May 5, 2009

 

2009-R-0185

insurance Credit scoring systems

 

By: Jillian L. Redding, Legislative Fellow

 

 

 

You asked (1) for a description of the credit scoring system used by insurance companies, (2) for a rationale for this system, and (3) whether the law requires applicants to be notified when their insurance credit score does not give them the “best rate.” This report has been updated by OLR Report 2018-R-0247.

SUMMARY

Insurance companies use credit scores to (1) assess the potential risk posed by those applying for insurance coverage and (2) determine insurance eligibility and premiums.  The score is numerical and based on the applicant’s credit history.  It may also include other factors, such as geographical location, driving history, age, and gender. 

 

Insurers reason that actuarial studies show a high correlation between insurance scores and loss ratio.  Essentially, applicants with lower scores are more likely to file loss claims.  Because the companies are taking a risk in insuring applicants, they must be able to accurately predict the premiums to charge in order to financially cover applicants in the event of a loss.  Insurers use many different scoring models, which they generally keep secret because they compete to offer the lowest prices to consumers.

 


Connecticut law requires insurance companies to file the scoring system they use with the Insurance Department.  It also requires them to notify the consumer when they take an an adverse action against the consumer’s policy (e.g., charge  a higher rate or deny a discounted rate).  The law sets out guidelines for the notice.  HB 6444 (File 318), reported favorably by the Insurance Committee, seeks to limit the use of credit information when underwriting or developing new rates for new automobile insurance policies.  It prohibits insurers from using credit history information when renewing a policy unless requested by the policyholder. 

 

At least five states have limitations on insurance companies’ use of credit scores.  Hawaii prohibits the use of credit bureau ratings in auto insurance rate determinations.  Georgia, Illinois, Utah, and Washington prohibit insurers from using only credit information in decisions to cancel or deny renewals of auto insurance policies.  

 

A Congressional report on the fairness of using consumer credit data in underwriting and rate setting concluded that:

 

1.   most insurance companies use credit-based insurance scores in determining the price to offer coverage to consumers,

 

2.   the scores are an effective predictor of risk under automobile policies, and

 

3.   the scores are distributed disproportionately among racial and ethnic groups and affect insurance premiums that these groups pay.

 

The Federal Trade Comission (FTC), which conducted the report concluded that it was unable to develop an alternative credit-based insurance scoring model that would not have such an effect among racial and ethnic groups.

insurance credit scoring systems

An insurance credit scoring system, or “financial history measurement program,” as termed by the Connecticut Insurance Department, uses credit report information and credit scoring systems or programs to measure the potential risk posed by an individual applying for coverage.  Insurers use the scores when estimating the number or cost of insurance claims that prospective customers are likely to file. 

 


According to the FTC, credit-based insurance scores “are numerical summaries of consumers’ credit histories.”  They are usually calculated using information about (1) past delinquencies (e.g., bankruptcies); (2) debt ratios (i.e., how close a consumer is to his or her credit limit); (3) new credit inquiries or applications; (4) the length of credit history; and (5) the use of certain types of credit (such as automobile loans) (Credit-based Insurance Scores: Impacts on Consumers of Automobile Insurance, July 2007, at 1, available at http://www.ftc.gov/os/2007/07/P044804FACTA_Report_Credit-Based_Insurance_Scores.pdf). 

 

According to the Insurance Information Institute, the score may also incorporate other factors, such as an applicant’s age, gender, geographical area, number of previous accidents, and number of traffic infraction tickets received (Credit Scoring, April 2009, available at http://www.iii.org/media/hottopics/insurance/creditscoring/). 

 

Insurers use the scores to assign consumers to “risk pools” and determine the premiums (FTC report at 2).  They often use the credit information to decide whether to offer the consumer insurance and at what price in two steps: underwriting and rating.  In the first step, underwriting, the insurer uses certain characteristics of the consumer to place him or her into a “risk pool” based on the apparent risk of loss (FTC report at 16).  Each pool has a set base rate for a policy; higher risk pools have higher base premium rates (Id.).  In rating, the next step, the insurer uses other risk characteristics to “adjust the base premium rate up or down to determine the actual amount the consumer would be charged” (Id.).  Because the insurance score systems differ, insurers may use the credit information in either step of the process.

 

According to the institute’s report, companies believe that credit scores are predictive of the applicant’s ability to pay premiums and his or her likelihood of filing claims.  The report reasons that an applicant who is responsible in his or her financial affairs is more likely to be as responsible in other areas, such as driving and taking care of a house.  The FTC report states that insurers argue the credit-based scores “assist them in evaluating insurance risk more accurately, thereby helping them charge individual consumers premiums that conform more closely to the insurance risk they actually pose” (FTC report at 16). 


connecticut insurance laws

Connecticut law requires insurance companies to file the insurance scoring system they use with the state Insurance Department (CGS § 38a-688; Ins. Dept. Guideline 1).  This must include (1) a description of the system, (2) the characteristics from which a consumer’s measurement is derived, and (3) the rules and procedures used in the system.  The system must not unfairly discriminate among consumers or result in excessive (unreasonably high) costs for the risk assumed (CGS § 38a-665(a); Ins. Dept. Guideline 9).  

 

Restrictions on the Use of Credit Information

 

The insurance company may choose to use either specific credit information or a financial history measurement program, but not both, determine the score for an individual policy (Ins. Dept. Guideline 2).  It can use a credit score only for new policies (Ins. Dept. Guideline 2).  It cannot penalize (by giving a higher score to the consumer) due to lack of a credit history (Ins. Dept. Guideline 2).  It may not cancel or decline to renew a policy solely due to an adverse credit score or measurement.  However, it may refer the policy to an affiliated insurer without violating this rule (Ins. Dept. 6).  The financial history measurement program may not measure a consumer based on:

 

1.   the number of credit inquiries;

 

2.   the use of a particular type of credit card, charge card, or debit card;

 

3.   the purchase or finance of a specific item;

 

4.   the total available line of credit; or

 

5.   disputed credit information while the dispute is under review by the credit reporting agency (Ins. Dept. Guideline 5). 

 

Notice of Adverse Action

 

By law, when an insurance company decides to take adverse action on a consumer’s policy, it must notify the consumer and provide an explanation for the action (CGS § 38a-985).  It must (1) either provide the


consumer with the specific reason for the adverse action in writing or advise him or her that he or she may receive the specific reason upon written request and (2) provide the consumer with a summary of rights under Connecticut law.  Further, if the consumer requests such information, the insurance company must provide:

 

1.   the specific reason (if not already given) for the adverse underwriting decision in writing,

 

2.   the specific items of personal and privileged information that support these reasons, and

 

3.   the names and addresses of the institutional sources that supplied the specific items of information (CGS § 38a-985(b)).

 

An adverse action includes (1) a denial or termination of insurance coverage, (2) changes from a preferred rate to a standard rate, or (3) changes from a standard rate  to a nonstandard rate (CGS § 38a-976(a)).

restrictions in other states

At least five other states have limitations on insurance companies’ use of credit information in the rate-making or underwriting process.  Hawaii prohibits insurance companies from using credit bureau ratings in determining auto insurance rates.  A violation is a discriminatory practice (Haw. Rev. Stat. § 431:10C-207).  Georgia, Illinois, Utah, and Washington prohibit insurance companies from canceling or refusing to renew an auto policy based solely on credit information (Ga. Code Ann. § 33-24-91(1); 215 Ill. Comp. Stat. 157/20; Utah Admin. Code 590-219-5; Wash. Rev. Code § 48.18.545(3)).  Illinois also prohibits adverse action due to lack of credit information or lack of a credit card account.  Washington prohibits coverage denial based on:

 

1.   the absence of credit history;

2.   the number of credit inquiries;

3.   collection accounts identified as medical bills;

4.   the use of a particular type of credit, debit, or charge card;

 

5.   the initial purchase or finance of a vehicle or house that adds a new loan to an existing credit history; or

 

6.   the total available line of credit held by consumer (Wash. Rev. Code § 48.18.545(5)).

 

Illinois and Georgia prohibit the use of an insurance score calculated from, among other things, gender, income, marital status, or address.

 

federal trade commission study

Congress enacted the Fair and Accurate Credit Transactions Act (FACTA), Pub. L. 108-159, 117 Stat. 1952, in response to concerns raised about credit-based insurance scores.  FACTA expanded the Fair Credit Reporting Act (15 USC § 1681 et seq.).  Section 215 of FACTA requires FTC to conduct a study of the effects of credit-based insurance scores on the availability and affordability of automobile and homeowners insurance policies.  

 

The resulting FTC report found that risk prediction “is an important method of competition among insurance firms” (Federal Trade Commission, Credit-based Insurance Scores: Impacts on Consumers of Automobile Insurance, at 20).  The FTC determined that:

 

[i]nsurance companies have a strong economic incentive to try to predict risk as accurately as possible.  In a competitive market for insurance in which all firms have access to the same information about risk, competition for customers will force insurance companies to offer the lowest rates that cover the expected cost of each policy sold.  If an insurance company is able to predict risk better than its competitors, it can identify consumer who are currently paying more than they should based on the risk they pose, and target these consumers by offering them a slightly lower price.  Thus, developing and using better risk prediction methods is an important form of competition among insurance companies (Id. at 8).

 

Insurers claim that these credit based scoring systems are “an important form of competition.” Thus, they are usually kept confidential (Id. at 12).  However, as mentioned above, some states require disclosure of these systems, and the insurers responded with the system, but say that they use a different scoring model in these states than elsewhere “to minimize the competitive disadvantage. . . as a result of such mandated disclosures” (Id. at 13.) 

 

The FTC concluded that, while the credit-based insurance scores are an effective predictor of risk under automobile policies, they are distributed differently among racial and ethnic groups, likely leading to a disparate effect on the premiums that these groups pay.  For example, it found that non-Hispanic whites and Asians are distributed evenly over the range of scores.  However, African-Americans and Hispanics are “substantially overrepresented among consumers with the lower scores (scores associated with the highest predicted risk) and substantially underrepresented among those with the highest scores” (Id. at 3).  The FTC was unable to create an alternative credit-based insurance scoring model that would effectively predict risk yet correct the uneven scores on average among racial and ethnic groups.

 

JLR:ak