Is Credit Used In Insurance Underwriting?

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As of April of 2010, 77 million Americans – that’s 25% – found themselves staring more frequently at past due bills and answering the phone to hear bill collectors on the other end. (There’s no telling how many collection phone calls those 77 million Americans received – or ignored.) 

Whether they answered those collection calls or not though, that 25% still slid into the ‘lease creditworthy’ FICO score category, with scores under 600, in comparison to only 15% before the recession hit, according to Deutsch Bank. Even for those who managed to pay off debt  and dig themselves out of a paycheck to paycheck lifestyle though, one issue remains: We live in a credit dominated world, and although the hopes would be that hard economic times would spur entrepreneurship and force many to pull themselves up by the bootstraps, there’s a shadow that follows those with less than fair credit scores, and it’s not a shadow that’s only cast when trying to get approved for a new credit card or a mortgage. Now, the shadow of poor credit follows consumers into some of the most unexpected places – places some people deem is no place for credit score consideration, such as insurance.

That must be just for some big-time insurance products though. Surely one’s credit history has nothing to do with the price of their homeowners insurance, or even their eligibility for insurance, right?

Unfortunately, that’s not the case, and credit and insurance are perhaps more closely linked than one would initially think. Although news to many, insurers began adding credit scoring to their underwriting formulas for personal lines products such as homeowners insurance and auto insurance two decades ago. According to the American Insurance Association (AIA), 90% of insurers now utilize credit based scoring, compared to a “handful” roughly 20 years ago.

Since the beginning, there’s been public outcry, not just from consumers but from independent insurance agents who began losing countless policies from their books of business due to increased premiums and sometimes even ineligibility due to poor credit. They were left with the duty of explaining to their policyholders what credit had to do with insurance and what affect poor credit had on insurance policies, although most have come around.

But two decades later – although the industry has largely eased into the use of credit and even finding it accurate and fair — some people still wonder the same, even calling it discriminatory. Two decades allowed for plenty of studies, data collection, and explanations from insurers, but the issue isn’t entirely forgotten, popping up in legislative and consumer to insurer conversations that are perhaps more heated than those with bill collectors.

According to the National Association of Insurance Commissioners (NAMIC), there have been 19 studies on the use of credit scores by insurers, all with similar conclusions – using credit when developing policyholders’ insurance scores is not only “valuable” in an underwriter’s arsenal, it’s fair.

Many consumers, legislators, independent insurance agents, and consumer advocacy groups say it’s not. One of the most recent outcries came from Congressmen Rep. Hansen Clarke (D-Mich), John Conyers Jr. (D-Mich), and Bennie Thompson (D-Miss), who created Bill H.R. 6129, ‘Ban the Use of Credit Scores in Auto Insurance Act,’ a proposed amendment to the Fair Credit Reporting Act (FCRA). The bill, presented to the House of Representatives in July, 2012, proposed banning insurers from using consumer credit reports as part of the underwriting process.

“We have to end insurance rating factors that are unfair. Companies penalizing citizens for their credit score and other redlining practices must end,” Rep. Clarke affirmed in a post on his Facebook page.

The bill, unlike many a policyholder’s dream of lower premiums, died. The effect of poor credit on insurance premiums and eligibility – and the argument surrounding it — lives on.

The Effects of Poor Credit on Insurance Premiums & Eligibility

According to the 2011 Nevada Consumer’s Guide to Auto Insurance Rates, a 30 year old woman with a clean driving record may suddenly see an increase of nearly 70% in her premiums if her credit were to go from great to average or ‘neutral.’

If her score went from average or neutral to the worst possible rating, her rates will likely more than double from what they were the previous year.

What this means is that even if someone is the best driver and has never had even a minor driving infraction, they could potentially still pay as though they’d received a major driving infraction, like reckless driving or a DUI. A few late payments, stolen identities, frequently moving, or suffering a debilitating, disabling illness could potentially cause one’s auto insurance to become completely unaffordable, or cause them to be denied coverage from the especially ‘picky’ insurers.

For companies placing great emphasis on credit, there’s a wide dividing line. In extreme cases, some insurance companies are increasingly using strict restrictions on certain types of policies that can be written. Although credit is a rating factor for all lines of insurance, some insurers place more weight on credit scores for certain types of policies more than others. For example, some insurers find credit is more important when rating or determining eligibility for property policies, like homeowners insurance, than they do for a product like auto insurance.  Even if a customer isn’t denied coverage for auto insurance with that company, they may be denied for a property policy on account of credit, especially if they’ve filed bankruptcy. One could find themselves unable to obtain auto insurance with an insurer, but not a property policy, causing them to miss out on discounts like multi-policy discounts.

If an insurer doesn’t outright deny coverage or increase rates dramatically, they’ll often refer the customer to non-standard insurance companies, typically reserved for high-risk drivers, such as those with DUIs, lengthy violation records, extensive accident histories, and lapses in coverage. Non-standard insurance policies are often significantly higher than standard policies.  Some insurers have non-standard departments within the company, while other companies have separate non-standard insurance companies, such as Nationwide Insurance owned company Victoria Insurance. When insured by in-house non-standard companies, customers may not even know they’ve been placed with a non-standard insurer, such as Allstate’s non-standard policy Allstate Indemnity. Unfortunately, this can result in policyholders believing they’re receiving competitive rates while actually in a non-standard rating tier.  Many consumers don’t even know what a non-standard company is, and if you don’t know to ask, you don’t.

So that’s the how – but what’s the why?

Credit’s Place in Insurance Underwriting & Premiums

Ashley Hunger, insurance specialist at HM Risk Group, provides two simple explanations:

“People with poor credit are more likely to file a claim and financially stable people have been shown to have fewer traffic violations or accidents than those who are financially stressed.”

So in a way, it’s an insurance policy for the auto policy insurer: Charge extra premium to protect themselves against higher-risk customers. In 2007, the Federal Trade Commission (FTC) looked at data from approximately 1.4 million policies and found that insurers paid nearly twice the amount on property damage claims from those who had low or bad credit scores in comparison to those with higher scores. The FTC surmised that “Credit-based insurance scores are effective predictors of risk under automobile policies. They are predictive of the number of claims consumers file and the total cost of those claims.  The use of scores is therefore likely to make the price of insurance better match the risk of loss by the consumer.”

The correlation, according to some reports, are staggering and convincing. One statistical analysis states the correlation between credit scores and relative loss ratio is .95, described as “extremely high and statistically significant.”

Additionally, statistics have shown that people with bad credit histories have greater chances of not paying premiums and becoming a high risk for cancellation due to non-payment. Also, statistics have shown those with low credit scores tend to ‘hop’ between different insurance companies, not sticking with one for long. This can be another benefit to high credit scores –an insurance company isn’t going to increase rates if they believe you’ll remain with them for a long time. As a result, many companies offer  ‘long-term customer’ discounts. This is why insurers often offer incentives like diminishing deductibles and accident forgiveness in an effort to get customers to stick around.

Many insurers measure the amount and frequency of entries on the credit history, both good and bad. High activity level can be negative reporting from late payments, accounts going into collections, or loan defaults. Additionally, high activity level can be from neutral or positive entries such as opening or closing credit accounts or ending repayment agreements.

Regardless of the reasons for a low score though, supporters say the bottom line is the same, as stated in 2003 University of Texas findings:

“The lower a named insured’s credit score, the higher the probability that the insured will incur losses on an automobile insurance policy, and the higher the expected loss on the policy.”

That Was Then, This Is Now: The Legality of Credit-Based Scoring

A compelling argument for sure, and there’s plenty of data to back up insurers’ defense of credit use. But it hasn’t been that easy for insurers, and if they were met with contention in the mid-1990s when they first began incorporating credit into underwriting formulas, they surely met it in 2003 when the Fair and Accurate Credit Transaction Act was passed. The FTC was required to study how some of the largest personal lines insurers were using credit scoring in pricing and eligibility. This was followed with the FTC examining it again in 2007, and again in 2011.  In 2007, after examining over 2 million policies, the FTC reported to Congress that when insurers did use credit in scoring, “…more consumers (59%) would be predicted to have a decrease in their premiums than an increase (41%).” The general verdict is that credit use is legitimately used, and this was seemingly validated in 2002, when the National Conference of Insurance Legislators (NCOIL) model law, Model Act Regarding Use of Credit Information in Personal Insurance,  was developed, now adopted in 27 states.

Although policyholders with poor credit certainly still face ineligibility or increased premiums, the NCOIL law does provide some protection. Quite simply, it regulates how credit information is used in personal lines underwriting in an effort to protect consumers.

The NCOIL law essentially has four main provisions:

  1. Insurers can’t use insurance scores that are calculated by using income information or scores calculated with the use of gender, addresses, ethnicity, or other personal information that could be deemed discriminatory.
  2. Insurers can’t deny coverage, cancel policies, or non-renew policies solely on the basis of a policyholder’s credit. They also can’t base renewal premiums solely on credit information.
  3. Insurance companies can’t take any adverse action based on consumer credit information unless they use the most current credit score, and they must notify the consumer.
  4. Insurers can’t factor in an absence of credit information when underwriting policies or determining premiums.
  5. Currently, only three states no longer allow for car insurance companies to use an applicants’ credit history to help them assess the “risk” of a policyholder.

Some states currently don’t allow insurance companies to rate premiums based on credit at all, including: 

California: Bans credit use for homeowners and auto insurance

Hawaii: Bans credit use for auto insurance

Maryland: Bans credit use for homeowners insurance and greatly restricts credit use for auto insurance.

Massachusetts: Bans credit use for homeowners and auto insurance. 

If you’re lucky enough to live in one of those states, you don’t have to worry about credit affecting certain insurance policy rates, no matter who the insurer. States that have attempted to fight this practice in the past have often run into brick walls. Michigan passed a law years ago prohibiting insurers from using credit history for personal lines underwriting, but after insurers sued, the ban was lifted in 2010. However, in July of 2012, Michigan created a law stating insurers can’t use insurance scoring for insurability, but can use credit as a way to provide discounts. But if you’ve befallen some unfortunate situation and are paying for it with your credit, is the opportunity to benefit from such discounts being absent unjust? This is just one question shelved under the ultimate one.

Does Using Credit as an Underwriting Factor Unjustly Penalize the Poor?

Despite protection in place, there are still those who don’t think credit has any place in the world of insurance, and that its discriminatory nature makes it completely illegal, not to mention unfair. The question of its use is heightened especially when poor credit may be through no fault of one’s own.

But can credit truly be discriminatory in the way that some say it is when used in insurance underwriting? A 2004 report from the Texas Department of Insurance says no, or at least not in the traditional sense.

“Credit scoring…is not unfairly discriminatory…because credit scoring is not based on race, nor is it a precise indicator of one’s race.”

Perhaps the most prevalent argument against the use of one’s credit rating when assessing their credit rating is the fact that it penalizes “lower-income” consumers — those who are more likely to have a poor credit rating.  The less one makes, the less they’ll be able to afford inflated insurance rates.

Consider the possible results from credit use for auto insurance alone. Approximately 57% of Americans drive, equating to 143 million people. Assuming each one of those people have a car, taking 25% of that 143 million people means approximately 35,750,000 million Americans are — perhaps unjustifiably — paying a higher premium on car insurance because they’ve been hit harder by the recession than other, more fortunate citizens.

For those millions though, perhaps part of the problem was solved in 2009, when the NCOIL law was amended in order to address the effects of the recession, inadvertently addressing the unfortunate situations that can befall any of us in life, recession or not. To the relief of many consumers who faced challenges as a result of the economy, an important provision was made which recognized “extraordinary life circumstances,” which included:

Federally recognized catastrophes:

  • Death of a family member
  • Divorce
  • Serious illness or disability
  • Employment loss from involuntary termination or if a result from being deployed overseas
  • Identity theft

With protection in place, there are even those who argue that credit-use can be beneficial to policyholders. If credit scoring is truly indicative of risk and more accurate than not, insurers have simply encountered one more underwriting tool to accurately price risk and charge consumers accordingly. That means those with less risk, as identified by their credit score and other factors in their insurance score, will be rewarded with better premiums and the ability to shop competitively. For those who don’t have a history – such as younger policyholders — the NCOIL provides protection by not allowing insurers to use the absence of history. Additionally, the laws that have evolved since the introduction of credit-based scoring explicitly protect against unfairly using an individual’s exact numbers like income, but place focus on the consumer’s financial habits – do they pay on time? Do they pay their bills at all?

The possible discounts that naysayers exclaim are being unfairly missed are perhaps few and far between: according to a report by the Arkansas Insurance Department in 2009, “…87% of consumers either received a discount for credit or it had no effect on their premium” and “for those policies in which credit played some role in determining the final premium, those receiving a decrease outnumbered those who received an increase by 3.21 to 1.”

Aside from all the protection of any amendment and the data on any side of the argument though, there’s one basic, simple point argued by those who don’t agree with credit use in insurance underwriting. Upon presenting H.R. 6129, Rep. Clarke, stated his argument simply:

“The cost of insurance for everyday people is simply too high.”

But in 2010, when the NAIC proposed looking into the data supporting credit-based insurance scoring, insurer groups opposed it by saying that the NCOIL law already addressed the issue, and Neil Alldredge, senior vice president of state and policy affairs for the NAMIC ,basically stated that the debate was as good as over.

“Credit-based insurance scoring has been the most debated, legislated, regulated, and adjudicated tool in recent memory, and in virtually every jurisdiction it has been found to be a benefit to consumers.”

History is generally a good indicator of the future, and no one believes that more than banks and insurance companies. However, the future is always uncertain – too much so for those who befall hard times– and as to whether an end of credit-based insurance scoring is near is probably a question that will be played out over and over in consumer advocacy rallies and legislation for years — just like the question of whether your driving has anything to do with your FICO score.

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