Wild West Of Credit Scoring

Canadian property and casualty insurance companies have been using credit-based insurance scores to help underwrite home, commercial and auto policies for at least the past 10 years, but you would never know it after a consumer outcry related to its use in 2008-09.

Insurance companies are only now coming to grips with the lack of consumer awareness around credit scores, which are basically numbers representing a consumer’s ability to pay bills and manage debt. Credit scoring is widely accepted as a highly predictive underwriting tool, since statistics show that the better the credit score, the less frequently a consumer is likely to make a claim.

For the most part, provincial insurance regulators have let the practice go, with a few notable exceptions. Ontario prohibits the use of credit scoring for underwriting auto lines only. In Alberta, the regulator does not allow an insurer to use credit scoring in auto lines unless the consumer explicitly grants consent to its use. If an Alberta insurer insists on seeing a credit score before underwriting an auto risk, the regulator would deem that insurer to be engaged in an “unfair practice.” So for all intent and purposes, credit scoring in Alberta is prohibited in auto lines without the consumer consenting to it. In Nova Scotia, the regulator is looking into the possibility of banning the use of credit in auto lines, although it is consulting with other jurisdictions before it comes to its final decision (as of now, no such prohibition exists). The rest of the provinces canvassed are looking at the issue, but no prohibitions exist against using credit scoring in home, auto or commercial lines. Federal privacy legislation governs the collection of the data, although this legislation speaks more to whether the consumer knows his or her personal data is being collected, as opposed to what insurers are doing with it.

So in terms of using credit scoring as a means to underwrite insurance risk, it’s been a veritable ‘Wild West’ in Canada since at least 1997-98 (earlier in Quebec). So why all of a sudden are Canadians becoming aware of what’s going on?

Five years ago, the Insurance Brokers Association of B.C. (IBABC) posted a report on its Web site calling for an industry-wide discussion on the use of credit scoring for the purpose of insurance underwriting. At that time, the use of credit scoring in the United States had been widely debated, and IBABC suggested that the topic be discussed in Canada as well. At that time, the call for an industry debate about credit scoring met with resounding silence.

In late 2008, the Insurance Brokers Association of Ontario (IBAO) expressed concern about evidence that suggested insurers were using credit scores to rate risk in auto lines, contrary to the province’s prohibition. Public concerns raised a crescendo in early 2009, when daily media started reporting stories of people who were unaware that insurers were using their credit scores for the purpose of underwriting their home insurance as well. Ontario’s insurance regulator, the Financial Services Commission of Ontario (FSCO), issued a bulletin in February 2009 re-iterating its prohibition against the use of credit in auto lines. On Apr. 24 FSCO followed up with another bulletin, stating it was “pleased to report that almost all insurers have indicated they understand the [February 2009] bulletin, and already conform to the practices outlined in the bulletin, or plan to do so in the near future.” FSCO went on to say it was continuing “…to actively review this issue. Statements from automobile insurance industry participants that suggest the review is complete, or that FSCO has determined that specific insurance companies are in conformance with the bulletin, are incorrect and should be disregarded.”

Concerned about what was happening, Ontario insurance brokers held a press conference in May 2009 calling for a total prohibition on the use of credit scoring in homeowners’ lines as well. One month later, IBABC announced it had asked the B.C. legislature for a change to the provincial laws that would prohibit credit scoring for underwriting purposes, period.

Needless to say, insurance companies do not agree with the broker associations’ calls for prohibition. For their part, insurance companies argue the use of credit scoring requires clear (self-regulated) market conduct guidelines, greater transparency, fairness and consumer education — not bans. They note consumers with good credit scores — representing a majority of consumers, in fact — stand to gain premium discounts because they are a good risk for insurers.

Sniffing smoke in the air, the ‘sheriffs’ in town, the provincial regulators, are starting to round up a posse. Credit scoring was a hot item of debate at the Spring 2009 meeting of the Canadian Council of Insurance Regulators (CCIR). Word is that FSCO has recently completed a study of when, where and how credit scoring is being used. As of press time, however, the results of that study had not yet been posted on the CCIR Web site. According to sources, publication of the report is imminent.

So the debate about credit scoring has finally moseyed along to the Canadian frontier and the outcome remains uncertain. One thing is for sure: This town sure is talkin’ again, what with the presence of this credit scoring ‘stranger’ in our midst….

Who is that Masked Man?

A credit score or report is a history of how consistently a consumer pays his or her financial obligations.

“On a regular basis, the companies that lend money or issue credit cards to you (banks, finance companies, credit unions, retailers, etc.) send…credit reporting agencies specific and factual information about their financial relationship with you — when you opened up your account, if you make your payments on time, if you miss a payment, or if you have gone over your credit limit, etc.,” says a report by B2B Credit Chex Inc., a company that provides a number of advisory services related to credit. In Canada, two agencies collect such credit information: Equifax and TransUnion Canada. Using this information, these agencies produce credit reports for use by financial institutions, which basically want to know whether a consumer is a good risk to pay back a prospective loan. The credit reports include a “credit score,” a three-digit number generated by a statistical formula (or algorithm). Equifax and TransUnion Canada use a scale from 300 to 900 — a score of 300 suggests a poor credit risk and 900 is an excellent credit risk. B2B notes that the proprietary formula used to establish the score includes:

• a person’s payment history (whether or not they have paid their bills on time),

• amounts owed (including current credit limits),

• length of time on file (how long a person had has credit accounts),

• new credit (indicates how often the person has sought credit, determined by the number of credit inquiries that have been made) and

• the type of credit (be it car loans, lines of credit or credit card balances). Speaking at a July 30, 2009 seminar organized by the Insurance Institute of Ontario’s Hamilton chapter, Bruno Santia, vice president of B2B, says 98% of all the credit granters in Canada report financial transactions on a monthly basis to Equifax andTransUnion Canada. “Ninety-eight per cent [transaction reporting coverage] in a country where we are the highest users of credit or debit-type transactions,” Santia observed. “Do you think they know us? Do you think they can track us by the second as to where we’ve been? Yet less than 15% of people are aware of what [their] score is.”

Credit scores are strictly about payment history and are not, strictly speaking, a measure of a policyholder’s insurance risk. But credit scores do play a part in something called a “credit-based insurance score,” which was developed by Fair Isaac Corporation (FICO) and introduced to the United States in 2003. Based in the United States, Fair Isaac designed and developed the credit scoring models used by Equifax in Canada. Credit-based insurance scores have been part of the Canadian insurance landscape since 1997-98.

“The real purpose of those [creditbased insurance scores] was to see if we could identify something within the individual consumer’s credit report that correlated statistically with whether or not they were likely to have losses in the future, or whether they were likely going to be larger losses,” says Lamont Boyd, the director of product management for FICO.

Predictive Power

That correlation has apparently been found. “One of the reasons why we introduced credit-based insurance scores is because it is extremely predictive,” Boyd said. “It is something that the insurance industry, from which I came many, many years ago, had never really considered effectively. It just added another piece of information to the overall underwriting or pricing decision.

“It was never intended to, and does not replace all of the other pricing factors that should be considered. It’s just one more tool in the arsenal for the insurance company underwriter to make the best possible decision based on the exposure that’s presented to them.”

FICO’s conclusions have been replicated using a variety of different in-house models, insurers say. “They all tend to use a lot of the same variables and just weight them differently,” Troy Duhot, senior vice president of EGI Insurance Services, said. “All of the models tend to say the same thing: the higher the credit score, the lower the loss frequency.”

Why are those scores so powerfully predictive?

“We don’t know if it’s a measurement of responsibility,” Boyd said. “We don’t have behavioural psychologists that tell us that. But it seems to me, and it seems to others that have looked at this, that when a person is decided to be responsible or conscious with respect to their financial obligations, they also tend to be responsible with respect to their insurance obligations as well.”

Consumers arguing that insurers are using credit numbers that don’t correlate to risk are likely to be told that that ship has already sailed. Not even insurance brokers in favour of prohibiting credit are making this argument. “My perspective is that we are past the debate of whether it is predictive or not,” says Martin Beaulieu, senior vice president of personal lines at Intact Insurance, reflecting a general consensus within the industry on this aspect of credit scoring. “I think that everybody, even those who are against the use of it, will acknowledge that this is predictive. Where we’re at now is, now that we know it’s predictive, how are we going to use it such that consumers can say, ‘This is the right way to do it.'”

Transparency and Education

One of the biggest problems for insurers right now is that consumers don’t know much about the underwriting process. They don’t know much about the ratings factors used to calculate their risk, and so they don’t understand how their premium is derived. That, in turn, brokers argue, makes it difficult to explain to consumers why two similar risks might be priced differently, based on a consumer’s credit score.

“The reason brokers are having some difficulty with [the use of credit] is that generally credit isn’t a transparent process,” said Dan Danyluk, CEO of the Insurance Brokers Association of Canada (IBAC). “So what happens is that, built into the underwriting process, will be some action triggered by a credit score. Because a lot of credit systems are proprietary, the underwriters themselves — the first-line underwriters that you are dealing with [at an insurance company] — can’t explain to [the broker] what the issue is. So the first concern we have is that any underwriting criteria should have some level of transparency. As an industry, we’ve said that consumers ought to know why they are being rated the way they are, what the risk assessment is, so they can mitigate their risk and take some personal responsibility to improve their situation and that means that they need to know.”

In fact, insurers are also arguing in favour of more transparency, for several reasons. One is a public policy reason. Simply put, most consumers have a good credit score, and that would make them a low risk for losses and hence eligible for premium discounts. Intact has done a study, for instance, that suggests 75% of policyholders have a good or decent credit score, only 10% have a poor credit score and the rest are somewhere in between. When citing numbers, most P&C industry representatives in Canada point to the results of a July 2007 report to the U.S. Congress by the U.S. Federal Trade Commission. The report, Credit-Based Insurance Scores: Impacts on Consumers of Automobile Insurance, reveals that “if credit-based insurance scores are used, more consumers (59%) would be predicted to have a decrease in their premiums than an increase (41%).”

“If you’ve got a good credit score, you are going to get as good a rate, if not lower,” Duhot says. “The problem with [credit scoring] from a public policy standpoint is that the people who will get a better rate today will not complain [to regulators] that they’re not getting better rates. It’s the people who get the worse rate who are going to become extremely vocal, even if they are vocal minority.”

Unfortunately, those who are vocal in opposition are often relying on misconceptions about the reasons for their being disadvantaged, insurers say. Leonard Sharman ofThe Co-operators was in the front lines dealing with the public when the company announced in July 2009 that it was introducing credit scoring as a rating variable. “It’s been a bit of an eye-opening experience going through this personally, realizing how little consumers understand about the product,” Sharman said. “I mean, we knew that already, but it really hits home when this whole issue came to light…. A bit of surprise to us was [to see] how much of a concern there was from consumers…who didn’t realize that this was a fairly widespread practice already in the industry.”

There is a great deal of public suspicion around credit being used in a discriminatory fashion. Sharman, for example, said he had to dispel a widespread popular misconception that low income is correlated with a poor credit score. Duhot has seen this, too. “The big misconception is that everyone is saying, ‘Oh my gosh, the people who make a lot of money have a good credit score.'” Duhot said. “There have been numerous studies to show that that is not true. Your credit score is a function of how you use the money you have, not how much money you have. As long as someone is… on time paying their bills, they handle their money the right way, they are going to have a good score.”

Sharman saidThe Co-operators took great pains to research this issue before adopting credit scoring as a rating variable. “We did a lot of…our own internal studies and we wanted to be comfortable that it wasn’t discriminatory in any way,” he said. “We checked internally [to see whether there was a correlation between] credit scores versus incomes as best as we could, and that showed that there was no correlation between your credit score and your actual income…. That made us comfortable that it wasn’t discriminatory against low-income people.”

In fact, credit scores might be better for the consumer than other rating variables precisely because the consumer can do something about it, insurers say. “You can influence your credit score,” said Bob Fitzgerald, executive vice president and chief operating officer of Aviva. “You can’t change your age, and it’s pretty damn difficult to change your sex, but you can absolutely pay your bills and live within your means and move up your credit score.”

That leads Fitzgerald and other insurers to advocate for improved consumer education around credit scoring. “We think there should be a public dialogue to get the facts out, because there are a lot of myths about credit,” Fitzgerald said. “[We need] education in terms o f the public, politically and distribution education — i.e. brokers — because I’m not sure if you asked or polled a bunch of brokers if they would have the in-depth knowledge that maybe some of the company guys have.”

On Bans and Market Conduct

Which brings us to the broker associations’ requests to the regulators to ban the practice. No insurer said as much, but it’s probably safe to assume many insurers feel a ban to eliminate problems related to credit is akin to burning down the house to get the flies out of the living room. For many insurers, the ideal world would be to start the public education piece first. Fitzgerald says public education was a key factor in reversing a referendum vote about credit scoring in Oregon, which initially looked to be going the way of a ban until consumers were told credit scoring would actually lead to more premium decreases than increases.

Such a public dialogue would include a discussion with politicians and regulators about how the practice might be conducted transparently, fairly and ethically, before prohibitions are even considered, much less adopted. Fitzgerald agrees the use of credit should be regulated in some fashion. “We do think it needs to be used in a controlled way,” he said. There should be “a level playing field” and “the industry should self-regulate through a Code of Conduct.”

But pointing to incidents of questionable market conduct, and emphasizing their role as consumer advocates, representatives of the IBAO and IBABC say the discussion should be taking place in a kind of “safe zone,” in which consumers are protected by prohibitions banning the use of credit. Once the industry and its regulators have reached agreement on how to proceed, restrictions can be revised or dropped as needed.

In arguing for the most severe restriction, an outright prohibition, some brokers say insurers are using credit scoring in vastly disparate ways. In a bulletin to brokers, one insurer, for example, calls for a 20% increase on ‘B-rated,’ second-tier credit risks. In response, another insurer discusses the need to “protect itself” by implementing a 25% surcharge on property policies transferred by the above insurer. Still another insurer says it will accept risks transferred from the first insurer only if the applicant has a source of income or is gainfully employed and has received an A-tier credit rating from the first insurer. Basically, the insurers above are trying to protect themselves from being “selected against,” which means taking on poor risks transferred from other companies.

Brokers feel consumers need to be protected in light of these kinds of actions. “I can tell you from our perspective that a prohibition is the only way it’s going to work, because you can’t police the insurers adequately,” says Randy Carroll, CEO of the IBAO. “If you take a look at what’s happening at least in Ontario, it’s rampant in regards to insurers using credit where they shouldn’t be using credit today. I think insurers had an opportunity, way back when, to [establish] a case that they may want to take the voluntary approach versus what we’re asking for, which is a complete prohibition.”

Better to have a prohibition in place during the discussions about credit, adds IBAO’s president-elect Bryan Yetman. “I think if the progression is a ban, discussion, reconsideration or repositioning, that’s probably a far safer approach than, ‘Let’s just continue to do what we’ve done in the past.’ What we’re seeing now is extremely silly things taking place in the marketplace in really only nine short months. There’s no point of having the discussion after 12 months [without a ban], because those who have been discriminated against will have been discriminated against, and those who are advantaged will continue to be advantaged.”

Chuck Byrne, CEO of IBABC, also thinks a ban is the best way to go, adding the following qualifier: “Being pragmatic, obviously if the prohibition isn’t about to come, then we have to seriously look at some kind of market conduct approach that will stabilize [its use] across the industry for the sake of the consumer,” he says.

Carroll agrees. “Market conduct is probably one of our biggest issues today.”

Not all broker associations are alike, it should be noted. Some say they might favour a type of solution that has some resonance with insurers — namely, rules around the use of credit that would ensure policyholders are treated fairly and not left uninsured as the result of a poor credit score.

For insurers, some form of self-regulation would be preferred. To this end, Beaulieu and Fitzgerald both note the Insurance Bureau of Canada (IBC) already has a committee preparing a Code of Conduct around the use of credit scoring.

“At the moment, the industry is looking at, working on defining guidelines as to what is the proper use [of credit scoring] and being proactive as to how to behave as an industry rather than having someone else come in to tell us how to do it,” Beaulieu says.

Based in Georgia, Duhot summarizes some existing regulatory models in the United States. “It’s pretty easy from a regulatory standpoint,” he says. “In a lot of states, if you’re rating on it, you have to file it. You have to file the credit model you’re using. Anybody that wanted to see how his or her score was calculated could quickly see that. In addition to that, there are requirements when we put (an inquiry) on a line of credit that the agent and broker let the consumer know before they go to credit. When it’s run, there’s a document print-off that’s given to the insured that has partial data, what the credit score is, and it tells them how to contact the different bureaus to dispute it if they disagree with it. They’re designed so that people don’t run it without telling the consumer, first of all. And second, there’s a dispute mechanism in place.”

The above model is likely one of many that will likely be discussed in Canada over the next year. No one is expecting a rapid-fire solution to the credit scoring issue. Thus far, Canadian regulators appear to be trying to research the extent and type of its use. Certainly the idea of a ban has made the issue a “lightning rod issue,” as one insurer describes it. And thus the discussions in this town have begun. The outcome of this arrival of ‘High Noon’ awaits.

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All of the models tend to say the same thing: the higher the credit score, the lower the loss frequency.

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Credit scoring was never intended to, and does not replace all of the other pricing factors that should be considered. It’s just one more tool in the arsenal for the insurance company underwriter to make the best possible decision based on the exposure that’s presented to them.

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The reason brokers are having some difficulty with the use of credit is that generally credit isn’t a transparent process. Some action might be triggered by a credit score. Because a lot of credit systems are proprietary, the underwriters themselves can’t explain to [the broker] what the issue is.

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Now that we know credit is predictive, how are we going to use it such that consumers can say, ‘This is the right way to do it.’