June 2007  

From the Insurance Information Institute, New York

Insurance Information Institute

The goal of every insurance company is to correlate rates for insurance policies as closely as possible with the actual cost of claims. If insurers set rates too high they will lose market share to competitors who have more accurately matched rates to expected costs. If they set rates too low they will lose money. This continuous search for accuracy is good for consumers as well as insurance companies. The majority of consumers benefit because they are not subsidizing people who are worse insurance risks — people who are more likely to file claims than they are.

The computerization of data has brought more accuracy, speed and efficiency to businesses of all kinds. In the insurance arena, credit information has been used for decades to help underwriters decide whether to accept or reject applications for insurance. Now advances in information technology have led to the development of insurance scores, which enable insurers to better assess the risk of future claims.

An insurance score is a numerical ranking based on a person’s credit history. Actuarial studies show that how a person manages his or her financial affairs, which is what an insurance score indicates, is a good predictor of insurance claims. Insurance scores are used to help insurers differentiate between lower and higher insurance risks and thus charge a premium equal to the risk they are assuming. Statistically, people who have a poor insurance score are more likely to file a claim.

Insurance scores do not include data on race or income because insurers do not collect this information from applicants for insurance.

RECENT DEVELOPMENTS

Florida: On December 29, 2006 in Florida an administrative law judge threw out a rule that would have effectively eliminated the use of credit. On June 30, the Florida Office of Insurance Regulation noticed in the Florida Administrative Weekly its intent to adopt two new rules which insurers believe also effectively eliminate insurance scoring. Insurers are now considering their options.

In 2003,  the Florida Legislature passed a law regulating the industry’s use of credit-related information. The measure basically allowed insurers to use credit scoring as long as they complied with the consumer safeguards set out in the law. These generally follow provisions included in the model law passed by the National Conference of Insurance Legislators in 2002. However, the state’s regulators, who must implement laws enacted by the legislature, chose to implement the 2003 law by adding a rule that would have required insurers to prove that their use of credit-related information does not unfairly discriminate against specific demographic groups or places of residence, a provision that was not part of the original legislation. Insurers have no way of knowing whether or not any demographic groups are adversely impacted by the use of credit scores because they do not collect demographic data about their policyholders or the people who apply for insurance. This information would have been needed in order to prove or disprove the disparate impact concept. The court found that the state’s Financial Services Commission did not define such terms as ”unfairly discriminatory” adequately enough to allow insurers to know whether their rates could be categorized as such. The new rules are still being reviewed by the Florida Insurance Council and national insurance trade groups, but they require insurers to collect sensitive, personal information on consumers and raise standards and tests for the use of credit as an insurance took which practically cannot be met. 

Oregon: Voters rejected Oregon ballot initiative 42 that would have banned insurers’ use of insurance scores in rating and underwriting. Currently, insurers doing business in the state must notify policyholders if use of their credit history results in an adverse decision and they may not use credit as a justification for canceling or non-renewing a homeowners or auto insurance policy.

A study by ECONorthwest commissioned by Oregonians Against Insurance Rate Increases shows that in Oregon, 58 percent of auto policyholders and 53 percent of homeowners policyholders paid lower premiums due to the use of credit information by their insurer. Auto insurance policyholders with a favorable credit score paid as much as 48 percent less than they would have paid without the insurer’s use of credit information, with an average saving of $115, and homeowners paid an average of $60 less. The actual savings varied significantly from insurer to insurer. The report released by ECONorthwest also explains how credit information supplements other rating factors such as age and territory – where a driver lives – allowing applicants with a good score who might otherwise have been categorized as a bad risk obtain coverage and/or qualify for a better rate.

Michigan: The Michigan insurance department is appealing a circuit court ruling in April 2005 on insurers’ use of credit. The judge said that the rule as proposed by the Office of Financial and Insurance Services (OFIS) was illegal, invalid and unenforceable because the Office was attempting to rewrite the Insurance Code through administrative rulemaking. The judge said that the evidence shows that policyholders with low credit scores present a higher risk than policyholders with higher scores and that one of the basic principles of insurance was that higher risk policyholders should pay higher rates. The lawsuit stemmed from a decision by Michigan Governor Jennifer Granholm and Insurance Commissioner Linda Watters, announced in April 2004, that the state would ban the use of insurance scoring in personal lines insurance as a rating factor and in underwriting. The two officials said eliminating the use of credit would produce lower base rates and make insurance more affordable but, in fact, because more people benefit from the use of insurance scoring than are penalized, most people would have seen a rise in rates. Auto insurance rates are higher than average in Michigan, in part because the state’s auto insurance system provides generous medical care benefits. The court is expected to issue a ruling soon. Meanwhile, insurers may use credit scoring to discount premiums.

Other States: In Minnesota and Arkansas, bills have already been filed this year that would limit insurers’ use of credit. According to Property Casualty Insurers Association of America, 26 states have adopted laws on credit or regulations based largely on the National Conference of Insurance Legislators’ model law. Four states restrict the use of credit in some way, one prohibiting it for only one type of insurance.

In Delaware, a compromise bill on credit scoring was worked out that would still make the state one of the most restrictive. The bill originally banned the use of credit scoring for homeowners and auto insurance but was amended to prohibit insurers from using credit as the sole determinant of new policy underwriting and rating decisions, similar to provisions that already existed. However, the bill also prohibits insurers from increasing premiums on renewal due to a change in credit history. The bill was approved by the Senate in May.

In New Mexico, insurers and the state’s insurance department have launched a campaign to help the public understand the state’s credit-based scoring law. The law is based on the National Conference of Insurance Legislators (NCOIL) model law which protects consumers whose credit has been lowered by financial difficulties following a divorce, illness or other “extraordinary life circumstances.” The New Mexico law also protects people who have no credit history. About half of the 48 states that have a law on credit scoring use the NCOIL model.

Adverse Action Notices: In Washington State, the state insurance department promulgated a new rule that requires insurers to provide specific and detailed reasons and explanations, in plain, unambiguous language, whenever they inform consumers of an “adverse action.” Adverse actions include nonrenewal of an existing insurance policy, an increase in premium or a refusal to issue a new policy, based on credit scores. Under the rule, insurers must provide a description of the element in the credit history that adversely affects the consumer’s insurance score. They must also explain how this affects the insurance score and what consumers can do to improve this aspect of their score.

In June 2007, the U.S. Supreme Court overturned appeals court rulings in two cases that centered on when insurers are required to send consumers notices to comply with the Fair Credit Reporting Act (FCRA). Siding with insurers on the issue, the high court said that the companies were not breaking the law. The 9th Circuit court had ruled in the first case that an insurer must issue adverse action notices whenever a consumer’s credit information does not result in the consumer receiving the best possible rate but the high court said that such actions would result in too many notices being sent that were likely to be ignored. In the second case, it said that the company had not acted recklessly in willful disregard of the law.

Federal Activities: The General Accounting Office (GAO) has concluded, based on a survey of some 1,500 consumers, that people understand the basics of credit reporting but are largely unaware of the impact their credit history can have on employment opportunities and insurance rates. The survey was taken in accordance with provisions in the Fair and Accurate Credit Transactions Act of 2003, see Background. The GAO has recommended that the Treasury and Federal Trade Commission take steps to improve consumers’ understanding of credit scoring and how credit histories are used, targeting in particular those with less education and less experience in obtaining credit.