Credit-Based Insurance Scoring: A Simmering Debate

March 2002

With consumer groups squarely and vehemently lined up against the insurers, and regulators caught in the middle, compromises on this issue are virtually assured.

by Robin Olson
IRMI

"Regard your good name as the richest jewel you can possibly be possessed of—for credit is like fire; when once you have kindled it you may easily preserve it, but if you once extinguish it, you will find it an arduous task to rekindle it again."

—Socrates

Imagine this scenario. You are a retired carpenter and you have just opened your bill for your personal auto insurance renewal. You have not had a ticket or accident in over 3 years; however, your auto insurance premium has still jumped significantly. As you research this matter, it becomes apparent that your premium rose, in part, due to your credit rating. It's not that your credit is poor per se; it is simply thin because you normally pay cash for your purchases. Is this fairness on the part of the insurer? Not according to consumer groups and a growing number of state insurance departments.

Credit-based insurance scoring is becoming a popular measure of risk by insurance companies. One survey last July indicated that 92 percent of insurers now use credit scores in accepting policies and/or setting rates. The argument is that a person's credit rating is positively related to the future likelihood of insurance losses. In other words, persons with excellent credit are less likely to have future insurance losses and vice-versa. There are numerous and substantive arguments for the use of credit-based insurance scoring in personal lines policies, including the following.

• Use of credit-based insurance scoring has legal authority.
• Credit characteristics are predictive of future losses.
• The use of credit improves insurers' ability to measure risk.
• The use of credit reduces the insurer's uncertainty in writing new business.
• Studies indicate there is no correlation between income level and credit rating.
• No evidence indicates that credit-based scoring is inherently discriminatory.

Due to the controversial nature of this issue, various perspectives are presented to provide a balanced view of the debate.

National Association of Independent Insurers' Perspective

The National Association of Independent Insurers (NAII), an influential, full-service property and casualty trade association, strongly supports the use of credit in underwriting and rating personal lines exposures. According to Vice President and Western Regional Manager Sam Sorich, this use has legal authority due to the passage of the Fair Credit Reporting Act (FCRA) over 30 years ago.

"The FCRA clearly authorizes the use of credit information for insurance underwriting purposes," said Mr. Sorich. He went on to draw a direct correlation between credit characteristics and a person's risk of having loss. He referred to numerous studies, including insurer studies and credit risk-scoring company studies, to support this argument. NAII rejects the allegations that insurance scoring is inherently discriminatory to lower-income persons.

"The scoring does not try to determine how much money someone has, but how he or she manages their financial affairs," Mr. Sorich said. He said that the disbursement of scores is similar through all income strata. In addition, the insurance score provides a more uniform and objective standard, reducing the likelihood of human bias. When asked about errors in credit reports, Mr. Sorich believes that these are at a low rate and could swing in both negative and positive directions to the consumer.

"There are avenues for persons to remedy the problem, such as direct communication with the credit bureau," he answered.

Some states have proposed placing a cap, such as 20 percent, on the difference between the premiums charged to people with excellent credit and those with poor credit. The NAII believes this is an arbitrary figure.

"If the data indicates that credit information should have a greater impact, we think it's a fair practice to use it," said Mr. Sorich.

State Farm's Perspective

State Farm Insurance, one of the top writers of personal lines insurance in America, firmly believes they have the right to use credit characteristics in their underwriting models. According to Dick Luedke, a public affairs specialist with this insurer, State Farm matched up credit characteristics from a prior period for over a million of its insureds and then compared this to their loss experience for the following 2 years.

"The results of the study indicates a predictive correlation between credit characteristics and claims experience," he said.

State Farm is in the business of measuring risk. "This improves our ability to measure risk," according to Mr. Luedke. "It thus results in greater fairness for consumers." He also cited other studies, including those performed by the Casualty Actuarial Society and the Virginia Bureau of Insurance, both of which reported similar correlations and results.

When asked about a potential bias against lower-income families, Mr. Luedke said, "We found no correlation between income level and credit rating. How you manage your money is not a function of net worth or income."

State Farm's media fact sheet on this issue states, "Our models are not designed to assess wealth, income or creditworthiness, but focus on the prediction of future insurance losses … we believe the use of these models will lessen the extent to which those who represent higher potential risk are subsidized by those who represent lower potential risk."

According to Mr. Luedke, State Farm is careful regarding the way they use this information in underwriting. For example, they do not use it for renewals. In addition, for those applicants with no credit history, the insurer uses regular underwriting practices, since the model would be unable to generate a credit score.

"We also build into our underwriting the flexibility in order to reevaluate based on the updating of a credit report containing errors," he said.

When asked for specific examples or scenarios regarding the models State Farm has developed, Mr. Luedke cited that this was proprietary information, which they have to protect for competitive reasons. Their work in this field began in the mid 1990s and continues to evolve today.

Fair, Isaac and Company's Perspective

Fair, Isaac and Company is described as a leading provider of "creative analytics." According to Craig Watts, Consumer Affairs manager with the firm, "We help businesses solve problems and are the pioneers of credit risk scoring through the development of mathematical models." Fair, Isaac and Company developed this work in the early 1990s and now has over 300 insurers using their mathematical model.

"We look at a given body of credit reports from 2 years ago," Mr. Watts said, "and see how they perform loss-wise in the subsequent 2 years." The company found a strong correlation between the credit characteristics and loss experience.

"Our opinion is that the consumers who are more stable and responsible in their use of credit tend to be better insurance risks. They tend to pay more attention to car and home maintenance and are more careful drivers," he stated. Fair, Isaac believes that individuals who are more stable in one aspect of their lives (e.g., credit characteristics) tend to be more stable in other aspects of their life, such as being careful and responsible in their driving.

When asked about criticism from some groups that Fair, Isaac is not truly independent from insurance companies, Mr. Watts said that, "Much of the criticism comes from people who haven't studied this issue or who have not read any of our findings." He mentioned other entities have performed their own studies with similar findings, such as Tillinghast-Towers Perrin and the Virginia Bureau of Insurance study mentioned earlier in this article.

Mr. Watts responded quickly to concerns about the use of credit to discriminate against lower-income families and minorities. "We found that higher-income persons tend to have lower credit scores. They tend to be more careless about their money, knowing that more of it is coming. If you don't have much money, you tend to protect it better," he said. Fair, Isaac and Company believes that the use of credit history in underwriting and rating can help lower insurance premiums for more responsible people and drivers.

National Association of Professional Allstate Agents' Perspective

The National Association of Professional Allstate Agents (NAPAA) opposes the use of credit reports, credit scoring, or credit algorithms by insurance companies for any purpose associated with underwriting, rating, or marketing of insurance policies. This organization believes the use of credit as a tool of insurance underwriting is discriminatory, inappropriate, and invasive.

According to Rod Guilmette, editor of NAPAA's weekly newsletter Direct Express, the "credit-scoring mechanism is secret and not subject to examination by the various states." Mr. Guilmette, whose comments apply not just to Allstate but other insurers who use credit-based insurance scores, contends that these studies do not establish any type of cause.

"There may be some correlation; however, there has been no independent study on this matter to see if the conclusions are correct. In addition, there have also been no studies to see if these algorithms are discriminatory by effect or intent," he said.

Mr. Guilmette drew up the following scenario in which things are flipped around. What if your mortgage company decided to base your interest rate, in part, on your driving record? This would mean that if you have two recent tickets, you might pay 1 percentage point more. How would consumers respond to that? In his opinion, there would be a powerful aversion toward this, and justifiably so.

Mr. Guilmette said that traditional methods of personal auto underwriting, based on characteristics such as tickets, accidents, and vehicle usage, should be applied, as these are not discriminatory, and people can more easily control these types of characteristics.

Consumer Organization's Perspective

The Consumer Federation of America (CFA) opposes the use of credit-based insurance scoring. CFA Director of Insurance J. Robert Hunter sees the use of credit as a surrogate for race and income.

"Intuitively, poorer people do not use credit as often or as wisely," he said. One of his chief concerns is that insurers refuse to share their mathematical models, as they consider this proprietary information.

"Why can't the insurers agree to an independent study, not affiliated with the insurance companies?" he asked. In his opinion, a prominent statistical professor could be selected to review the data and information with an appropriate confidentiality agreement. "Insurers have not agreed to this," he commented.

Mr. Hunter, a former Insurance Commissioner of Texas, further believes that the use of credit decreases incentives for people to reduce losses. "What do you say to someone who asks his insurance agent about ways to reduce his premium?" he said. "The agent might respond 'drive more carefully.' But with credit, there is virtually nothing a consumer can do. He is locked into that price. There is no incentive for him to improve his rate."

The Center for Economic Justice also believes that the use of credit-based insurance scoring is inherently unfair. Birny Birnbaum, the executive director, believes one's credit report "is not a complete picture of a person's credit. Some people choose not to use credit, but are good money managers. People in poorer neighborhoods often frequent vendors and other companies (e.g., rent-to-own companies) that do not report to the credit bureaus. These people often do not use professional lending institutions."

Mr. Birnbaum also believes that events can happen in people's lives that are beyond their control, such as medical catastrophes or layoffs. "These people are unfairly penalized," in his opinion.

Another concern of the Center is that the use of credit in these secret algorithms reduces the state insurance department's ability to regulate rates. The argument is that regulators are less able to properly evaluate the rating mechanisms used by the insurers and the effects on consumers.

Mr. Birnbaum believes that the use of credit is discriminatory to lower-income people. "These factors are weighted against poor people. It relates more to assets, not financial management," he stated. In addition, Mr. Birnbaum believes one of the important purposes of insurance is to provide incentives to reduce losses. "The use of credit does not provide the necessary incentive to reduce losses," he said.

According to these consumer groups, approximately 30 states have some type of bill before the state legislatures to restrict the use of credit-based insurance scores. So, how are the state insurance departments handling this hot issue?

State Insurance Departments' Perspective

The National Association of Insurance Commissioners (NAIC) is looking seriously at this issue. The NAIC point person in this controversy is Joel Ario, the Oregon Insurance Administrator. He is heading up an NAIC work group, whose purpose is to create a model act for state insurance departments to consider and potentially implement.

"There are two issues to address," he said. "The first is the process issues, covering items such as disclosure procedures. There appears to be much agreement on this. The second is the substantive issues, such as restrictions on the use of credit in underwriting or rating, for which there is more conflict."

Mr. Ario said, "There are real issues to consider, particularly concerning the impact on poorer people. Is there actuarial correlation between credit and future losses? Yes, there is probably good evidence of this."

He believes, however, more study of the mathematical models is needed, which should include conditions of confidentiality. In Oregon, insurers can currently use credit-based insurance scoring. He believes the matter will be addressed in the next several months at the Oregon Insurance Division and restrictions are a distinct possibility in the future.

This use of credit is being heatedly discussed at the Washington Insurance Commissioners Office as well. Stephanie Marquis, a public affairs officer with this office, said that this whole issue began when hundreds of complaints started filing into their office. She cited a "high number of complaints from women with credit problems due to divorce and people who were laid off due to the economic downturn."

According to Ms. Marquis, a bill restricting the use of credit-based insurance scoring is now out of the state senate and house committees, with solid support. It will now go to a vote before the full senate and house in the next few weeks. Some of the restrictive provisions of the bill include the following.

• An empty credit history cannot be utilized in any scoring.
• Credit problems relating to medical or health problems must be disallowed.
• The total line of credit available must be disallowed (some credit scores may penalize someone with high credit availability as this may be viewed as risky).
• Disputed credit history must be disallowed while the dispute is under review.
• Any credit factors that could restrict lower-income persons' access to insurance must be disallowed.

According to Ms. Marquis, these types of restrictions are being considered or debated in slightly over half of the state insurance departments.

Conclusion

The more this issue is analyzed, the more complex and thorny it becomes. The insurance consumer groups are squarely and vehemently lined up against the insurance companies. The regulators, caught in the middle, have to look at it from both perspectives. As one commissioner put it, their objective is to "protect insurance consumers while promoting a positive business climate for insurers and insurance agents alike."

This hot potato makes for a particularly difficult and clumsy juggling act. Expect compromises where neither claims total victory. In other words we'll probably see some restrictions imposed on the use of credit-based insurance scores in many states - but not a complete ban on the practice.

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