Executive’s Life’s 1991 collapse made a mockery of the insurance company rating system. Just months prior to its demise, S&P had given that insurer its highest rating (AAA, “Extremely strong capacity to meet financial commitments”) and Moody’s was awarding it one of their highest ratings at a1. An excellent review of this debacle was published by the GAO in 1992, for those interested in that sort of background. Effectively, though Executive Life had established sufficient insurance reserves to qualify for those high ratings, the ratings companies (and, for that matter, the state insurance commissions) failed to give sufficient weight to the fact that those reserves were made up of junk bonds of, shall we say, dubious value.

There have been at least three notable downstream (though much delayed) effects resulting from this failure which should be of interest to the retirement community. The first was Dodd Frank’s 2010 virtual banning of the use of any financial ratings in the federal regulatory system, including their use in establishing fiduciary standards under ERISA. The second was the eventual establishment in 2011 by the NAIC-after, embarrassingly, some two decades of consideration-of the Risk Based Capital (RBC) standards governing the investments of life insurance companies, a standard which arguably could have prevented Executive Life’s collapse. The third was the establishment of the insurance company ERISA safe harbor for fiduciaries under the Secure Act, upon which fiduciaries can now rely in the absence of any adequate rating system.

In spite of the resultant lack of value of insurer ratings to the ERISA fiduciary, there still remains a sort of residual impact on fiduciaries arising from the fact that higher ratings are still being pursued by insurers. This impact occurs because one of the key elements attendant to any rating from a rating agency is their assessment of the level of insurance reserves established by the insurer. State laws requires an insurer to establish sufficient “regulated capital” (my term, in reference to those investments of life insurance companies subject to the RBC rules, the value of which now exceeds $9 trillion in the U.S.) to back up that seemingly audacious promise to fund benefit payments decades hence. Though the state laws may establish minimums, insurers may establish greater reserves in order to obtain higher ratings.

The end result of this condition is a subtle but important one for the fiduciary “industry.” It calls for an effort (aside from the assessment of the design of any DC lifetime income program) to understand whether the cost of any high rating of an insurer is worth the impact on the “return” on the policy purchased by the plan. It’s not cheap to maintain the highest ratings offered by the ratings agency, as it requires paying for the maintenance of higher reserves. This can create downward pressure on an insurer’s choice of crediting rates to be offered under annuity polices purchased by plans. The question is then joined: what is the value to the fiduciary in accepting a potentially lower crediting rate in return for choosing an insurer with a higher claims paying rating? Put more directly, is there a value difference in utilizing a company with higher rating, and where-and how- do you draw the line?

Engaging in this sort of highly technical assessment effort will not be for the faint of heart, as there are also other of these sorts of issues lurking in the background which will demand unique quantitative analysis. I would think that the quants performing these services would also be interested in becoming familiar with things like the details of the Risk Based Capital standards, and the current industry and regulators’ efforts at addressing risks related to the growing offshore schemes.

This then suggest to me that there is likely to be a sort of bifurcation in the professional fiduciary market. There will be those who will be able to perform the valuable task of assessing any particular DC lifetime income program for plans or their fiduciaries, identifying any program’s relative advantages and disadvantages. But then there will need to be a limited segment of the industry which has developed the capability to perform the sort of quant analysis suggested above. Though only being part of any overall assessment of any lifetime income program, I would think the questions it addresses eventually becomes an important piece of any ultimate review.

Note: the image included in this blog is from my favorite Dr. Sues book, Bartholomew and The Oobleck. Its a drawing of the magicians coming up from the dungeon, an image I often think of when called upon to do weird technical stuff, like called for in this blog…