We implement a new methodology to measure credit rating inflation that separates default risk from liquidity risk, using private letter ratings (PLRs)—ratings disclosed only to the paying investor. After a proposed capital charge reform, the most affected life insurers drastically increased PLR usage, raising regulatory arbitrage concerns. We estimate that bonds with PLRs carry additional risk equivalent to three rating notches, supporting the arbitrage explanation. Our new methodology reveals a substantial part of this rating inflation is explained by decreased liquidity rather than hidden default risk.