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Insuring your car or home? Your credit history can cost you

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Missing a credit card payment could increase the cost of insuring your car or home, due to the widespread use of an insurance scoring model that considers policyholders' credit histories.

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Your borrowing behavior may appear unrelated to the risk of something bad happening to your house or vehicle. The insurance industry, however, says that a credit history can be used to help predict the likelihood of a policyholder eventually filing a claim and costing the insurer money. As a result, insurers are increasingly relying on credit-based insurance scores -- calculated using information from policyholders' credit reports -- when providing insurance coverage.

"Insurers use credit-based insurance scores in a variety of ways. Some companies use it for ratemaking, some for underwriting, others do not use it at all," says Loretta L. Worters, vice president of the Insurance Information Institute, an industry group. Consumer advocates, meanwhile, say the use of these scores unfairly penalizes consumers with poor credit, who may otherwise be no more risky than other policyholders.   

These credit-based insurance scores share similarities with traditional credit scores used by banks and other lenders, including the types of information they consider in order to gauge risk. But they also have some important differences.

"Insurance scores are designed to predict insurance losses; credit scores predict the likelihood of delinquency or nonpaying of credit obligations," Worters says. "While some of the same factors or characteristics are used to develop a credit-based insurance score, not all of the credit information is used."

Credit-based insurance scores gain popularity
Insurance scores have been in use for more than 20 years, but have experienced a recent surge in popularity. Today, the use of credit-based scores is widespread. FICO, creator of the leading financial scoring model that bears its name, says that roughly 95 percent of all auto insurance policies and close to 90 percent of all homeowner's policies are awarded today based on credit-based insurance scores.

We think it's unfair for consumers to pay more for insurance when they're good insurance risks, but may have had some problems with their credit history.

-- Norma Garcia
Consumers Union

Although insurers largely agree on the usefulness of credit data, they can't come to a consensus about what model to employ. Unlike lending decisions, which are most often based on the FICO score, there isn't a single go-to scoring model for insurers. "There are several different scoring models currently in use to calculate credit-based insurance scores, including models developed by third-party vendors and proprietary models built by individual insurance companies," Jeff Kucera, a senior consultant with property and casualty firm EMB, said on behalf of the Casualty Practice Council of the American Academy of Actuaries in April 2009 testimony.   

What factors into insurance scores?  
Insurance scores consider fewer factors than traditional credit scores. "Approximately 20 to 30 factors are used to develop a credit-based insurance score, whereas over a hundred are used to develop a financial credit score," says Worters. "The 30 or so factors used are those that have been statistically proven to be an indicator of future losses." She says those factors may include:   

  • Outstanding debt.
  • Length of credit history.
  • Late payments.
  • Collections and bankruptcies.
  • New applications for credit.

To create their own unique models, insurers may combine those data points with other consumer information. For example, State Farm Insurance spokesman Dick Luedke says the company has designed its own scoring models for auto and home insurance that incorporate data from FICO and other sources, but also use "three generic characteristics" from the credit report, including the applicant's number of open lines of credit, accounts in collection and late payments. The rest of the data used in State Farm's decision comes from more traditional sources like age, gender and claims data.

As with financial credit scores, certain types of personal information is off limits. "Credit-based insurance scores do not consider a consumer's income, race, age, address, marital status or nationality. In fact, federal privacy laws prohibit the consideration of such data," Worters says.

Insurance scores unfair, critics say
Still, some critics assert that credit-based insurance scores unfairly penalize certain groups, including minorities. Other consumer groups point to a disconnect between using credit data for noncredit purposes. "We think it's unfair for consumers to pay more for insurance when they're good insurance risks, but may have had some problems with their credit history," says Norma Garcia, senior attorney with nonprofit advocacy group Consumers Union. 

State insurance commissioners have responded to concerns about lower-income and minority policyholders. Michael McRaith, director of the Illinois Department of Insurance, chairs a committee under the National Association of Insurance Commissioners that's looking into a host of fairness issues associated with credit-based insurance scoring.

I remember getting a handwritten letter from a man who said he purchased everything with cash and was penalized with what he paid for car insurance because his credit score was neutral.

-- Michael McRaith
Director, Illinois Department of Insurance

"What we know is that the insurance industry has become more sophisticated in its ability to price risk. Digitized information has so exponentially increased the ability to collect that information, the public policy question is whether one or more categories of information that are available and collectible might be predictive, but at the same time discriminatory," he says. 

McRaith says his office receives complaints about insurance scoring not only from people with heavy debt loads, but also from those consumers with little or no debt at all. "We've had complaints (about scoring) from people who don't use credit," McRaith says. "I remember getting a handwritten letter from a man who said he purchased everything with cash and was penalized with what he paid for car insurance because his credit score was neutral."

Insurances scores and the economy
Not just poor or credit-shy consumers may be harmed, however. In this economy, there are "lots of reasons why people may have something on their credit reports. It doesn't make them a less-safe driver or less-responsible homeowner," says Consumers Union attorney Garcia.   

States are also turning their attention to insurance scores. More than 27 states have introduced legislation regarding the use of credit information in insurance, according to the National Conference of State Legislatures. But for those fighting the use credit-based insurance scores, the battle in some states may not be easy. Following a closely watched case in Michigan, for example, the state's Supreme Court in 2010 ended a six-year fight by state regulators against the use of insurance scores.

The industry says that eliminating insurances scores isn't the answer. "The removal of such insurance scores will not lower overall insurance premiums; rather, it will redistribute the premium charges so that those risks with lower expected costs will pay more than is actuarially fair, while those with greater expected costs will pay less than is actuarially fair," EMB's Kucera said in his testimony. 

Furthermore, the industry says that scores have held up in spite of the economy's troubles. "Mortgage failures, the recession and rising unemployment have led to assumptions that credit scores are declining. But the numbers tell a different story," says Worters. She notes that data from the three major credit bureaus (Experian, Equifax and TransUnion) and FICO shows that credit scores are holding steady -- and in some cases rising -- for most consumers as they focus on paying bills on time, reducing debt levels and not taking on excessive debt. "These prudent steps are helping to improve credit scores for many consumers," she says.

See related: Credit inquiries and your credit score, Don't automatically refuse extra rental car insurance coverage, 8 legitimate ways to improve your credit score now

Published: November 2, 2010


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