Does having bad credit make you a worse driver or a riskier homeowner?

No, but your insurance company probably sees a correlation.

Many home and auto insurance companies use your credit information, filtered through a formula to create an "insurance risk score," to determine how likely you are to file an insurance claim. Your premium bill could rise if you have a bad credit score, even if you haven't filed a claim.

According to the Insurance Information Institute (III), insurance companies use these risk scores to help differentiate between lower and higher insurance risks and thus charge a premium equal to the risk they are assuming. Statistically, people who have a poor insurance score are more likely to file a claim, according to III.

Insurance risk scores are similar to credit risk scores — used by lenders to determine whether or not to approve a loan or line of credit — because both look at your credit information, but the two are not the same thing, says Craig Watts, a spokesperson for Fair Isaac Corp., whose insurance risk scores are used by roughly 300 insurers nationwide.

"Consumers are becoming more familiar with credit risk scoring, but insurance risk scoring is still fairly arcane," says Watts.

A peak inside the "black box" While Fair Isaac Corp. will not release the details of its insurance risk-scoring model to the public, spokesperson Craig Watts says that your credit score can give you an idea of your insurance risk score. The five categories of your credit score are: Past payment history (approx. 35%) How you've paid your credit bills in the past, if your bills have been paid on time, items in collection, the number of "adverse public records" (bankruptcy, wage attachments, liens), and the number and length of delinquencies or items in collection. Amount of credit owed (approx. 30%) How many accounts have balances, what kind of accounts they are and how close you are to your credit limits. Length of time credit established (approx. 15%) How long you have had credit accounts and how long you have had specific accounts. New credit (approx. 10%) Number and proportion of recently opened accounts, the number of credit inquiries, and the reestablishment of positive credit history after payment problems. Types of credit established (approx. 10%) The number and activity of various types of credit accounts including credit cards, retail store accounts, installment loans, and mortgages. Insurers place importance on the factors that show long-term stability, so by demonstrating responsible use of credit and keeping your balances low, you should be able to improve your insurance score. That could translate into lower insurance premiums if you've been impacted by a negative credit history in the past. You can purchase your credit risk score, credit report and tips on how to improve your score at myFICO.com, from Fair Isaac Corp.

While both insurance scores and credit scores look at the same five characteristics of a person's credit report (see list at right), the data are weighted differently. This difference in weighting can swing 5 to 10 percent in each category.

"The biggest difference is that insurance risk scores look for stability, but credit risk scores look for a reliable pattern," says Watts. "Insurance scores are also more interested in how regularly you pay than in how much you already owe."

Insurers use these insurance scores to try to identify consumers who are consistent and reliable, as well as those who show a pattern of demonstrating common sense with money. Insurers say these people are less likely to file a claim on an insurance policy — thus costing the insurance company less money.

"We've studied millions of records and have found that there is a clear and reliable correlation between credit history and insurance risk," says Watts.

According to the latest study by the Bureau of Business Research at the University of Texas, published in 2003, there's a strong correlation between credit history and the filing of an auto insurance claim. The study matched credit scores with claim data and found that people with bad credit scores had claim losses 53 percent higher than the average.

Allstate Insurance Co. and State Farm, the nation's two largest auto and home insurers, have also noted this correlation and have developed their own insurance risk-scoring systems that incorporate credit information.

Insurers say that using credit information allows them to price their products more fairly. The better your credit, the lower your premium.

"Study after study has shown that credit history can be correlated with the likelihood that someone will file a claim," says Dick Luedke, a spokesperson for State Farm. "We don't claim to have the definitive answer as to why there is a correlation, but we believe one exists."

Luedke says that State Farm uses credit information in deciding whether or not to issue an insurance policy and points out that, in some cases, the use of credit information has allowed State Farm to cover people that wouldn't ordinarily have qualified.

"That would be somebody that didn't have good characteristics in their driving record or on previous claims but did have good credit characteristics," Luedke says. "If we didn't include that in the overall measurement of risk, we wouldn't have insured that person."

Correlations and explanations

The use of credit information to help set premiums and approve or deny coverage has its critics. Birny Birnbaum, executive director for the Center for Economic Justice, has testified before Congress on insurance credit scoring and outlined reasons it should be prohibited. He argues that credit-based insurance scores are arbitrary and unrelated to how well a consumer manages their finances and that scores penalize consumers due to the business decisions of lenders. He also says that 87 percent of family bankruptcies result from job loss, major medical bills and divorce.

"Study after study has shown that credit history can be correlated with the likelihood that someone will file a claim." — Dick Luedke, spokesperson for State Farm

"It is only in the cloistered world of insurance actuaries and executives that charging higher auto and homeowners insurance rates to some who have suffered an economic or medical catastrophe is considered fair," he says.

Birnbaum also believes that credit scoring discriminates against poor and minority consumers. He cites a Missouri Department of Insurance study from 2004 that found that credit scores for minorities were consistently lower than scores for non-minorities.

While some critics acknowledge that credit information — which has been used by some insurers for more than a decade — can be useful to insurance companies for avoiding insurance fraud-motivated arson and similar hazards, they place little faith in computer-modeled insurance scores and statistical relationships. They also attack insurance risk scores because insurance companies won't divulge their methods for calculating insurance risk scores.

"They haven't verified that minorities, people with disabilities and the poor aren't discriminated against by these systems." —Robert Hunter, Consumer Federation of America

Alex M. Hageli, an expert on credit information issues at the Property Casualty Insurers Association of America, says that computer models used to generate insurance scores from credit information represent a tremendous investment of time and money for insurers.

"Some companies have developed their own models and others use third-party vendors' models. In either case, a lot of money has been poured into perfecting the model to allow companies to price better than their competitors, or in the case of competitors, to allow them to say their model is the best," Hageli says. "If everyone has access to everyone's algorithms, i.e. secret ingredients, then all that money is wasted."

Robert Hunter, the director of insurance for the Consumer Federation of America (CFA) and a former Texas Insurance Commissioner, finds this alarming.

"This is very disturbing — it's like a black box," he counters. "They haven't verified that minorities, people with disabilities, and the poor aren't discriminated against by these systems. Indeed, studies by Maryland and Texas seem to confirm that this is a problem."

According to Watts, insurance risk-scoring models do not discriminate. "In the studies we've done, we looked specifically at the scoring of low- to moderate-income and high minority areas," says Watts. "People in those areas score the same as in areas of higher income. We didn't see a pattern of indirect discrimination."