In some cases, for big, widely distributed batches of securities, insurers can use public ratings from "nationally recognized statistical ratings organizations," or credit rating providers, to figure out what risk charge to use.
In other cases, the issuers and insurers get risk-level designations from the NAIC's own Securities Valuation Office or private letter ratings from outside rating providers.
Crediting rating providers note that they must use highly regulated credit assessment processes and they say that competition increases credit rating quality, by pushing regulators, insurers and the providers themselves to compare the performance of the different approaches used and see what works.
In the past, smaller rating providers and others have suggested that the Securities Valuation Office and big rating providers may have a financial incentive to reduce the level of competition in the credit rating market.
