Do US insurers arbitrage capital regulations with private ratings?

U.S. insurers are increasingly using privately commissioned credit ratings for illiquid credit instruments, raising concerns about potential understatement of capital requirements. The amount of illiquid credit instruments held by U.S. insurers totals $807 billion, and private ratings now represent 12% of life insurance group portfolios, with some firms like Everlake, NZC Capital, and Athene having much higher shares at 36%, 28%, and 24% respectively. Research indicates a tenfold increase in the use of private ratings since 2018.

Concerns arise because these privately commissioned ratings, often from agencies like Morningstar, Egan-Jones, and Kroll, can support lower capital reserves compared to traditional public ratings. Analysis suggests private ratings average 2.74 notches higher than public ratings, and eliminating this discrepancy could increase required capital charges on insurers' bond holdings by $4.5 billion annually. The Bank for International Settlements has warned that private ratings appear systematically inflated, potentially creating an impression of greater safety and improving current profitability while weakening resilience to future shocks.

Regulators, including the U.S. Treasury and the Securities and Exchange Commission, are intensifying their scrutiny of this practice. The U.S. Treasury has discussed the issue with insurance groups, and the SEC is investigating Egan-Jones. While a 2008-style financial shock is deemed unlikely and current default rates remain low, this trend points to ongoing regulatory arbitrage in the insurance and private credit sectors, which could have implications for sector stability and investor confidence.

Starting December 31, 2026, the NAIC will require insurers to quantify every private placement supported only by private letter ratings, along with details like fair value and total book value. Additionally, the NAIC has adopted a proposal to challenge private ratings if they are three notches higher than an assessment from its Securities Valuation Office (SVO). If the SVO's analysis is upheld, solvency capital charges will be based on the SVO designation. There were eight instances in 2023 where securities were assigned private ratings six or more notches higher than SVO assessments, all from a smaller credit rating agency.