Public Policy Analysis & Opinion

Remain calm: All is well

Congress investigates credit-based underwriting and pricing

By Kevin P. Hennosy

On May 12, 2010, Congressman Luis V. Gutierrez (D-Ill.) called to order a hearing of the House Financial Services Committee, Subcommittee on Financial Institutions and Consumer Credit. The hearing concerned the “Use of Credit Information Beyond Lending: Issues and Reform Proposals.”

Chairman Gutierrez introduced the issue with this observation: “When legislators or regulators attempt to fully grasp an issue such as credit- based insurance scores, they see a complex system, laden with algorithms and ever-changing computer applications and models. But it is precisely this complexity that should make us here in the Congress delve further into an issue that affects every single American who owns or rents a house, a car, has insurance, has a job or is looking for a job, or is likely to incur medical debt.”

Furthermore, Chairman Gutierrez framed the issue in terms of how people don’t understand much about the relatively new connection between their credit score and the ability to secure or pay for insurance, or even find a job.

“Do most consumers know that their car or homeowners insurance rates may go up due to their credit score? Do they know that if one of their medical bills goes to a collection agency and they pay it in full or settle it, it will still affect their credit report for up to seven years? Do people realize that, even in these tough economic times, pre-employment consumer credit checks are increasingly widespread, trapping many people in a cycle of debt that makes it harder to pay off their debts and harder for them to get the job that would allow them to pay off their debts? Indeed, the current system facilitates the denial of employment to those who have bad debt, even though bad debt oftentimes results from…the denial of employment.”

The history

Since 1993, insurers have used credit data as part of the underwriting and pricing structure. At first, credit-based underwriting and pricing was rare, but now the vast majority of insurance carriers use it in the personal lines market.

Originally, the criticism of the use of credit history to underwrite and price insurance products centered on the technique’s ability to predict the race of an applicant or policyholder. In 1993, insurance regulators and Congress were cracking down on traditional systems of “red-lining” racial and ethnic minority communities. This pressure intensified after the South-Central Los Angeles Riot, which once again emphasized that insurance red-lining enabled banks and other financial institutions to “legally” redline: Banks do not have to lend to properties that cannot be insured.

Traditionally, unethical insurers red-lined geographic regions based on concentrations of minority residents. As recently as the late 1990s, investi­gators found a major insurance carrier using paper maps with minority/majority neighborhoods in Louisville, Kentucky, outlined using a red marking pen. Agents and brokers were not allowed to submit policy applications from inside those red lines on the map.

By the turn of the current century, major insurers introduced credit history into the underwriting and pricing process on a widespread basis. Consumer advocates alleged that instead of red-lining, insurers were red-flagging individual applicants and policyholders based on race, without having to ask “the race question” or eliminate entire neighborhoods.

Credit scores were established using norms and assumptions that matched white, middle-class experi­ence. If an individual or demographic class did not share that set of experiences, even if they paid their bills on time using money orders or cash rather than a checking account, their credit scores would suffer. The argument followed that people of color “looked different” statistically when credit history was analyzed.

Lack of transparency

Industry advocates argued that lower credit scores actually served as a prime predictor of future financial losses. The credibility of these assertions suffered because industry advocates refused to make public either the procedures used to produce credit scores, or how the credit scores were used in the underwriting and pricing process. Insurance regulators were denied access to credit rating agencies on jurisdictional grounds.

Numerous reports were published on the subject of credit-based underwriting and pricing without much consensus. Industry-sponsored reports claimed that the use of credit information was the greatest innovation since sliced bread but offered no reputable tests to support their results. Consumer groups offered reports that criticized the practice, but without access to data and procedures these reports were dismissed as “anecdotal.”

The Federal Trade Commission finally weighed in on the discussion by issuing a controversial report that contradicted the commission’s initial findings and endorsed credit-based underwriting and pricing. Looking back, the commission’s final report seems to follow the trend of regulatory and enforcement agencies (like those with jurisdiction over coal mining and off-shore oil drilling) that do not want to be a burden to industry by fulfilling their public mandate.

A new wrinkle

After the financial crisis of 2007-2008, a new concern arose regarding credit-based underwriting and pricing. The personal lines property/casualty subsector has profited from the economic downturn. As millions of Americans faced declining wages or lost jobs due to Wall Street’s sins, the use of credit scores to underwrite and price insurance allowed insurers to raise rates through denial of “discounts” and other methods.

As Chairman Gutierrez noted, few consumers or policymakers know or understand that in the view of most insurance carriers, a late payment on a credit card bill makes your neighbor’s tree more likely to fall on your car.

Personally, I have never believed the contention that credit scores, or insurance scores, presented an accurate predictor of future claims for financial losses arising from covered occurrences or perils. Yet, the causal relationship between credit data and the risk of financial loss is now a matter of doctrinal certainty to many insurance professionals. Of course, the Earth-centered universe was once accepted without question too.

Issues like credit-based underwriting and pricing remind me of an observation made by President John F. Kennedy: “There are three things in life that are real: God, human folly and laughter; since the first two are beyond our comprehension we must do what we can with the third.”

Which is why when I look at the National Association of Insurance Commissioners (NAIC), a center for human folly, I tend to compare the association’s activities to various aspects of the 1978, screwball comedy classic, “Animal House.”

The scene in “Animal House” that most makes me think of the NAIC comes at the end of the film. Chip Diller is proudly wearing the faux authority of an Reserve Officer Training Corp uniform, when a frightened crowd of people tramples him into the sidewalk after he utters the immortal line: “Remain calm, all is well!”

It does not matter whether Chip Diller really believed all was well, or whether the NAIC believes it operates in the public interest. There is a wrong side of history.

The NAIC submitted testimony to Chairman Gutierrez’s subcommittee, which seemed designed “not to offend” rather than address public policy. The NAIC stands foursquare for tough, aggressive regulation, as long as nothing is actually regulated.

Illinois Director of Insurance Michael T. McRaith, who is chair of the NAIC Property and Casualty Committee, used his testimony to explain the Illinois approach to regulating credit-based underwriting and pricing. The Illinois model depends on consumer disclosure to police potential abuses.

Director McRaith explained: “In Illinois, an insurer is required to inform the consumer at the time of application that credit information may be considered by the insurer. If the credit information causes an insurer to take an ‘adverse action’ against the consumer, then the insurer must notify the consumer. An ‘adverse action’ can include not offering the ‘best rate,’ not providing a discount, demanding a higher rate, or denying, canceling or non-renewing the policy. In other words, insurers have broad discretion about the use and impact of credit information.”

The value of the consumer disclosure approach to regulating markets assumes that markets are competitive and that the consumer is able to make an informed choice among competing products.

David Snyder, vice president and assistant general counsel of the American Insurance Association (AIA) delivered additional testimony. Snyder is a personable fellow, but I really cannot remember an issue over the past 15 years where he argued on behalf of people over profits.

Snyder observed that approxi­mately 90% of personal lines property/casualty insurance carriers now use some form of credit-based underwriting and pricing. Some carriers give the credit score (or insurance score in order to hide behind the McCarran-Ferguson limited exemption from antitrust enforcement) a little more, or a little less weight—but 90% of the market is 90% of the market.

If a customer receives a notice of adverse impact from an insurance carrier, what real worth is that to the customer? Even if consumers understand the complex vagaries of credit-based underwriting and pricing, where are they supposed to go to use that information to their advantage?

Perhaps the most galling assertion made in the American Insurance Association testimony relates to the Herfindahl-Hirschman Index (HHI), a measure of market concentration and competitiveness.

Snyder testified that when the HHI is applied to the personal lines property/casualty sector, it produces a result that ranks low on the scale of concentration (.333).

While the use of the HHI sounds “science-like,” as in something Mr. Wizard might approve of, the HHI measurement is not suitable for use in the insurance sector.

The HHI assumes that all partici­pants in a market are “competitors” that seek the same business and create products and prices to that end.

To apply those assumptions to the personal lines property/casualty sector simply ignores the widespread use of “advisory forms and rates” that are not subject to competitive forces. In addition, it ignores the fact that ABC1 Insurance Holding Company might form several participating companies to sell business to different classes of applicants—but these companies do not compete. Yet, the HHI assumes that as market participants these companies are competitors.

Inaccurate data

One important reason that there is an intuitive bias against using credit history to measure property and liability risk is that credit data is notoriously inaccurate. As Congresswoman Maxine Waters (D-Calif.) observed:

Furthermore, sometimes credit scores just aren’t accurate. Some consumers that identify errors on their credit reports—which can in turn impact their credit score—have a hard time getting that negative information removed. Moreover, consumers that receive loan modifications can see their score drop by 100 points, even though they are making their newly modified mortgage payments on time. Given the problems with accurate credit reporting, it is simply unfair for a person to be denied employment because of a low score.

Nor should it be a reason to raise insurance rates or deny insurance coverage. Uninsured and unemployed people, with no path to economic security can only form a sub-culture, which concentrates risk. A permanent divide between rich and poor runs counter to the promise that makes the United States a beacon of freedom to the world.

Congresswoman Waters has promised to reintroduce legislation designed to ban the use of credit-based under­writing and pricing by insurers.

The author
Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide Insurance Cos. and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.