Credit Ratings in Insurance Regulation: The MIssing Piece of Financial Reform

Table of ContentsI. Introduction 1668II. The Rise of Rating-Dependent Regulation of Insurance 1671III. The Financial Crisis, the Ratings Crisis, and the Insurance Industry 1676IV. Analysis Without Action: NAICs Inconclusive Review of Rating-Dependent Regulation 1680V. Action Without Analysis: The "Rule Bailout" of Life Insurers 1689VI. The NAIC and the Limits of Capital Regulation 1694VII. Conclusion 1697I. IntroductionOne of the few financial reforms on which Republicans and Democrats in Congress have agreed is the elimination of credit ratings from financial regulation. Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ordered federal financial authorities to excise credit ratings from their regulations within one year,1 and the House Republicans' alternative draft financial regulation bill contained a similar provision.2 Dodd-Frank' s sweeping and unequivocal command was noteworthy not just for its bipartisanship, but also because it seemed to resolve at one stroke a struggle over the proper use of credit ratings that had been going on for at least fifteen years. Law professors,3 financial economists,4 and even some of the rating agencies themselves5 had been criticizing the regulatory use of ratings since the mid-1990s with little to show for their efforts. Section 939A might have seemed like a sudden and complete, if unexpected, victory for the reformers.But Dodd-Frank, definitive as it was in ordering an end to the use of credit ratings in federal financial regulation, had nothing to say about the use of ratings in the state-based insurance regulatory system. It is as though the financial reformers forgot about insurance, the industry that owns about 20% of the corporate and foreign bonds6 and 16% of the municipal bonds in the United States,7 and that bears a corresponding amount of the credit risk that rating agencies assess and regulators monitor. By comparison, banks own about 7% of corporate and foreign bonds8 and 9% of municipal bonds9 outstanding.This Article explores the previously unexamined use of credit ratings by state insurance authorities, who have jealously guarded their primary authority over insurance regulation from Congressional intrusion for sixtyfive years.10 Part II of the Article traces the rise of rating-dependent regulation of insurance and the displacement of the state insurance regulators' in-house public rating capability by private credit rating agencies in the 2000s. Part II reviews how the failure of financial products that had received high credit ratings stressed the industry during the financial crisis.Part III examines the insurance regulators' reconsideration of their use of credit ratings in response to the crisis. Regulators have studied the problem for years, starting in February 2009, but their study and analysis has led to only limited proposals to reduce reliance on ratings. Even if all proposals pending today are adopted, the insurance regulation system will continue to be heavily rating-dependent. The insurance regulators' continued embrace of credit ratings is important on its own, because it threatens to defeat the purpose of Dodd-Frank' s directive to remove ratings from federal financial regulation: Artificial regulatory demand for ratings will continue, and credit rating agencies' decisions will continue to exert outsized influence through the regulatory system. Insurance regulators' continued reliance on credit ratings also is important because it illustrates how reluctant regulators are to give up using these measures of credit quality, which are readily available and are, for better or worse, widely recognized. …