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| The Basics | How bad credit costs you with insurers
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Insurers and consumer advocates are still debating the merits of credit scores as a way to gauge risk, but chances are you've already come under the microscope.
By Liz Pulliam Weston
If you've been late paying bills, maxed out your credit cards or filed for bankruptcy, the odds are good that you're paying more for insurance than you would if you had good credit.
Over the past half dozen years, the great majority of auto insurers have started to base insurance premiums at least partly on your credit history. Home insurers are starting to use credit-based scoring as well.
Insurers say credit scores are excellent predictors of who will make a claim, but consumer advocates say such scores are unfair to people wiped out by some catastrophe, such as a job loss, huge medical bills or identity theft. What nobody knows is whether using credit scores also results in a discriminatory pattern of higher premiums among minorities and the poor, the advocates say.
Bad credit equals bigger claims
Theres plenty of evidence to show the predictive link between credit and auto claims. Most recently, a massive study by researchers at the University of Texas at Austin found a statistically significant relationship between an individuals credit scores and his or her tendency to incur auto insurance losses.
The researchers created a database of 153,326 policies from the first quarter of 1998, matching the people named in the policies with their credit scores. Then the researchers tracked who made claims in the following 12 months.
The lower a named insureds credit score, the higher the probability that the insured will incur losses on an automobile insurance policy, the study concluded, and the higher the expected loss on the policy.
The policies with the lowest average credit scores had claims averaging $918, while those with the highest scores averaged $558. The average loss per policy was $695.
The worse the credit, the worse the risk
The University of Texas study confirmed earlier research conducted by the insurance industry. MetLife actuary James Monaghan published a study in 2000 that matched credit histories to 170,000 auto policies and found those with bad credit tended to cost insurers more.
For example, people with no collection actions on their credit reports had an average loss ratio of 74.1%. (A loss ratio is how much the insurer pays out in claims divided by how much premium is collected, so this represents 74.1 cents in claims paid for each dollar collected.)
Those with one collection action had a 92.5% loss ratio. Those with two, 108.4% -- meaning they cost more than they paid in premiums. Those with three had a 118.6% loss ratio.
Monaghan found similar patterns among people who were late paying their bills, those who applied for lots of credit, those who were maxing out their credit and those who had a derogatory public record, such as a bankruptcy, lien or foreclosure. Generally, the greater the strain on their credit, the higher the claims costs.
Why the link? No one knows
Insurers research and experience was so compelling that by 2001, nine out of 10 insurers were using credit data in their policy decisions, according to a study by Conning Research & Consulting. The industry has rallied to fight or modify restrictions that state lawmakers have imposed, arguing that credit scoring makes insurance less expensive for the majority of policyholders who have good credit.
They wouldnt fight so hard for it, said Conning insurance consultant Michael R. Weinstein, if they didnt think it worked.
Of course, insurers cant explain why it works -- no one really can. It could be that people who are careful with their money are also careful with their cars and other property. Or perhaps people with financial troubles are more likely to make claims than those who have plenty of cash.
Actuaries will tell you that its tough to prove any causal relationship between most of the factors that determine your premiums and your risk of filing future claims. In other words, the fact youve had an accident in the past doesnt cause you to have another accident in the future.
But most of us can accept the idea that people who have one accident may be more likely to have another. It seems logical. Not knowing the logical link between credit and insurance makes many people wary of combining the two.
Thats the source of most of the consumer complaints about insurers using credit scoring, said Joel Ario, head of Oregons insurance department and co-chairman of the NAICs working group on credit scoring. People dont buy the underlying statistics. ... Its not intuitive to them.
On the lookout for discrimination
The big question for the industry, regulators and lawmakers is whether the use of credit scores is inherently discriminatory. If the relationship between credit and race or income results in minorities or the poor paying consistently higher rates, the use of credit scores for setting rates will face increasing opposition.
Insurers are already prohibited from using ethnicity as a variable in making insurance decisions. Its well established, for example, that African-Americans on average have shorter life spans, but we dont permit insurers to charge African-Americans more for life insurance. Weve made a decision as a society that such discrimination is unacceptable.
Insurers say that the credit-scoring process is race-blind. There's no way to know from a credit report anything about a person's skin color, and credit scores dont factor in either race or income. Whether you have a high score or a low one is theoretically based purely on how you use credit and manage your debts. Insurers argue that a race-neutral system is inherently fair to everyone.
On the other side, consumer advocates worry that using credit scores to set premium rates may indirectly result in an unfair burden on minorities and the poor, although they're loath to presume that minorities or low-income people have worse credit than whites or higher-income folks. The truth is that no one knows how closely correlated race and credit scores may be.
Rules are still being written
A group representing state regulators, the National Association of Insurance Commissioners, is considering sponsoring a large-scale, independent study of the issue. But so far, the few studies that have been done on any links between credit and income or race have been inadequate.
The lack of information hasnt stopped state legislatures from acting. A majority of states now have some law or regulation on the books restricting the use of credit information by insurers:
- Some states, including Florida, require insurers to notify consumers of their right to receive a credit report if coverage is denied or premiums increased for credit reasons
- Other states, including Iowa, Colorado and Minnesota, forbid insurers from using credit as the sole criteria in determining coverage
- In Pennsylvania, credit scores can be used to set rates but not to deny, cancel or refuse to renew a policy
- In Alabama and Washington, the lack of a credit history cant be used in determining rates.
Until more is known about how credit scores vary by ethnicity and income, however, lawmakers -- and their constituents, and insurance companies -- are driving blind.
Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.
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