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Rating agencies took a well-deserved beating last week when they were called on the carpet by state regulators wary of trusting their assessments going forward.

Millions depend on the judgments of these agencies—not just insurance regulators, but buyers of coverage as well as investors. The only tangible asset rating agencies have is their credibility. Without that, their pronouncements are worthless.

The National Association of Insurance Commissioners put rating agencies on the hot seat at their meeting outside of Washington, D.C., because regulators depend on outside evaluations to determine insurer risk-based capital requirements.

The hearing, convened by the NAIC's Rating Agency Working Group, was designed to learn how insurance departments had come to rely so heavily on these firms, what went wrong, and what if anything can be done differently.

The regulators came away clearly dissatisfied with the status quo, but still uncertain about what to do about it.

New York Deputy Superintendent Michael Moriarty testified that because of its limited resources, the NAIC Securities Valuation Office essentially took a shortcut by delegating its oversight responsibilities to rating agencies.

As reported by NU's Phil Gusman, Mr. Moriarty explained that if a security was rated by a nationally-recognized agency, the carrier did not have to file it with the SVO. “The rationale at that time was fairly straightforward,” he said, citing the reliable track record of rating agencies.

However, Mr. Moriarty conceded to his colleagues that under the circumstances, it's obviously time to reconsider this relationship, given the collapse of highly-rated mortgage-backed securities and other overly-risky derivatives.

But is any change in standard operating procedure feasible, especially given the pressure on state budgets?

At the hearing, SVO Managing Director Chris Evangel testified his office could conceivably rate securities now evaluated by rating agencies. But he also warned the cost might be prohibitive.

Mr. Evangel also cautioned that even if the NAIC does decide to take over securities evaluation in-house, such a “sea change” could not be accomplished overnight, still leaving regulators at the mercy of the rating agencies in the interim.

Before regulators make this monumental decision, they first are seeking to determine whether the failure of rating agencies to red-flag toxic securities and derivatives was because they misunderstood and therefore underestimated the risks involved, or whether an inherent conflict-of-interest in how ratings are granted has damaged the credibility of agencies beyond repair.

Neither conclusion does credit to the rating agencies—whether they were clueless or corrupted still makes continued reliance on the integrity of their assessments problematic.

The rating agencies are facing other challenges. California Attorney General Edmund G. Brown Jr. sounds like he's already made up his mind about them. He subpoenaed Standard & Poor's, Moody's Investors Service and Fitch Ratings to determine whether the trio violated California law by “recklessly” giving “stellar ratings to shaky assets.”

But insurance commissioners have not made up their minds. They gave interested parties until Oct. 7 to submit comments.

Part of their dilemma, I imagine, is that in their hearts they realize they cannot take on this enormous responsibility—particularly in the middle of a crippling recession. But will they be able to take the rating agencies at their word that they have reformed whatever problems there were? Blind faith is what got them into trouble in the first place.

Fool me once, shame on you. But fool me twice, shame on me. That's what the regulators need to keep in mind.

What do you folks make of this?

Special Reports /

Regulators Understandably Wary Of Rating Agencies

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