June 2007

From the Insurance Information Institute, New York

(We believe this is a factual document, but it could be viewed as an advocacy statement. Sam Miller, Florida Insurance  Council.)  

Common Misunderstandings About Credit Scoring: Many people have no idea they are beneficiaries of insurance scoring. More than 50 percent of policyholders have a lower premium because of good credit, insurers say, although consumers themselves, when asked, think most people do not benefit.

Some consumers are disturbed by the fact that, when applying for insurance, one insurer will reject their application based on their insurance score yet another company will find it acceptable. They ask how insurers' responses can be so different when they are all working from essentially the same credit report information. Many large insurance companies have now developed their own insurance scoring model, using their own proprietary information in combination with standard actuarial data. Even when insurers use the leading vendors of insurance scoring models they may have the model tailored to their own target market. Not all insurers are looking to insure the same kind of drivers or homeowners. Some may target only the very best, with no recent accidents or traffic violations, while others may seek out people with a less than perfect record.

Since virtually all companies use credit information in different ways, insurance scoring fosters competition among insurance companies and more choices for the consumer.

Most people think that insurers can obtain all the information they need from state motor vehicle departments and that reportable accidents, speeding tickets, convictions for drunk driving and other traffic violations are automatically, and in this age of electronic communication, instantaneously recorded. But in fact much of that data is missing from motor vehicle records (MVRs).

A 2002 Insurance Research Council study found that MVRs are typically inaccurate. One in five convictions may be missing. An earlier study found that on average only 40 percent of reportable accidents appeared on MVRs. An analysis of current laws shows the amount of useful information is very limited. Some states don't require records of information that show how drivers perform, such as convictions for drunk driving. If a driver is found guilty of an out-of-state infraction, that information is not automatically provided to the state where the licensed driver or vehicle is registered. Other states offer drivers an opportunity to obtain a lesser sentence or to avoid having information noted in the official record. By contrast, credit records are generally complete and where they are not or are inaccurate, there is a clearly defined review process for correcting the deficiencies.

In short, credit information is generally more accurate and that works to the advantage of the majority of insurance consumers. With this information available to insurers, a majority of policyholders will pay less for home and auto insurance.

Research:  A 2004 study commissioned by the Texas Department of Insurance on the use of credit information by insurers doing business in the state found a strong relationship between credit scores and claims experience. The study also found that the use of insurance scores significantly improves pricing accuracy in predicting risk when combined with other rating variables such geographical area and age of driver. Although there was a consistent pattern of differences in credit scores among different racial/ethic groups, with blacks and Hispanics having worse scores than whites and Asians, on average the results were actuarially supported and not unfairly discriminatory. This means that all drivers with the same rating characteristics would be charged the same amount, regardless of race, income or ethnic background. The research, which was required by law, was conducted by the insurance department with assistance from the University of Texas and the Texas A&M University as well as the Office of Public Insurance Counsel. The findings, which were published in December 2004 and January 2005, confirm the results of other studies.

Another earlier Texas study published in March 2003 found a strong correlation between credit history and the filing of an auto insurance claim — both the size and frequency of claims. The Bureau of Business Research at the University of Texas found that when credit scores were matched up with claim data, those with the worst credit scores had claim losses that averaged $918 — 53 percent higher than the expected average—and those with the best credit score had losses that averaged $558 — 25 percent less than the average.

A June 2003 study by EPIC Actuaries conducted for the insurance industry also found that overall, insurance scores significantly increase the accuracy of the risk assessment process. Insurance scores, their study showed, are among the three most important risk characteristics for each of the six major automobile coverages. For example, for property damage liability coverage, those with the worst insurance scores had expected losses of 33 percent above average. Those with the best had losses 19 percent below average. Some 2.7 million records were studied.

Some states have examined the issue of whether credit scores have an adverse impact on low-income or minority populations. A February 2004 report issued by the Maryland Insurance Administration (MIA) found that there was insufficient data to conclusively determine whether the use of credit scoring has an adverse impact on these communities because insurers do not collect information on an applicant’s race or income. Without such data, it is not possible to match premiums paid to any socioeconomic group.

The Missouri Department of Insurance claimed in February 2004 that low income households and minorities are adversely affected by insurance scoring. However, the department’s findings were based on flawed methodologies. For example, it aggregates ZIP code credit score data for everyone in a ZIP code area, whether they own cars or homes and therefore purchase auto or homeowners insurance or not.

Typical Provisions in Legislation Regulating Insurers’ Use of Credit Information:

  • Need to File a Model with the Department of Insurance. Insurers are required to file their underwriting model based on insurance scores with the state’s department of insurance.
  • Restrictions on Factors. An insurance score uses information from an individual’s credit history that has been shown to statistically correlate with claim costs. Restrictions on factors that may be used vary from state to state, but may include:
  • Financing a specific item (house, car)
  • Total available credit
  • Disputed items under review
  • Number of credit inquiries (credit card or loan applications)
  • Debt from financing payments to hospitals or for health reasons
  • Use of certain types of credit (personal loans, credit cards)
    Limits on Use. Different states have proposed varying thresholds, but in general they allow insurers to accept or reject an application based on an insurance score.
  • Prohibitions on Penalizing Consumers with No Credit Histories. While credit cards, mortgages and other debt instruments are widely used today, there are still segments of the population (some elderly people, certain religious sects and some low income individuals, including students) that have no experience with credit. Regulations generally require insurers to consider an applicant with a so-called “thin” or “no-hit” file an average risk.
  • Sole Use Rules. Insurance companies are usually barred from using insurance scores as the sole determining criteria in making underwriting or rating decisions.
  • Disclosure Rules. Insurers are required to inform consumers they are using credit information in the underwriting/ratemaking process. If that is a deciding factor in rejecting the application for insurance or another adverse decision, in accordance with the Fair and Accurate Credit Transactions Act of 2003 (FACT), the insurer must notify the individual that credit report information was used and may have to make a copy of the credit report available to the consumer free of charge.
  • Even before the recent surge of interest in the use of credit reports, many states already required insurers to notify their policyholders if credit histories were used or played a role in adverse decisions, such as raising rates or placing a policyholder in a higher rating tier. Many also already barred insurers from using insurance scores as the sole determinant in underwriting — the process of deciding which applicants to accept and classifying those selected —or pricing/rating decisions. As the issue of credit has assumed a higher profile, additional states have passed such laws. Most are based on a model law passed in December 2002 by the National Conference of Insurance Legislators (NCOIL). Among other things, the model legislation requires insurers to disclose to consumers that a credit report may be used and to notify the policyholder in compliance with the federal Fair Credit Reporting Act when credit is the basis for an adverse action. The model law prohibits the use of credit information as the sole basis for refusal to insure or to nonrenew or cancel. It also bars the use of disputed information or information identified as medical collection accounts in the credit report. And it encourages insurers to take into account extraordinary life events, such as catastrophic illness or the death of a spouse.
  • Another area is how lack of credit history — “no-hits” and “thin files” — should be dealt with. The NCOIL model law says that in such cases either the credit score should be considered “neutral,” or average, or credit as an underwriting factor should not be used at all. As a third option, it allows the insurer to follow a procedure of its own. The justification for this must be provided to the insurance department.

A few states have very restrictive rules. A law passed in Washington state in March 2002 prohibits cancellations and nonrenewals based in whole or in part on credit history. Maryland, which had previously allowed the use of information from credit histories, bans the use of credit in homeowners policies and in auto insurance underwriting decisions on existing business. And while credit-related information may be used in rating decisions about new insurance policies, the law imposes a cap on discounts and surcharges related to credit of 40 percent.

Federal Activities: In December 2003, H.R. 2622, the Fair and Accurate Credit Transactions Act of 2003 (FACT) was signed into law, permanently reauthorizing the expiring Fair Credit Reporting Act. FCRA was first created in 1970 and amended in 1996. The new law preempts state privacy laws, some of which are more stringent than the federal law. Banks, insurers and others who use credit information can now work under a uniform set of federal rules. The law gives consumers new fraud and identify-theft protections. It allows them to opt out of information sharing among affiliates if the purpose of the sharing is for marketing. The law also entitles one free credit report a year upon request from the three major credit reporting agencies, Equifax, Experian and TransUnion. Consumers can obtain their free reports from http://www.annualcreditreport.com , a service funded by the three agencies.

The law directed the Federal Trade Commission (FTC) to conduct a study on the use of credit information by financial services companies, including insurers’ use of insurance scoring. The FTC was required to consult with the Office of Fair Housing and Urban Development, part of the Department of Housing and Urban Development, in researching this issue. The study will evaluate whether the use of credit information has an effect on the affordability and availability of financial services products, including the degree to which it may have a “disparate impact” on various demographic groups. The bill requires the FTC to make recommendations for legislative or administrative actions. The study was to have been completed by the end of 2005. As yet, there is no timetable for the release of the findings.