Giving Credit Where Credit Is Due

To some it is the greatest thing since sliced bread, but others see it as the most flagrant abuse the insurance industry has ever heaped upon the consumer.

Insurance companies, consumer advocates and regulators just cannot seem to agree about the value of using an applicant’s credit history as a tool for underwriting and pricing personal lines insurance. Underwriters who use credit-based insurance scores and the services that supply them insist that how a consumer handles credit obligations is a reliable predictor of future losses. The Consumer Federation of America (CFA) and other consumer advocacy groups maintain that credit history bears no logical relationship to the risk of loss, and advocate an outright and total ban on the use of credit information in underwriting. State insurance regulators have split on the issue. Some have no problem accepting credit-based insurance scores, while others favor banning any use of credit history in underwriting and pricing personal lines. The National Association of Insurance Commissioners (NAIC) and most insurance commissioners, however, remain on the fence, waiting for additional information before coming to a conclusion. That leaves agents and brokers in a familiar position, caught in the middle with some producers wondering which side is the rock and which is the hard place.

Using credit information to reach an underwriting decision is nothing new to the insurance industry, but it is a fairly recent innovation in personal lines. For generations, underwriters have used credit ratings to determine which commercial accounts to accept and which merit discretionary rate credits. In personal lines underwriting, on the other hand, credit information has been conspicuous by its absence. Insurance scores based on credit information trace their origin to a statistical study Fair Isaac Company conducted in 1993, and their use has become widespread only in the last three years.

The growing popularity of credit-based insurance scores coupled with a total lack of information about how scoring models work is what has sparked the current debate. Insurance companies acknowledge that they have not done an effective job of communicating the role of credit information in the rating process to their policyholders, their agents, the public or insurance regulators. Although the algorithms that insurers and vendors use to develop an insurance score from an applicant’s credit history are proprietary, the information they use is not. Insurers admit that they could and should have done more to educate the public and their agency plant about credit-based insurance scores and the steps consumers can take to improve those scores.

Assessing the value of credit information to the underwriting process requires understanding not only where the scores insurance companies use come from, but more importantly what they represent. Lamont Boyd, Fair Isaac’s business development director, explains that the company provides two sets of scores that predict distinctly different behavior. Lending institutions use credit scores that predict an individual’s debt repayment patterns, the leading measure of creditworthiness. Although insurance scores use publicly available credit information, Boyd explained that they are different because they forecast loss ratio differentials. Insurance scores are not a reliable indicator, for example, of whether a policyholder will pay installment premiums as they come due. Instead they segment the market into groups of consumers whose expected losses are similar. Boyd added that Fair Isaac uses different elements of an individual’s credit record to develop credit scores and insurance scores.

Insurers have been actively defending the value of credit information for underwriting personal auto and homeowners, and oppose any restrictions on the use of credit-based insurance scores. An applicant’s credit history, they insist, is an accurate indicator of future losses. “We believe there’s clear evidence that shows a correlation between some credit characteristics and the risk of loss,” argued Sam Sorich, senior vice president, secretary and general counsel of the National Association of Independent Insurers (NAII). “In view of that correlation and the predictive value of credit information, it’s unfair to limit the use of this information because severe restrictions would mean that insurance companies are going to have to charge people more than what they should be charged.”

The impact on premiums is another facet of credit-based insurance scores that consumer advocates, insurance agents and the public often appear to misunderstand. A frequent complaint is that insurance companies routinely use an applicant’s credit history to exact a higher premium, but the record indicates that just the opposite is true. All of the available data indicates that between 60 and 70 percent of policyholders benefit from rate credits or discounts because of credit-based insurance scores. The result is a premium that more accurately reflects the risk of loss the insurer is assuming.

Bob Hunter, CFA’s director of insurance, disagrees, insisting that there is no connection between how consumers handle their bills and the probability that they will be involved in an auto accident or suffer a loss to their homes. He complains that insurers and credit reporting services cannot explain why an insurance score based on credit information provides an accurate indication of future losses. “I don’t think that’s sufficient for a classification or for an underwriting decision,” Hunter asserted. “I think you need to know why.”

Fair Isaac disputes that contention, arguing that university studies that have nothing to do with insurance identify a logical connection between credit history and future losses. They conclude, Boyd explained, that a person who is risk averse and responsible in one area of activity tends to be risk averse and responsible in all other activities. NAII agrees with Boyd’s assessment. “I don’t find it so counterintuitive that someone that does not manage his or her credit affairs very well probably is less likely to manage upkeep of a car or how he or she handles a car while out on the road,” Sorich commented.

Equity is another central issue in the debate over using credit information for underwriting personal lines. The two principal antagonists articulate diametrically opposite positions, and each radiates absolute certainty that his stance is correct. “I don’t think there’s any doubt,” Hunter insisted, “credit scoring discriminates unfairly against low-income and minority people.” In support of his position he points to a study by the Maryland Insurance Administration, asserting that it found consistently lower scores among residents of a zip code whose residents are predominantly low-income and minority than in another zip code where the population is more affluent and principally white.

Sorich counters that the evidence suggests that the distribution of credit-based insurance scores does not depend on either ethnic background or income. He buttresses his argument with research from three sources: a 1999 study by the Virginia State Corporation Commission, which performs the functions of a state insurance department; a comparison the American Insurance Association made in 1998 of the insurance scores of hundreds of thousands of policyholders of one of its large member companies; and data that Progressive Insurance Company has submitted to regulators in several states.

Each side of the debate is quick to criticize the other side’s conclusions. According to Oregon insurance administrator Joel Ario, co-chair of a working group appointed at the NAIC’s Spring National Meeting to look into insurers’ use of credit information, consumer advocates contend that statistical studies by insurers and vendors of credit-based insurance scores indicate an even distribution across ethnic groups and economic strata because they do not go far enough. Insurers, on the other hand, accuse consumer advocates of basing their arguments on “bad science” and results that are not statistically significant.

Opponents of credit-based insurance scores, Sorich asserted, have tried to frame the argument so that insurance companies cannot win. “It is difficult for insurers to prove the negative here,” he said, “because we don’t have information on policyholders’ race and we don’t have information on policyholders’ income. So the best evidence insurers have been able to come up with are the zip code data and the census tract data, which are not perfect surrogates for income or race.”

The debate has left regulators uncertain, at least for the moment, about the best course to follow. Three states (Idaho, Utah and Washington) have adopted legislation that restricts the ability of insurers to use credit information in underwriting and pricing decisions, and a measure the Maryland legislature passed on April 8 is now awaiting action by the governor. Similar bills have failed to pass eight state legislatures, and are pending in 14 others. Although a few insurance commissioners have made up their minds, the National Association of Insurance Commissioners (NAIC) has not decided where the truth lies but is looking into the issues surrounding the use of credit-based insurance scores.

Ario, who co-chairs the NAIC Credit Scoring Working Group, said he expects the group to submit a report later this year. He added that the group is trying to listen to a broad variety of viewpoints and persuade all parties to the debate to agree on a methodology for an actuarial study to settle the question once and for all. Ario identified three principal issues facing regulators: options for regulating credit-based insurance scores; insurers’ use of credit information to make renewal and cancellation decisions; and rating. He indicated that he believes that adequate regulations are already in place to govern the use of credit information in setting rates, but that regulations may not adequately address the other two issues.

For their part, agents would prefer to see the problem resolved by changes in the way insurance companies do business than by new statutes or regulations. “We believe that the use of credit data can be extremely valuable in the underwriting process,” explained Wesley Bissett, vice president of state government affairs at the Independent Insurance Agents of America (IIAA), “but it needs to be used in a balanced and a reasonable and a consumer-friendly way. What we have seen is that too many companies have not used it in a reasonable and consumer-friendly way.”

The National Association of Professional Insurance Agents (PIA) echoes those sentiments. Patricia Borowski, PIA senior vice president, believes that insurers have to do an especially good job of keeping their producers informed and giving them access to all their underwriting tools, including credit-based insurance scores. The PIA national board of directors made such access the cornerstone of a policy on insurance scoring that the board adopted unanimously on March 17. Because agents are the initial point of contact, Borowski argued, putting all the underwriting tools in their hands makes good economic sense because it eliminates early cancellation of newly issued policies that fail to meet all of an insurers underwriting guidelines.

As chaotic as it appears, the debate contains the seeds of consensus. Despite their preference for relying on existing regulations to govern the use of credit information in underwriting, insurers and agents have expressed a willingness to accept a “reasonable” level of regulation that bears a remarkable similarity to proposals that have appeared in many state legislatures. Because they agree that they need to do a better job of explaining credit-based insurance scores to the public, insurers are prepared to accept notice requirements. Prohibiting insurers from making credit information the sole basis of an underwriting or rating decision would do little more than reflect current industry practice. Limiting the use of credit information for renewal and cancellation decisions is more controversial, but may become something that the industry has to live with.

The biggest concern to independent agency companies is that burdensome regulation will put them at a competitive disadvantage to direct writers. Progressive points out in a position paper on insurers’ use of credit information that direct writers and exclusive agency companies use credit information to screen consumers for solicitation, achieving the same effect as application of credit-based insurance scores. Because the Fair Credit Reporting Act (FCRA) protects this right, regulation or legislation that seriously impairs an insurer’s ability to use credit information in underwriting and rating would place direct writers at a competitive advantage.

Joseph F. Mangan, CPCU, brings more than a quarter century of experience in property and casualty underwriting to his current position as consultant, author and editor. His columns appear regularly in leading insurance trade publications. Mangan has authored four textbooks on commercial lines underwriting, and contributed to textbooks on personal lines insurance and insurance operations. In addition to his extensive experience as a line and staff underwriter, he served for 10 years as assistant professor of insurance at The College of Insurance in New York City.

Topics Carriers Profit Loss Agencies Legislation Underwriting