Insurers are dancing in the streets, hailing a long-awaited (and feared) report from the Federal Trade Commission concluding not only that credit scores are an “effective predictor” of risk for auto policies, but that the use of credit-based insurance scores “may result in benefits for consumers.” The question is, will the party last? Or will carriers soon be left with a bad hangover?
(For full coverage of the report and the industry's reaction, click here.)
Much to the delight of carriers, the report said credit scores "permit insurance companies to evaluate risk with greater accuracy, which may make them more willing to offer insurance to higher-risk consumers for whom they would otherwise not be able to determine an appropriate premium.”
The report went on to say that credit scores "also may make the process of granting and pricing insurance quicker and cheaper—cost savings that may be passed on to consumers in the form of lower premiums.”
The report said that, in general, credit scores “are predictive of the number of claims consumers file and the total cost of those claims,” and that “the use of scores is therefore likely to make the price of insurance better match the risk of loss posed by the consumer. Thus, on average, higher-risk consumers will pay higher premiums and lower-risk consumers will pay lower premiums.”
It doesn't get any better than this for insurers, who have been on the defensive about credit scoring in insurance underwriting and pricing since the practice began.
However, before getting too crazy here, insurers should also note that there is plenty of material skeptical consumer advocates can seize upon to continue their campaign to ban the use of credit scores by the industry.
For one thing, while noting how credit scoring can benefit consumers, the FTC sheepishly concedes that such savings remain theoretical. Indeed, the report cautions, “little hard data was submitted or available to quantify the magnitude of these benefits to consumers.”
Are there benefits or aren't there? Insurers shouldn't gloat until they can demonstrate actual savings for buyers.
In addition, one of the big problems opponents have with credit scoring is that it unfairly hurts low-income and minority groups, and does not make allowances for those who deal in cash or are impacted by one-time events such as medical emergencies, as NU's Dave Postal reports.
Unfortunately for insurers, the FTC report confirms this negative trend. As Mr. Postal writes, "the report does say that credit-based insurance scores are distributed differently among racial and ethnic groups, and this difference is likely to have an effect on the insurance premiums that these groups pay, on average."
In his article, Mr. Postal writes, "African-Americans and Hispanics are substantially overrepresented among consumers with the lowest scores—the scores associated with the highest predicted risk—and substantially underrepresented among those with the highest scores.”
The FTC tried valiantly to reconcile the fact that credit scoring appears to accurately predict insurance risk, without the disparate impact on low-income and minority groups, but they couldn't pull it off.
“The FTC was not able to develop an alternative credit-based insurance scoring model that would continue to predict risk effectively, yet decrease the differences in scores on average among racial and ethnic groups,” the agency lamented.
The FTC didn't give up hope, however, noting that while it could not construct a model that meets social and economic objectives, one might yet be developed. Still, the agency admitted, “it does strongly suggest...that there is no readily available scoring model that would do so.”
Could it be that credit scores are accurate predictors, but its results are not politically correct? Will I be decried for even introducing the question?
Another report issued earlier this week doesn't help at all. The study by the Consumer Federation of America and Washington Mutual revealed that consumer knowledge of the potential impact from credit scores remains low, and on some issues has declined in recent years. (For Matt Brady's coverage of this report, click here.)
The study also found that while there were some gains in the public's understanding of the practice, there were also increases in the number of consumers with mistaken beliefs about credit scores.
Bottom line, while the FTC report may rally insurer spirits, as long as there is a politically unpopular disparate impact, and as long as so many people remain in the dark about the subject, credit scoring will continue to come under fire. But at least now insurers will have more ammunition to fight back.
Comments (5)
We're always going to be criticized that any model for scoring is racially disparate, no matter how it's based.
Ethnicity and economics have always been a part of the argument for not using certain formulae in developing rates; crying racism when the rates go against those who cause the most losses seems pretty hollow when it can be borne out time after time on paper that it's a viable method of predicting the greatest losses for population segments.
Like Prop 103 here in California, some politicians would have us believe there is some great inequity in how every rating is accomplished, and all policyholders should be considered equal. Thus, every driver should be considered equal, no matter where they drive, where their vehicle is parked or where they are domiciled.
The middle of a Section 8 housing project should receive the same rate as a gated community, regardless of loss ratio differentials, just to preclude profiling based on potential ethnicity and neighborhood. With ZIP code rating influence out of the picture, what's left? Credit scoring.
Thanks, Uncle Sam. Maybe the light has finally started to shine in the dark cortex of the judicial gray matter....
Posted by BJ | July 23, 2007 12:40 PM
Posted on July 23, 2007 12:40
Credit scoring in an automated underwriting tool. It provides an automated way to underwrite business. Exactly how accurate or fair the system is does not really seem to be a concern.
The fall out of the sub-prime lending world will surely send average credit scores in a downward spiral. It will be interesting to see industries using this data react. (Insurance, banks, credit card companies, wireless phone carriers, utilities.)
Posted by Gloria | July 23, 2007 3:20 PM
Posted on July 23, 2007 15:20
It has been said in Mr. Friedman's blog many times before: Credit scoring is only ONE part of proper underwriting of a risk.
There is still the major factor of driving history, along with the type of vehicle and previous loss history that need to be heavily considered before looking at the credit score.
Sometimes people have an emergency that causes them to fall behind in debt but make every attempt to rectify the debt as soon as they can. These are the type of customers that I would want. Honor, commitment and desire to do things the right way.
Should they be penalized if they have made good on the past debts? Not in my book.
Another underwriting tool that I feel helps loss ratios is the inspection of the vehicle. Those companies that require the vehicles to be insured to be inspected as well is one of the best ways to see the attitude of the applicant in terms of pride of ownership. Inspections of the vehicle are also a great way to reduce the potential for fraudulent claims to be made.
Some agents back in 1992 told me that when the company they represented mandated inspections of the vehicles, they saw new applications drop some, but their loss ratios improved.
Apparently, when applicants were told that they must come by the office and have pictures taken of their vehicles for the applications, some just hung up. I wonder why?
Posted by J R Baker | July 23, 2007 3:37 PM
Posted on July 23, 2007 15:37
I take issue with some of BJ's comments and his summary on the insurance scoring issue.
If the insurance score for an individual was an amalgam of credit history, driving record, loss and payment history, and driving/vehicle profile, I would probably not have any objection to it. However, if it is primarily credit history, then I do.
If an insured has an existing record of good driving and loss experience, as well as a history of paying their premiums in a timely fashion, those should be the overriding factors in determining that individual's premium rate--not his credit score, which could be in error or affected by factors other than his lack of financial discipline.
If the the so-called insurance score is such a scientific way of predicting loss experience, then everyone who has a low score should have a poor driving and loss history.
As a 30-plus-year producer, I can tell you with certainty that many low-to-medium scorers have good driving records, no claims and are excellent paying clients.
And, conversely, some high scorers are bad risks and poor payers.
It's a flawed system based on less than perfect assumptions. It will eventually be outlawed and replaced, in my opinion.
Posted by Steve Daroff | July 24, 2007 1:03 PM
Posted on July 24, 2007 13:03
I agree with Steve, it is flawed. Very much so! So is ZIP code rating when you consider the periphery of some ZIP codes intrude into lower socio-economic areas and may not truly be factored into the ZIP code rate without the dreaded "redlining" we heard so much about years ago.
Driving records are also flawed. We look at a person's driving record only as it pertains to his use of a personal vehicle and not as it pertains to his commercial driving.
States and federal rules have neatly squirreled violations while driving commercially out of the realm of insurance rating. Having worked both law enforcement and insurance, I see both sides of the coin and the insurance company stays in the dark on those on the job commercial violations for ths most part.
So, where do you go for HONEST rating information? I agree, type of vehicle, lack of modifications, driving records for non-commercials (although I believe we should have access freely to all) credit scores, place of abode, work history, how and where they drive are all important factors, and all deserve significant weight.
Posted by BJ | July 25, 2007 9:42 PM
Posted on July 25, 2007 21:42