Credit Scoring for Insurance Benefits Consumers

Published August 1, 2009

Legislators across the country have been proposing bans on the use of credit scores in companies’ decisions to issue or price insurance, even though insurers say the practice benefits consumers.

“Setting reasonably accurate prices for insurance is a difficult task because insurers must establish prices without the benefit of knowing all of the costs involved,” said Lawrence Powell, Whitbeck-Beyer Chair of Insurance and Financial Services at the University of Arkansas-Little Rock.

“To offset this hardship,” Powell said, “actuaries have developed complex pricing models using applied economic and statistical tools. While this complexity is necessary, it unfortunately leads to a lack of understanding among people who have not developed such specific expertise.”

That misunderstanding has led to resistance to many of the tools used by insurers, including credit scoring, Powell said.

A consumer’s credit score is one of dozens of factors an insurer takes into account when determining the risk involved in writing a new policy.

Allowed in 26 States

As of this writing, 26 states allowed insurance companies to use credit scoring in determining risk. Legislation aimed at limiting the use of credit scoring has been proposed in at least 19 states this year, including Connecticut, Indiana, Maryland, Mississippi, Montana, and North Dakota, where attempts to ban it were rejected, according to the Insurance Information Institute.

Bans on credit scoring shift costs from high-risk to low-risk consumers, said Robert Detlefsen, vice president for public policy at the National Association of Mutual Insurance Companies (NAMIC). In an American Legislative Exchange Council report he argued credit scoring bans do not serve the public interest and are less fair than the current system.

“[Supporters of credit-scoring bans] should be prepared to acknowledge to the insurance-buying public—especially those consumers whose costs are reduced and coverage options expanded through insurance scoring—that a prohibition against insurance scoring would force some individuals to subsidize the insurance costs of others, thereby violating the individuated-risk standard of fairness,” Detlefsen wrote.

Predicts Future Losses Well

Since credit-based insurance scoring was introduced into the market 15 years ago, numerous studies have demonstrated it is an excellent risk predictor and has improved insurance affordability.

A 2005 study by the Texas Department of Insurance compared credit scores to insurance claims and determined drivers with poorer credit scores generated losses 65 percent higher than those with the highest scores. The study also found that when used with other rating factors such as location, credit scoring allows insurers to accurately predict the risk involved in writing a new policy.

In April 2009, Neil Alldredge, vice president of state and policy affairs for NAMIC, testified before the National Association of Insurance Commissioners regarding credit scoring studies. He noted, “Several other studies have been conducted by different state insurance departments over the last 10 years; Virginia, Washington, and Alaska, for example. All these studies have two clear findings—that credit-based insurance scores are predictive of loss and that the vast majority of consumers benefit from the tool.”

Expands Insurance Choices

David Snyder, vice president and associate general counsel for the American Insurance Association, argues credit-based insurance scoring (CBIS) “has allowed companies to continue to write coverage and to increase their writings. This has improved availability.

“CBIS has also allowed many insurers to progress from the old pass/fail underwriting system with high denial rates to multiple-tier rating with dozens of prices,” Snyder said, “thereby enhancing an insurer’s ability to offer insurance to almost anybody and the ability to charge the best risks less.”

Consumer activist groups that oppose credit scoring argue it discriminates against minority and low-income applicants. Supporters of credit scoring dispute this claim, citing studies demonstrating the neutral nature of credit scoring. In the 2005 Texas study, the state insurance commissioner determined credit scoring is not discriminatory because it is not based on race or income.

In his April 2009 testimony, Alldredge agreed with that assessment, stating, “There have been no academic studies that include insurance loss or rate information that have found that credit-based insurance scores are either predictive of, or a proxy for, race or income.”

Matthew Glans ([email protected]) is legislative specialist in insurance and finance issues for The Heartland Institute.