What’s up with private credit ratings?
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
There’s no real reason for individual direct loans held by a private credit fund to carry a credit rating. Very few do. But loans held by insurers? They’re different.
And we know that insurers everywhere hold a lot of private credit. US private equity-sponsored life insurers in particular lead the charge:
It’s not that the insurers lack the wherewithal to come up with their own opinions about how likely it is that a borrower will default. It’s just that their regulators want them to have more capital for the risky stuff they own. The more boring their assets, the more leverage their insurance supervisor will let them accumulate. And you know what’s really boring? Investment grade credit.
As the IMF wrote in last week’s Global Financial Stability Report, “most insurers’ exposure to private credit is classified as investment grade”. But investment grade according to who? Mostly, it turns out, not according to Moody’s, S&P, or Fitch.
The number of securities that Moody’s, S&P and Fitch collectively rated stayed pretty much flat between 2020 and 2023. But the total number of privately rated securities ballooned over the period. And it was the little guys that scooped up this business: AM Best, Egan-Jones, HR Ratings, the Kroll Bond Rating Agency, and Morningstar DBRS. [Update — while AM Best was listed in the redacted NAIC report as one of the five specialised rating agencies, it turns out they don’t issue private letter ratings.]
Oligopolies are generally bad, so this explosive growth on the part of the little guys is . . . good? The IMF doesn’t seems sure, noting that:
Insurers’ search for private credit exposures classified as investment grade has changed the rating landscape in the United States . . . Misclassification of below-investment-grade instruments into the investment-grade bucket may result in default losses significantly exceeding those expected during an economic shock, leading to the erosion of insurers’ capital and potentially causing liquidity gaps because of insufficient cash flow from the defaulted entities.
Why would the rise of so-called private letter ratings be in any way connected with misclassification of below investment grade instruments into the investment grade bucket? On this question the IMF is silent.
But it might have something to do with a story covered by MainFT back in May.
Hold on, I don’t read every FT story, can you remind me?
The US lacks a single supervisory regime for insurance, with every state having its own regime. And so, rather than potential problems just being identified and resolved centrally, it falls to the National Association of Insurance Commissioners, as US insurance supervisor cat-herder-in-chief, to flag issues, convene working groups, and develop consensus.
Earlier this year we covered their multiyear efforts to remove a completely wacky and irrational capital arbitrage opportunity that arises if insurers securitise their junk. As far as we’re aware, it’s still in place.
One of the issues that the NAIC has been looking at is potential rating-inflation in the private credit arena. It published a short report on the topic, which got broad attention only when Kroll Bond Rating Agency accused Fitch Ratings of misleading market participants by relying on the study to raise doubts about the quality of its ratings.
A highly entertaining public spat ensued, and in May the NAIC removed the report from their website “to undergo further editorial work to clarify the analysis presented”. This editorial work appears still to be ongoing as an updated version is nowhere to be found.
But we did find a copy of their original report on Egan-Jones’ website. The retracted analysis stated that:
NAIC designations based on PLRs [private letter ratings] averaged 2.74 notches higher than designations assigned by the NAIC Securities Valuation Office (SVO), according to data from 2023, with designations 3 notches higher at small CRPs [credit rating providers] and 1.9 notches higher at large CRPs.
Three notches seems a lot.
OK, so what do I need to know about NAIC insurance ratings?
Insurers need to report investments using NAIC designations for accounting and risk-based capital calculations. Ratings from all the credit rating agencies map to these designations: NAIC 1-2 is investment grade, and NAIC 3-6 corresponds to various forms of junk. If a loan is unrated, it is be treated as NAIC designation 6, which is bad and very capital intensive.
So when an insurer makes a loan, the loan really needs to be rated. Absent a rating, they can go to the NAIC’s Securities Valuation Office to get an NAIC designation, for a fee.
Highly-rated loans require less risk-based capital than lesser-rated loans. So, regardless of actual credit quality, insurers will want the loans they make to have the highest ratings possible from a regulatory capital perspective.
Sometimes a loan starts off with an NAIC designation provided by the SVO, and then becomes rated by a rating agency. When this happens, the NAIC can compare its own SVO’s ratings to the new rating the insurer has purchased. And there’s nothing to stop the NAIC from publishing their findings:
The NAIC found that 80 per cent of the 109 securities migrating from a SVO-assigned designation to a PLR-driven designation in 2023 received upgrades, just 4 per cent were downgraded and the rest were unchanged.
Alphaville has no view as to whether the SVO is a better judge of credit risk than rating agencies, large or small. We can see that if an insurer thinks that the SVO has got things wildly wrong, it might be worth them paying up for a second opinion.
After all, an upgrade means they can use more leverage, write more business, make more money. And so there’s a good reason why four-fifths of re-rating events result in upgrades. The little guys accounted for three quarters of these higher ratings, and the eight instances where a rating moved six or more notches (!!) were all from these smaller firms.
All this led the NAIC to write that:
As a matter of policy, the NAIC and insurance industry must deem any one particular CRP rating as the functional equivalent of any other, regardless of the methodology used or consistency of the ratings assigned. That is, a AAA rating is treated as AAA no matter which CRP assigns the rating. However, as noted above, the NAIC has observe disparities between CRP ratings of the same credit, particularly with PLRs. These rating disparities, some of which are significant, call into question the quality and comparability of PLRs, and they could have an averse impact on capital requirements under the RBC [risk-based capital] framework.
Maybe it’s a cost thing?
Let’s for now put aside possibility that insurers are ratings-shopping to reduce their risk-based capital. Maybe the little guys are just better value?
Unfortunately, there’s no publicly available rate card we can use to compare costs. But Alphaville understands that you can get an initial corporate analysis from one of the smaller firms at less than half the average price of one issued by the big three. That said, the sticker rates vary quite meaningfully by agency.
Bloomberg reported earlier this year that one small rating agency is keeping its costs pretty tightly controlled. Perhaps this enables them to pass on better value to their clients?
This is the best shot we can find showing the corporate headquarters of Egan-Jones:
At the end of 2023, Bloomberg found that the firm, headquartered in this four-bedroom house just outside Philadelphia, employed just 20 analysts. And yet was able in 2024 to rate more than 3,000 private credit deals.
We at Alphaville salute their Stakhanovite work ethic.
How does this impact individual insurers?
According to Moody’s Ratings, just under 12 per cent of US life insurers’ bond holdings use private letter ratings. But usage is uneven:
Global Atlantic — the insurer 100 per cent owned by private equity group KKR & Co — leads the pack with a quarter of its $100bn bond portfolio carrying private letter ratings. MassMutual, the mutually-owned insurance company that owns Barings, holds more than $50bn of privately-rated securities. Other insurers, like New York Life, had a measly 6.7 per cent of their bond book privately rated.
What’s the bottom line?
It’s the IMF’s business to worry about everything, from equity valuation, to the basis trade, fiscal sustainability, and the interconnectedness of nonbank financial institutions. It feels fair to throw into this mix the possible undercapitalisation of insurance companies based on private rating misclassification risks. And it looks — at least on this side of the Atlantic — like an issue that is going to get more and more attention.
In simpler times, the big three rating agencies were the go-to bad guys. Allegations that they hawked around inflated ratings, and as such were complicit in the subprime securitisation fiasco that snowballed into the global financial crisis, left a nasty shadow hanging over their integrity. How times have changed.
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