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Miles Livingston and Lei Zhou

Credit rating agencies have developed as an information intermediary in the credit market because there are very large numbers of bonds outstanding with many different features. The Securities Industry and Financial Markets Association reports over $20 trillion of corporate bonds, mortgaged-backed securities, and asset-backed securities in the United States. The vast size of the bond markets, the number of different bond issues, and the complexity of these securities result in a massive amount of information for potential investors to evaluate. The magnitude of the information creates the need for independent companies to provide objective evaluations of the ability of bond issuers to pay their contractually binding obligations. The result is credit rating agencies (CRAs), private companies that monitor debt securities/issuers and provide information to investors about the potential default risk of individual bond issues and issuing firms. Rating agencies provide ratings for many types of debt instruments including corporate bonds, debt instruments backed by assets such as mortgages (mortgage-backed securities), short-term debt of corporations, municipal government debt, and debt issued by central governments (sovereign bonds). The three largest rating agencies are Moody’s, Standard & Poor’s, and Fitch. These agencies provide ratings that are indicators of the relative probability of default. Bonds with the highest rating of AAA have very low probabilities of default and consequently the yields on these bonds are relatively low. As the ratings decline, the probability of default increases and the bond yields increase. Ratings are important to institutional investors such as insurance companies, pension funds, and mutual funds. These large investors are often restricted to purchasing exclusively or primarily bonds in the highest rating categories. Consequently, the highest ratings are usually called investment grade. The lower ratings are usually designated as high-yield or “junk bonds.” There is a controversy about the possibility of inflated ratings. Since issuers pay rating agencies for providing ratings, there may be an incentive for the rating agencies to provide inflated ratings in exchange for fees. In the U.S. corporate bond market, at least two and often three agencies provide ratings. Multiple ratings make it difficult for one rating agency to provide inflated ratings. Rating agencies are regulated by the Securities and Exchange Commission to ensure that agencies follow reasonable procedures.


Richard C. van Kleef, Thomas G. McGuire, Frederik T. Schut, and Wynand P. M. M. van de Ven

Many countries rely on social health insurance supplied by competing insurers to enhance fairness and efficiency in healthcare financing. Premiums in these settings are typically community rated per health plan. Though community rating can help achieve fairness objectives, it also leads to a variety of problems due to risk selection, that is, actions by consumers and insurers to exploit “unpriced risk” heterogeneity. From the viewpoint of a consumer, unpriced risk refers to the gap between her expected spending under a health plan and the net premium for that plan. Heterogeneity in unpriced risk can lead to selection by consumers in and out of insurance and between high- and low-value plans. These forms of risk selection can result in upward premium spirals, inefficient take-up of basic coverage, and inefficient sorting of consumers between high- and low-value plans. From the viewpoint of an insurer, unpriced risk refers to the gap between his expected costs under a certain contract and the revenues he receives for that contract. Heterogeneity in unpriced risk incentivizes insurers to alter their plan offerings in order to attract profitable people, resulting in inefficient plan design and possibly in the unavailability of high-quality care. Moreover, insurers have incentives to target profitable people via marketing tools and customer service, which—from a societal perspective—can be considered a waste of resources. Common tools to counteract selection problems are risk equalization, risk sharing, and risk rating of premiums. All three strategies reduce unpriced risk heterogeneity faced by insurers and thus diminish selection actions by insurers such as the altering of plan offerings. Risk rating of premiums also reduces unpriced risk heterogeneity faced by consumers and thus mitigates selection in and out of insurance and between high- and low-value plans. All three strategies, however, come with trade-offs. A smart blend takes advantage of the strengths, while reducing the weaknesses of each strategy. The optimal payment system configuration will depend on how a regulator weighs fairness and efficiency and on how the healthcare system is organized.