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.

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.

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.

"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.

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