The Case for Credit Scores

Until widespread use of vehicle telematics and usage-based insurance (UBI) provides a reliable real-time stream of customer driving information, insurers are going to have to rely on the old tried-and-true method for determining a customer’s risk profile — the educated guess, based on proxies like age, gender, type of car and so on.

There’s no equivalent to UBI on the property side of the business (at least not yet), so the educated guess — based on proxies like neighbourhood crime rates — is likely here to stay for home insurance.

That doesn’t mean insurers shouldn’t use every available tool to help make their guesses as accurate as possible. Customers expect their insurance providers to charge according to the risk, and good risk customers do not want to subsidize bad risk customers.

One of the most accurate and powerful indicators of risk is the way that customers manage their finances. There’s a large body of research linking credit behaviour and claim losses.

A 2003 Texas Department of Insurance study, for example, looked at data for 2 million policyholders. It found that insurance customers with the lowest credit scores had claim losses that were 53% higher than the expected average, while those with the highest credit scores had claim losses 25% lower than the expected average.

Here in Canada, a study last year by Barons Insurance Services for the Canadian Association of Direct Response Insurers (CADRI) that used solely Canadian insurance data found the same strong correlation between credit score and insurance losses.

Given all of the evidence, it’s not surprising that most insurers in Canada and the United States now use insurance or credit scores (where allowed), a practice endorsed by both the American Academy of Actuaries and the Insurance Information Institute.

Why then is the use of credit information in insurance still controversial?

IT’S NOT ABOUT INCOME

One argument that keeps coming up, even though it has been largely disproven, is that the use of insurance or credit scores unfairly penalizes low-income consumers. In fact, these scores do not evaluate income, assets or liabilities — and they don’t include any personal data. Instead, they focus on the consumer’s credit behaviour. Consumers who manage their finances well by paying their bills on time and who don’t abuse their access to credit will have a high score, regardless of how much or how little money they make.

The correlation with insurance claims is fairly easy to understand. People who manage their finances well tend to also manage other important aspects of their lives responsibly. This includes properly maintaining and driving a vehicle and keeping a house in good repair, which, in turn, will generally result in fewer and less costly claims.

Major U.S. studies have consistently rejected the idea that using credit information penalizes the poor. In Canada, TransUnion, one of two major credit rating agencies in Canada, matched 2010 credit data to Statistics Canada income data by postal code and determined that the percentage of people with poor scores was roughly the same in each income band. In other words, there was no correlation between credit score and income level.

Whether or not we like it, credit information is routinely used in a variety of sectors because it is widely acknowledged as a meaningful indicator of risk. If you are looking for an apartment or a new job, or signing up for a cell phone plan, it helps to have a good credit score.

IT HAS CONSUMER SUPPORT

Another common argument is that consumers oppose the practice. If you ask a simplistic question in a survey, you’ll get a simplistic answer. But if you take the time to explain how and why credit scores are used, including the benefits to the consumer, you get a very different response.

At Desjardins General Insurance Group (DGIG), the rate of consent from consumers who contact us online or by phone is around 99%. When an agent clearly explains why and how we use the information, the vast majority of consumers feel strongly that there is an advantage in providing consent.

It’s not difficult to figure out why. Most people in Canada have a good credit score and, thus, would benefit from an insurance discount. Even consumers who have a low credit score can take steps to improve their credit rating and consequently reduce their insurance premium.

In a submission last year to the New Brunswick government, the Consumers’ Association of Canada pointed out that any restriction on the use of credit scores “is contrary to the principle that good public policy should reward — not punish — those… who have, through responsible credit management, earned the chance to reduce the cost of their premiums and save their hard-earned money.”

CONSUMERS ARE PROTECTED

A third argument used against insurance or credit scores is that insurers have acted improperly in how they have used the information. This was true of some companies when insurers first began using credit information. Unfortunately, the actions of a few hurt the reputation of the entire industry.

However, this market conduct issue has since been corrected. In the United States, a number of regulators have established rules to ensure that credit information is used fairly. Here in Canada, the Insurance Bureau of Canada’s (IBC) Code of Conduct for Insurer’s Use of Credit Information addresses virtually every significant concern that has been raised about the use of credit information. These range from how you deal with new immigrants and young people who don’t have credit profiles, to the requirement to obtain the customer’s explicit consent before accessing their credit file.

The Code of Conduct provides an effective approach that protects consumers while allowing the industry to continue to use what is a very powerful rating and underwriting tool. In that sense, it’s a win-win.

DGIG and the majority of the major insurers who use credit information — representing 85% of the market — have provided their written commitment to IBC to adhere to the code. We all recognize that this is in our best interests and, more importantly, the best interests of our clients.

IT IS FAIR

In the final analysis, the strongest argument supporting the use of credit information is that it is fair.

As the Consumers’ Association states: “Credit history is the one variable over which consumers [have] control and [can] leverage to reduce the cost of their premiums. When consumers allow insurance providers to access their credit reports, they are able to give an accurate depiction of their insurability risk, thereby allow companies to fairly price polices, compete for customer’s business and offer discounts.”

When regulators are pressured to ban the use of credit scores, they penalize the majority of consumers who manage their finances responsibly. These consumers end up paying higher premiums, whereas higher risk consumers who don’t pay their bills on time, don’t keep their homes in good repair, don’t maintain their cars or drive safely see their rates reduced.

Clearly this isn’t fair. It hits low-income consumers with good credit scores particularly hard for the simple reason that they are less able to afford the higher rates.

Insurance is an expensive product. All of us in the industry should be using every tool available that can help us to better match premiums with risk, thus reducing the cost for the majority of consumers. That includes the appropriate use of credit information.