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Life Insurers and Ratings Agencies

|Includes: Allianz SE (ADR) (AZ), BRK.A, MCO, SPGI

Life Insurers, because they sign contracts of very long duration with their customers, live and die by their credit ratings. Customers need to know that the insurer will be around thirty-odd years later and able to pay claims. That's why companies like New York Life and Northwestern Mutual trumpet their top credit ratings with all the major agencies, and their perceived financial strength has helped each of these companies prosper in relative and absolute terms through the financial crisis.

And yet, the National Association of Insurance Commissioners (NAIC) was sufficiently dubious of the credit ratings' abilities to evaluate their RMBS holdings that PIMCO -- a unit of German insurer Allianz, mind you -- was called in in the fall of 2009 to do an independent evaluation.  PIMCO, having dug through life insurer's RMBS portfolios, found that the ratings agencies had been too conservative and that life insurers could free up some $5 billion in capital to do business -- underwrite policies, fund acquisitions, hire, invest in technology, etc.

I don't want to comment on the merits of the valuations, and am indeed not qualified to do so.  I think we can all agree that PIMCO has been more successful evaluating fixed income securities, and by extension those backed by residential mortgages, than the ratings agencies have.  As the crisis has made clear, the ratings agencies have been all too happy to slap AAAs on mortgage-backed and other asset-backed securities of questionable quality. 

But the basic the question is, obviously, if the industry can't trust the ratings agencies to evaluate their financial strength, why should consumers? Why should ratings agencies be better at evaluating the financial strength of insurers than they are at evaluating the strength of their RMBS portfolios which are, after all, a constituent element of their overall robustness?  After all, according to the American Council of Life Insurers (ACLI), at the end of 2008 slightly less than a quarter (~$529 billion) of life insurers general account assets were held in mortgage-backed securities, of which about half were privately issued (i.e. not Fannie, Freddy, Ginnie, or Federall Home Loan banks).  A decidedly non-trivial portion.

All in, one reason to believe that ratings agencies could generally do a better job rating life insurers than they could CDOs is this: one of the primal scenes of CDO-ratings was alpha-driven, very well-paid investment bank mortgage traders presenting to and overawing less well-paid and well-educated ratings agencies employees.  Once one AAA had been slapped on crap, it was hard to go back.

Now, while I do not wish to imply that compensation made the i-bankers better, compensation does nonetheless serve as an index of drive and goal-orientation. Since Michael Lewis's time, it has been considerably more difficult to just amble onto a fixed-income desk at a serious bank. The people who get there do so because they want the job, the stress, and the associated lifestyle.  Ratings agencies are different.  They do not hire the creme de la creme of Wall St.  I know guys who rated bonds at Moody's and none of them have ascended to the helm of Wall St. Smart guys, good guys, but not world crushers.  That's why I like them.

Life insurer employees have more in common with ratings agencies employees. The only people who really make lots of money in life insurance are senior management and top salespeople.  Other than that, it's a stable place to make a career and a reasonable living.  So the people at life insurers who interface with the ratings agencies do not overmatch their counterparts and, indeed, generally would not want to.  They understand that the agencies' credibility is intertwined with their own.

Which makes the NAIC's move to erode the agencies' authority all the more confusing.

post script:  Driving in to work there was a BBC story on ratings agencies which focused more on the institutional relations between banks and ratings agencies, which is obviously as important if not more so than the personal dimension I called out above.  Gillian Tett of the Financial Times made the interesting point that the small number of investment banks issuing CDOs and the like gave them a clear advantage over the ratiings agencies: the agencies didn't have a diversified set of counterparties from whom they were getting data, so they didn't have as robust a methodology for evaluating it.  The very newness of the instruments would also contribute to this dynamic.

By contrast, there are lots of life insurers in America (many would say there are too many, and that consolidation should be expected in upcoming years), and agencies have been evaluating them for years, so there are well-developed methodologies and risk dispersion.

But the NAIC's recent two-step with PIMCO and the agencies is still mildly troubling.

Disclosure: Indices only