Credit Scores: Credit-Based Insurance Scores
Released: 2005-01-19T00:00:00

RS21341 -- Credit Scores: Credit-Based Insurance Scores

Updated January 19, 2005

Background on Insurance Scoring

An insurance score, a type of credit score, is a number produced by a proprietary computer scoring model that analyzes a person's credit history information,such as payment history, collection, balances, and bankruptcies. While credit scores are used by lenders to helpthem decide whether to offer a person a loan,insurance scores are used by insurers to determine what level of risk a person represents. The information used incredit and insurance score models is obtainedprincipally from credit reports, generated by the three major national credit reporting agencies (CRAs): Equifax,Experian, and Trans Union. (1) CRAs aresubject to the consumer protections set forth in the Fair Credit Reporting Act (FCRA). (2) Credit scores have been used widely for some time in credit-relatedbusinesses such as banks, home mortgage lenders, and credit card issuers, but the use of insurance scores by insurersis relatively new. FCRA allows CRAs tofurnish a credit report without the consumer's permission to an insurer when the report is to be used in connectionwith the underwriting of insurance. However, FCRA also provides that when any users of credit information from CRAs use such information to takeaction that is adverse to the consumer, thennotification of that action must be given to the consumer.

Over the past several years, insurers increasingly have included credit information from credit reports as factors in insurance underwriting, especially inpersonal lines of insurance such as automobile and homeowners insurance. There is some indication, however, thatcredit information may also have somerelevance in commercial lines of insurance. (3) It hasbeen estimated that 90% of property insurers now use credit information in some way in their underwritingdecisions. (4) Insurers maintain that there is a clearstatistical connection between a person's insurance score and the likelihood of that person filing claims, aswell as how expensive such claims might be. Thus, even though a good insurance score does not necessarily meana person is a good driver or a moreresponsible homeowner, insurers contend that their research has shown that persons with better insurance scoresgenerally file fewer insurance claims and havelower insurance losses. Insurers maintain that as a result of using insurance scores, they can charge lower premiumsor give discounts to many customers whootherwise would pay more for insurance, and are also able to offer coverage to more consumers. Many insurers havedeveloped their own scoring models,while others contract with third parties to obtain their insurance scores. Either way, insurers say the link betweeninsurance scores and insurance losses is clear,and point to two possible explanations. The first explanation relates to stress -- that people under stress are morelikely to have auto accidents, and financialproblems are a known cause of stress. The second explanation relates to risk-taking behavior -- that people havedifferent aversions to risk, and people withpoor insurance scores are more likely to engage in risky behavior and, therefore, more likely to incur losses.

State insurance laws generally provide that insurance rates cannot be unfairly discriminatory. Some state regulators and consumer advocates insist thatinsurance scores do in fact discriminate against low-income and minority consumers and that their use should bebanned or limited. Critics also say thatinsurance scores penalize poor people, immigrants, and seniors who may not have credit records. One consumeradvocate recently asserted that insurancescores are the most controversial new addition to the rate-setting process, that they allow insurers to doubleautomobile premiums even for drivers whoserecords are pristine, and that states should ban insurers from using them to set rates. (5) Another consumer advocate has created a separate website to informinsurance consumers about the use of insurance scores and to urge them to get involved in forcing insurers toabandon the practice. (6)

Federal Regulatory Aspects

FCRA allows CRAs to furnish a credit report to an insurer without the consumer's permission if the report is to be used in connection with the underwriting ofinsurance. However, if any user of credit information from CRAs uses such information to take any adverse action,the person so affected must be givennotification of that action. The provisions of FCRA fall under the enforcement jurisdiction of the Federal TradeCommission (FTC), which, in its commentaryon FCRA, stated that "An insurer may obtain a consumer report to decide whether or not to issue a policy to theconsumer, the amount and terms of coverage,the duration of the policy, the rates or fees charged, or whether or not to renew or cancel a policy, because these areall 'underwriting' decisions." (7) Subsequently, in an interpretative letter, the FTC opined that the term "underwriting decision" included the casewhere an insurer would be obtaining creditreports on existing policyholders to determine whether they would be entitled to a discount under a Good CreditDiscount Program upon renewal of existingpolicies. (8)

The use of credit scores in the mortgage lending industry and its potential impact on mortgage applicants have been addressed by the Federal Reserve System'sMortgage Credit Partnership Credit Scoring Committee. The Federal Reserve Bank of Chicago published an articlein 2000 in which it outlined how creditscores are used in the mortgage application process and also addressed several related issues. (9) One such issue is that while credit scores can servean importantfunction to facilitate access to credit, their nature and usage could result in unlawful discrimination againstminorities and low income applicants. This isgenerally referred to as the "disparate impact" of the use of credit scores.

Congress has continued to monitor the effectiveness of FCRA with interest peaking during the first session of the 108th Congress as portions of FCRA were setto expire at the end of 2003. Following a wide-ranging series of hearings and two markups, the House FinancialServices Committee reported H.R. 2622 amending the Fair Credit Reporting Act on July 25, 2003. While the FCRA's primary focus is onthe regulation of credit information,the usage of this information, particularly insurance scores, by insurers drew congressional interest. CongressmanGutierrez previously introduced H.R. 1473 to specifically regulate insurers' use of credit information and he offered an amendment at thesubcommittee markup of H.R. 2622 calling for a study of insurer usage of credit information. This amendment was accepted andincluded in the bill as reported from the fullcommittee. The Senate held hearings and passed a bill amending the FCRA, S. 1753 , after the House. Thisbill also included the requirement for aslightly different study on the usage of credit information in insurance. The conference committee made furtherslight changes to the study requirement and itwas included in the conference report as passed and signed by the President ( P.L. 108-159 ).

State Regulatory Aspects

Unlike banks and other financial institutions that are regulated primarily at the federal level, insurers are regulated primarily at the state level. (10) Most stateinsurance laws prohibit unfair trade practices, and also require that insurance rates not be unfairly discriminatory. Many states require prior approval ofinsurance premium rates, especially those for personal lines such as automobile and homeowners insurance. Statelawmakers are beginning to turn theirattention to the issue of insurers' using credit-based insurance scores in making underwriting, marketing, and ratingdecisions. According to the NationalAssociation of Mutual Insurance Companies (NAMIC), 48 states have taken legislative or regulatory actionaddressing insurer use of credit historyinformation. (11) Many of the state laws arefollowing a model law (12) recommended by theNational Conference of Insurance Legislators (NCOIL) and generallysupported by insurers. The law was described in congressional testimony (13) as requiring "insurers:

to notify an applicant for insurance if credit information will be used in underwriting and rating;

to notify a consumer in the event of an adverse action based on credit information, includingnotification of factors that were the primaryinfluences on the adverse action;

to re-underwrite and re-rate a policyholder whose credit report was corrected;

to indemnify insurance agents/brokers who obtained credit information and/or insurance scoresaccording to an insurer's procedures andaccording to applicable laws and regulations;

to file its scoring models with the applicable state department of insurance; such filings are deemedtrade secrets."

Although described by a prominent consumer group as improving upon the previous market practices, the NCOIL law is seen as far from the prohibition on useof credit scores that some would prefer. (14)

State insurance regulators are also increasing their regulatory oversight over credit-based insurance scores. In some states, the regulators have already addressedthe issue, but in an effort to develop a more unified national approach, most regulators are working through theirtrade organization, the National Association ofInsurance Commissioners (NAIC). In March 2002, the NAIC appointed a credit scoring working group to focuson the various regulatory issues related to theuse of credit information in the insurance underwriting and rating process. The working group has drafteddocuments to aid insurance consumers, and to assistthe regulators in clarifying the issues and recommending a set of best practices. Two draft documents were citedin NAIC congressional testimony (15) andapproved by the full NAIC shortly thereafter:

Consumer Brochure: Understanding How Insurers Use Credit Information : This is a question/answer brochure, addressing such mattersas the legality of an insurer's obtaining a credit report under FCRA without permission, why and how insurers usecredit information, and how to improve one'sinsurance score.

Credit-Based Insurance Scoring: Regulatory Options : This document seeks to set forth thepros and cons of various regulation options,including a ban on the use of credit history for rating purposes.

These two documents, however, did not complete the recommendations or policies some hoped would emanate from the working group and the NAIC. A studyon the possible disparate impact of credit scoring was proposed. This proposed study, however, provokedsignificant debate and opposition. The workinggroup cancelled a previously scheduled session at the regular NAIC summer national meeting that was held June21-24, 2003. (16) At the NAIC fall nationalmeeting, held September 13-16, 2003, this study was put off and it was suggested that concerned states should dostudies of their own. (17) Indiana, Louisiana,Maryland, Missouri, Montana, Nevada, Oregon and Washington planned such a study, eventually abandoned theeffort under the threat of litigation from theindustry. (18) More recently, the NAIC workinggroup produced a white paper with a set of "best practices" relating to the usage of credit scoring.

Litigation

A number of lawsuits have been filed alleging violations of either state or federal law relating to the usage of credit information. For example, a lawsuit againstAllstate was filed seeking class action status in U.S. District Court in San Antonio, Texas, by several minorityplaintiffs alleging that the insurer usedinformation from credit reports and improperly factored it into a secretive scoring formula to target non-whites formore expensive policies than similarlysituated whites. Allstate's motion to dismiss was denied, and the case as been allowed to proceed after successiveappeals to the 5th U.S. Circuit Court and theU.S. Supreme Court. Insurers are concerned that the case could lead to a determination of a new discriminationstandard over and above the state lawprohibiting unfair discrimination, and thus usurp the authority of state insurance regulators and state laws. (19)

Allstate is not the only insurer who has been to court on such an issue. In Illinois, a suit alleged that State Farm had engaged in the practice of refusing to issueor renew insurance policies solely on the basis of a credit report, in violation of the Illinois Insurance Code. (20) In Texas, the attorney general sued FarmersInsurance Group, alleging, among other charges, that the insurer was "using credit history as a significant factor insetting premiums, without disclosing theadverse impact of doing so...." (21) A settlementwas reached in the Texas case in December 2002, but it was challenged by some Texas policyholders. (22)