The insurance industry is the biggest buyer of this kind of private debt; according to the NAIC, the number of privately rated securities reported by U.S. insurance companies totaled 5,580 at year-end 2021, an increase from 4,231 in 2020 and 2,850 in 2019.¹ An A.M. Best report calculated that the total holdings of private placement investments reached $1.4 trillion in 2019, so that number has likely more than doubled in 2021 to over $3 trillion.² It is this type of exposure to risk, and a lack of transparency of the extent of that risk, that has had NAIC officials concerned. The new rules, which went into effect January 1, 2022, require issuers of private debt to provide private rating letter rationale reports to investors, both at the time of investment and every year thereafter. These reports provide an analytical review of a security, detailing the transaction structure, and any business, financial, industry and legal and operational risks and mitigants that were considered. Requiring that the private letter ratings are sent to investors is the second step in a process initiated in 2018, when the NAIC began requiring insurance companies (or their asset manager) to provide the NAIC’s Securities Valuation Office (SVO) with proof of ratings for private credit issued on or after January 1, 2018. (Before 2018, private letter ratings were a self-administered system, with no oversight by the NAIC or other regulatory body.)

The backstory

Regulators have become increasingly concerned about how risk assessments of privately issued bonds and asset-based securities have been made. The concern has intensified as these types of investments have burgeoned, especially in the insurance industry. The growth in private credit investments is understandable, since investors are seeking better yields in a multi-year, low-interest rate environment, and private placements offer the possibility of higher yields and covenant protection. Naturally, with the potential for higher returns comes higher risk, and the NAIC is determined to add some oversight—or at least insights—into the methodologies that are used to quantify risk. Historically, those risk calculations come from a group of Nationally Recognized Statistical Ratings Organizations (NRSROs).³ What’s concerning is that NRSROs are paid by the companies whose bonds they rate. True, ratings firms have improved governance and compliance, a trend that accelerated after the financial crisis of 2008-2009. Still, this business model presents the potential for a conflict of interest. That’s because the better the rating, the less capital an insurance company is required to set aside to protect investors in case of a default or bankruptcy. Substantially lower costs to borrow provide a powerful incentive to use the NRSRO whose ratings may tend to skew upwards.

Rating firms need scrutiny

Are private credit investments riskier than their ratings indicate? A 2021 NAIC task force did a deep dive into ratings data and revealed significant discrepancies not only among credit rating agencies (CRAs), but between credit rating agency (CRA) ratings and those the SVO assigned for the same investment. When a sampling of 43 securities was scrutinized over 11 quarters, from 2019 through Q3 2021, the researchers found that the CRA ratings averaged 2.375 notches higher than the SVO ratings.⁴ In the most egregious cases, the swing scaled five notches (for example, from BBB3 to A1), meaning that one CRA considered a bond less risky whereas a competitor CRA found the exact same bond to be much riskier. Securian AM’s analysis also found that greater ratings disparity was generally found outside of the big three ratings agencies, and therefore we typically rely on external ratings from Moody’s or Fitch when conducting our due diligence. The task force concluded that risk in cases of wide swings was “materially higher” than the NAIC ratings indicated, putting the validity of the risk assessment into question. The implications: If ratings are unreliable, risk assessment is too. The real danger is the potential for undercapitalization in case of default or bankruptcy of the bond issuer, and that of course spells trouble for insurance companies, institutional investors and others.

Securian Asset Management assessment

We fully support the NAIC rule changes. More transparency into metrics and methodologies will reinforce the already rigorous processes our private credit analysts and portfolio managers follow. Yes, it’s an added expense, and it means additional work for underwriters, but at least in our case those costs are not passed along to our investors. We applaud processes that strengthen our already robust due diligence. What do the changes mean for the average investor? Actually, very little. Current portfolios are not impacted. New purchases may be required to provide rationale documentation to the SVO to obtain or maintain the private letter rating, but this whole process will be monitored and managed by Securian AM. We follow up to ensure that filings are completed and verify that any ratings are as expected. Since the new requirements were telegraphed by the NAIC for years, there was plenty of time for asset managers, and especially their legal departments, to prepare. For new issues receiving a private letter rating, extra language will be inserted into the deal documentation to ensure the rating report is provided to the NAIC. The Securian AM legal team has inserted language that includes limitations on which rating agencies would be acceptable providers of a rating. There is a two-year grace period ending December 31, 2023, in which to comply for investments funding on or after January 1, 2022. There is no requirement for retroactive documentation for investments made before 2018.

New intensive scrutiny on the horizon

Although the SVO doesn’t currently have an enforcement function, there is speculation that it may at some point begin rejecting private letter ratings it finds questionable. The NAIC is reportedly considering tightening the ratings process. One possibility is that ratings for every security must be acquired from at least two CRAs; the lowest number would get assigned for the rating. If there’s only one rating, the SVO’s Valuation of Securities Task Force might conduct a review to decide whether it needs to do its own analysis before a rating can be assigned.