Insurers Look To Demystify Credit Scoring

While the application of credit information to personal lines underwriting and rating decisions has increased, it also has evolved. Insurance credit scores, rather than credit reports, are now the preferable credit tool of insurers, and while the earlier NAIC discussions focused largely on underwriting, credit information may now play a prominent role in the rating process.

Further, the number of insurers using credit scoring has more than doubled. A recent study by Hartford-based Conning and Company found that because of statistical validity, 92 percent of the largest personal lines insurers are using insurance scoring in their underwriting and/or rating decisions.

The Alliance of American Insurers supports the right of companies to consider credit information in their underwriting decisions because such data may provide a valuable underwriting tool. At the same time, we recognize that misconceptions and misunderstandings continue over the use of credit information in personal lines.

Some of the misunderstandings may be a result of the very terms used. The terms "credit reports," "credit scores" and "insurance scores" are used interchangeably when referring to the concept of considering an applicant or policyholder's credit history as an indication of the likelihood of future loss. But actually the terms are distinct.

Credit reports are detailed histories of an individuals or firm's current and past credit-related transactions. They include detailed information on revolving credit, mortgages, collections and bankruptcies, collected by credit bureaus.

Credit scores, on the other hand, are numerical indicators of risk. Credit information is received from the credit bureaus and entered into a computer model designed to produce a score. The score represents an objective snapshot of the credit habits of an individual. Insurers then use insurance scores to predict the likelihood of future losses.

Independent studies have documented a clear correlation between insurance score and chance of loss. Indeed, studies on the relativity between score and loss frequency are so convincing that reasonable opponents of insurer use of scores rarely contest the statistical validity of the process.

Despite this statistical evidence, several common concerns are voiced by consumer advocacy groups, legislators and regulators, and whether their concerns are valid or not, it is important for insurers to understand the concerns of their critics. It is equally important for those critics to understand how consumers can benefit from the use of insurance scoring.

It can be difficult for some to understand credit's correlation to risk of loss. What does credit have to do with driving habits or home maintenance, many ask?

The answer is that insurance scores reveal a picture of the individual's ability to handle and manage credit–they objectively measure such subjective concepts as responsibility and stability, allowing insurers to gain a more accurate picture of subsequent risk and potential loss.

Some opponents of insurance scoring charge that its use is discriminatory to lower-income individuals, but in actuality, people of all economic levels have good and bad credit records, and insurers may use scoring as a tool that increases fairness through the use of another objective standard.

Further, federal law prohibits the factors of ethnicity, religion, gender, marital status, nationality, age, income and address from being considered in a credit score. Therefore, consumers can benefit from increased competition and company choice.

By adding another level of sophistication to the underwriting process, credit information allows insurers to accept business with a higher degree of certainty, and thus may allow an insurer to write more business, not less–leading to a more competitive marketplace with more choices for the consumer.

Allegations that insurers use insurance scoring or credit information to refuse business are unfounded. Insurers are in business to write policies. Any insurer that seeks to disqualify as much business as possible, or to unfairly rate their policies, would not remain in business long.

Privacy is another issue raised in opposition to the use of credit scores. Today, more than ever, consumers are concerned with privacy and confidentiality of personal records.

Ironically, insurance scoring allows an underwriter to carefully evaluate a risk without the disclosure of sensitive or private information. The use of scoring allows the underwriter to objectively consider a snapshot of the applicant's credit management habits without having to scrutinize all the details of one's credit history. Likewise, an applicant or policyholder will not have to fear that every detail of his private credit information will become known to his insurance agent.

Insurers also have been charged with failing to be open and honest about how insurance scoring is used. But insurers and independent scoring modelers have gone to great lengths to demystify the process by better explaining how credit information is used and how consumers can take control of, and improve, their scores. Consumers can easily obtain their scores from various vendors, along with complete explanations of the factors considered in the score.

Some people also have voiced concern over possible inaccuracies or errors in their credit records. While errors can occur, their impact on insurance underwriting may be negligible, because errors found on credit reports often are not relevant to the information considered by insurers. For those records found to be in error, the Federal Fair Credit Reporting Act already protects consumers by prohibiting insurers from considering information known to be in error, and by allowing consumers to correct incorrect information.

Finally, it is important to remember that regulatory controls already exist to monitor insurer use of credit. Market conduct surveys and the Unfair Trade Practice Act provide sufficient tools to monitor insurer use of credit–or any other underwriting or rating tool.

To specifically target insurance scoring as "bad public policy" would be as draconian as prohibiting consideration of motor vehicle records. As with driving records, the small percentage of applicants with a "bad" credit record may pay higher rates than those with a more favorable record–a fair result based on a higher likelihood of future loss.

Lynn Knauf is a policy manager in the property-casualty department of the

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, December 10, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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