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Is it fair to use credit histories in setting insurance premiums?

Is it fair for an insurance company to base your homeowners premiums, in part, on how well you pay your bills?  Michigan Financial and Insurance Services Commissioner Frank Fitzgerald is one of the state regulators asking that question.

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“Insurance companies legally can, and do, use credit history to establish insurance rates in Michigan," says Fitzgerald. "This practice is considered a discount for homeowners and automobile insurance, just like discounts for seat belts or fire alarms. Because the link between credit history and the likelihood of a consumer filing a claim is not clear, the increasingly common practice of using credit to set insurance rates has raised many questions."

Fitzgerald issued an order in February 2003 to insurance companies doing business in his state to provide policyholders with more information about how credit histories are used to set premiums. “Consumers’ overwhelming concern about the use of credit information to set insurance rates is due to the lack of information available,” says Fitzgerald. “Insurance companies doing business in Michigan that establish consumer credit scores to set insurance rates will have to recalculate scores annually or when a consumer corrects their credit history, provide detailed information about the company’s use of credit, and justify the company’s use of credit scoring.”

Discrimination?

Mike Kreidler, the insurance commissioner for the state of Washington, released a study in January 2003 on the use of credit scores to set insurance rates in his state.  Kreidler says he found evidence the process is not always fair.

"The intent of the study was not to single out a particular company, but to see if industry-wide use of credit scoring in insurance results in discrimination against the poor or people of color," Kreidler says. "It's clear that interesting questions have been raised that warrant further investigation."

Insurance companies provided data to Kreidler’s office on their policyholders.  The information included the age, gender, policy start dates, credit scores and rate classifications for those customers.

Kreidler’s office contacted approximately 3,000 of those policyholders, to ask them about their ethnicity, marital status and income level.

Kreidler says credit-based insurance rates tended to favor wealthier policyholders. The study found as incomes rise, credit scores improve and premiums go down. Kreidler says credit scoring raised the average premiums for poor policyholders relative to more affluent insurance customers.

Kreidler says ethnicity was found to be significant in some cases. In general, Asian/Pacific Islanders and whites in Washington State had better credit scores than other ethnic or racial groups. Kreidler says when other minority groups had significant differences from whites, “the differences were in the direction of higher premiums.” Due to the differences among the three insurance companies studied and the small number of minorities in the sample, Kreidler admits the results for ethnicity were not broadly conclusive.

"The industry alleges credit scoring is an income-blind, color-blind tool for assessing risk," says Kreidler. "Our study indicates credit scoring is not blind to income and the jury is still out on how it impacts race."

"As co-chair of the National Association of Insurance Commissioners' working group on credit scoring, I intend to pursue a more broad-based study at the national level," says Kreidler. "It is likely this study will need to be conducted in states with larger ethnic minority populations."

Insurers defend credit-based rates

Bill Schroeder of the American Alliance for Insurers defends the use of credit histories in setting premiums as a fair way to help distinguish which customers are the least likely to file claims, and therefore get the lowest rates. "The Alliance believes that insurers should be able to consider credit information in their underwriting and rating decisions," Schroeder says. "Credit history and credit-based insurance scores are fair and accurate tools that allow insurers to rate risks with greater certainty, to the ultimate benefit of consumers who are charged rates that more accurately reflect their risk of loss."

The American Insurance Association (AIA) took a look at the Washington-state study.  The AIA claims the study is limited and should not be portrayed as a definitive examination of credit-based insurance scoring.

“The study adds some insights into the vigorous debate over credit scoring, including further evidence that scoring is not a monolithic, standardized rating and underwriting tool used across the board in the property-casualty insurance industry,” says David Unnewehr, AIA senior research manager. “However, some critics of insurance scoring may be tempted to spotlight very weak statistical findings on demographic variables, while underplaying the cautious note sounded by the authors of the study. That would be a mistake.”

Led by Unnewehr, AIA’s Policy Development and Research team conducted a thorough review and analysis of the Washington-state study. The study analyzed 3,000 policyholders from three large insurance companies in the state. AIA claims the three companies in the study varied so much regarding the extent to which credit scoring was used, researchers were unable to combine data from the three companies for any overall analysis of credit scoring impacts.

“Because scoring generally helps to individualize and refine rating and underwriting variables that are more difficult for a consumer to control, such as age and location, scoring and its varying uses by insurers as they compete with one another may have helped to create a more competitive marketplace for Washington consumers,” Unnewehr says.

Unnewehr says the stated purpose of the study was “to find out whether credit scoring has unequal impacts on specific demographic groups.” The study focused on three demographic factors: age, income and ethnicity. The study’s strongest finding, according to its authors, was that policyholders’ insurance scores tended to rise steadily with age.

“The relationship between credit scores and age and the widely accepted finding that credit scores are a useful tool for predicting future loss experience has an intuitive logic,” Unnewehr says.

On the issue of ethnicity, the Washington study notes “relatively small numbers of ethnic minorities and the number of refusals and unclassifiable survey responses” made it difficult to pin down any statistical significance between minority status and credit scoring.

“We have already witnessed critics attempting to hold the Washington study up as something more than it is,” says David Snyder, AIA vice president and assistant general counsel. “At the end of the day; however, the study does nothing to diminish the fact that credit-based insurance scoring is an actuarially sound underwriting and rating tool that is used in accordance with existing federal and state laws.”

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