The High Price of Credit Scoring

The latest volley in the credit scoring battle came in late January, with the release of an Insurance Commission of Missouri study citing the negative impact of credit scores as an underwriting tool on low income and minority groups. The study incited insurance associations in the U.S. who have been fighting a seemingly endless assault on their use of credit history – including number of collections made against the borrower, types of accounts, timing of payments, exceeding credit limits, number and age of accounts – in underwriting since the practice was officially allowed under the Fair Credit Reporting Act in 1970.

Insurers may have had the capacity to use credit scoring for some time, and been using the practice with commercial clients, but in the past few years, the credit scoring debate has reached national proportions. In 2003, at least 40 states were drafting some form of credit scoring legislation. The proposals ranged from full-out bans to limits on credit information use, many falling within the guidelines set out by the The National Council of Insurance Legislators (NCOIL) credit scoring model.

That model, adopted in late 2002, suggests legislation requiring insurers to disclose when credit scoring is being used, and that credit scoring not be used as the sole reason to deny coverage to an individual. The pretense of the model was to “allow states to establish uniformity regarding how insurers can use credit information to determine eligibility for insurance coverage”, says bill sponsor, Representative Timothy Osmond of Illinois. But in reality, the states remain divided, as do Canadian regulators, on the practice of credit scoring.

In Canada, credit scoring is banned in Ontario. But, while other provinces allow the practice, it is discouraged, sources say. Nonetheless, some insurers do use it, mainly for homeowners’ coverage. But, most insurers have shied away from credit scoring, fearing the same public backlash that has hit their peers south of the border.

STUDY BATTLE

The debate over credit scoring in the U.S. has become a “battle of studies”. Several statistical reports have been released to corroborate the link between credit scores and loss ratios, with two high-profile studies last year. The first, commissioned by the Texas Department of Insurance in March 2003, concluded based on more than 150,000 actual policies that there was a 99% probably of a correlation between an individual’s credit score and incurred losses. In the study, those with poor credit scores had average incurred losses of US$918 per policy, while those with excellent credit scores showed losses of US$558, a 65% difference (see Chart 1).

The Texas study also concluded that a person’s credit score is among the top three most important factors in determining the probability of loss, along with age/gender and geography. This finding was backed up by another study, conducted by EPIC Actuaries for a group of U.S. insurance industry associations, showing that credit scores are a better predictor of loss than driving records.

In the EPIC study, more than 2.7 million auto insurance records were reviewed, with the conclusion that people with the lowest credit scores had 33% higher losses than the average, while those with the highest credit scores had 19% lower losses than the average (see Chart 2). Further evidence was produced by the Casualty Actuarial Society, suggesting the best credit scores produced a loss ratio of 57%, while the worst credit scores were a whopping 101.4% loss ratio on personal auto policies (see Chart 3).

With statistics like these backing them, it is not surprising that 92% of personal auto insurers in the U.S. use credit scoring, according to Conning Research. But, policyholders have not taken kindly to credit scoring. Many legislators looking to ban the practice were acting on public complaints suggesting that insurers were using the scores to deny coverage, and specifically to deny coverage to low-income and minority groups. In some cases, insurers were even accused of using credit scores for “redlining”, or denying coverage to people in low-income areas.

The impact of credit scoring on low-income and minority groups is the single biggest stumbling block to its widespread acceptance, and the Missouri study will not help insurers’ cause. Past studies have not found a significant link between credit scores and other personal information, although a Washington State University study did cite “statistically detectable patterns in the demographics of credit scoring”.

Insurers, for their part, insist credit scoring is more likely to help a prospective policyholder, given that most people have good credit ratings. They add there is no reason to think someone who belongs to a minority or has a lower income would be worse at managing their credit than anyone else. But, with the renewal of the Fair Credit Reporting Act late last year comes the provision for further study by the Federal Trade Commission of the effects of credit scoring on different demographic groups.

FEW PLAYERS

Regulators in Canada do not have credit scoring so prominently on their radar screens. The Canadian Council of Insurance Regulators (CCIR) is not currently looking into the issue, says the group’s chair, Jim Hall, superintendent of insurance for Saskatchewan. Discussions with insurers have not revealed any company using credit scoring in his own province, he adds. However, some insurers are known to use credit scoring, including Economical and ING. Economical uses credit scoring for personal property policies, but would not comment further on the issue.

ING uses credit scoring as “an integral part of our underwriting processes”, says the company’s spokesperson, Gilles Gratton. “It is used in most provinces where it is allowed further to receiving consent from customers to access their credit history.” He adds that, “credit scoring is one of the many variables that are taken into consideration when evaluating risks and as such does not replace traditional underwriting tools and techniques. Consequently, no risks are denied coverage solely for credit reasons.” The company began using credit scores first in Quebec in 2002, and then spread out to other provinces where the practice is allowed.

The Bureau Assurance du Canada (BAC, the Quebec arm of the Insurance Bureau of Canada) looked into the issue of credit scoring in that province, and at last count there were only five companies using it, says Serge Boulard, public affairs consultant for the BAC. In general, the IBC has not gotten involved in the credit scoring issue, with spokesperson John Karapita noting that this could be considered an issue of competition and companies’ personal underwriting decisions.

BLACK BOX

In the U.S., the “mystery” surrounding how credit scores were being used added to the public backlash, says Roger Beck, president and CEO of American Country, a Chicago-based Kingsway Financial subsidiary. While none of the Kingsway operations uses credit scoring for underwriting, Beck says he had experience with it at a previous company. “A lot of scoring models were a black box,” he says of the secrecy surrounding them. Beck adds that U.S. insurers created “a mess” by using credit scores to decline risks. “It should be used not as a means to decline a risk, but to find an appropriate price point for that risk.”

The U.S. National Association of Insurance Commissioners (NAIC) recently released a brochure on credit scoring which, to the dismay of insurers, highlighted public concerns over credit scoring methodologies being kept secret. The NCOIL model requires insurers not only to disclose the use of credit scoring, but also if it has an adverse affect on the rate quotes, and requiring credit scoring rules to be filed with state insurance commissions.

Canadian brokers express concern of a similar nature about the use of credit scores here. “Our concern is to make sure if it’s going to be done, the client is aware,” says Dan Danyluk, CEO of the Insurance Brokers Association of Canada (IBAC). If an insurer is looking into a person’s credit history, that client should know how the information is going to be used. At the very least, this allows the consumer to confirm that their credit information is correct. Given current privacy requirements, Hall says, insurers should be looking at the need to get consent to use credit information for purposes other than to decide on a payment plan.

INCITING GOVERNMENT

The question for Canadian insurers may be “is credit scoring a battle worth fighting?” Given the public’s current animosity towards insurers as a result of rising auto insurance rates, throwing credit scoring into the mix may be like adding grease to the fire.

Aviva Canada is one of the companies who has not taken up the practice of underwriting with individual credit information, based in part on the public distaste witnessed in the U.S. “Our reason [for not using credit scores] is based on the history in the U.S. and where we believe it would go in terms of sensitivity around the issues in Canada,” says Ron Noiles, senior vice president, personal lines, for Aviva Canada. He says that if insurers use credit scores to reject risks, they open themselves up to further government crackdown on underwriting rules. “We have the feeling that the acceptance or rejection of risk based on things like that [credit scoring] may cause government to introduce laws that are more onerous.”

Given the propensity in new auto insurance legislation to limit underwriting criteria – even going so far in some provinces as to limit the use of age, gender and other long-accepted rating factors – arguing that credit scoring is viable, even backed by statistical evidence, may bring on a political headache. Noiles says the American studies do lend credence to the correlation between a person’s ability to manage their credit and the ability to manage other aspects of life, such as home maintenance. “You have to look at credit as, it is not about the amount of credit you have, but how you use it. There’s a correlation between how you look after credit and how you look after your house.”

That said, he thinks insurers should be taking a “softer approach”, rather than outright rejecting risks based on credit information. It may be more reasonable to look at credit scoring as a means of pricing risks, rather than a basis for rejection or acceptance.

The NCOIL rules provide strong guidance for insurers’ use of credit information, observes Armie Francescut, vice president of CGI’s Insurance Business Services. His company gathers credit information from both Equifax and Trans Union Canada, which insurers could use as underwriting tools, subject to regulation. Francescut argues that credit information should not discriminate against any one group. “People with a bad credit rating are not necessarily low income people. You can have bad credit and be a millionaire.”

He adds that there is ample evidence of a link between credit information and propensity for loss. “Credit information is probably the most predictive piece of information you can use to predict risk for homeowners and auto losses. You could build a case that credit information is more predictive than the number of tickets you’ve had.” If insurers use good business practices and do not rely solely on credit information but use it as one of a number of underwriting tools, he thinks policyholders, most of whom have good credit ratings, will actually benefit with better rates.

Beck agrees, noting that while insurers would never want to rely solely on credit scoring, if he had to choose just one underwriting tool, given its predictive value, he would “take credit every time”. Calling it, “the single biggest predictor”, he notes that if you went through a book of business and took out the top 10% most profitable business, he believes these would have the best credit scores.

POLITICAL MIRE

But, Francescut observes, the future for credit scoring in Canada does not look rosy. While insurers generally like to see the same rules in force in all provinces, it is not likely that Ontario will lift the ban on credit scoring any time soon. Given the political nature of the issue, he expects consumer groups would come out strongly if credit scoring became widespread. Also, he adds, “I don’t think there is anyone in public service who is prepared to champion it.”

The Financial Services Commission of Ontario (FSCO) confirms that it is not looking to change the rules on credit scoring. This is despite insurance superintendent Bryan Davies having looked into the issue. At an industry conference late last year, Davies acknowledged the number of studies indicating a correlation between credit scores and loss ratios. “The challenge for credit scoring is one of historical prejudices that it will be used in an inappropriate manner to refuse people coverage,” Davies says. “We know it’s predictive of risk, but socially it’s not acceptable…it’s a tough sell.”