When I first saw your POV, I agreed whole-heartedly. I'm a relative newb to online gaming, so I realized I'd been using that feature to get an idea of relative strengths of characters.
Nothing worse than forming a party with newbs in it that can't take a quest, then you spend another 10-20 minutes real time trying to figure out WTF you are going to do now.
But from a RP perspective, it's very hard for a computer screen to convey subtleties like power, toughness, confidence and personal auras in general. If a guy is in full plate, draws a flaming greatsword on you after he just slayed a stone giant singlehandedly, you know he's a bad man. But other than something like that, or actually having someone whip your ass, you have no idea how strong they are. I think IC, that a character would have a general clue as to the relative strength of another character.
In the real world, you can just look at people and see that they are people of imporance, confidence, strength, or whatever. Using the "rating system" conveys to your character that so-and-so has some qualities that would seem to indicate their general level of experience.
A mage might radiate confidence and a powerful gaze, a cleric may seem to have a strong charisma about them, a fighter type may ripple with strength or may have very obviously smooth and efficient movements, and a thief may seem extraordinarly quick or nimble in their motions.
True, it does make it hard to deceive others if that is your intent. Disguises and such. Perhaps it could be tied to "Hide" and "Hide in plain sight" abilities? If you want to turn off your Challenge Indicator, you have to roll a successful check that is progressively harder the weaker or stronger you wish to appear. It seems more likely that a rogue would "act like a servant or simple villager to get close to their target then to somehow amazingly stroll across a well-lit room to stab the warrior that is on guard and knows an enemy is in the room?
Some cool RP possibilities could be connected to this. Rogue type stuff, spying, political intrigue etc. Even cooler if you could change the name above your character at will using this skill....prolly tough on DMs though, eh?
$0.02