Pros & Cons of using credit scores

Randy Carroll, CEO, Insurance Brokers Association of Ontario (IBAO)

A woman called the offices of the Insurance Brokers Association of Ontario (IBAO) recently, confused and worried. After 14 years as a customer of a particular carrier, she’d just learned that her policy wouldn’t be renewed–not because she’d missed a payment (ever), not because she’d filed a claim (never did)–but because the carrier had started using credit scores to assess risks. With a low score, she’d been deemed too risky.

IBAO chief executive officer, Randy Carroll, calls it “the most difficult conversation I have had.” But it’s the sort of conversation that brokers and agents might need to get used to having as the use of credit scores in risk assessments becomes more common.

Ask around the industry, and you’ll find people have all sorts of opinions about the practice. Some say credit scores have proven to be an excellent indicator of risk, and should be considered. Others say credit scores confuse customers and go against the very principles of insurance.

New Opportunities
There are pros and cons, either way. Circle back to the woman we introduced earlier. Carroll says the IBAO was able to find a new carrier for her. That’s good news for the customer, of course–but it’s also a positive for the company that took her on. While many insurers seem to be using credit scores, a handful, including Peace Hills Insurance, The Dominion of Canada Insurance Co., Axa Canada, and Wawanesa Insurance, don’t, Carroll says, pointing to the obvious pro here–some carriers could find that their business picks up.

The con is equally clear: others could lose business. In the woman’s case, a carrier lost a reliable, generally low-risk and profitable client.

“It’s a risk for the carrier,” Carroll says. “But for some, it’s a risk they’re willing to take.”

In fact, it’s a risk that some insurers find necessary. Since the credit score controversy hit the media about a year ago, it seems more and more carriers are using credit ratings to inform policy prices. “It’s been a domino effect,” Carroll says. “When it started to get rampant,” carriers turned on their business-defence systems: if everyone else is using it, we’d better use it too, or risk losing money on policies we might have known were underpriced.

The media frenzy surrounding this issue may have started with The Co-operators Group Ltd., which bravely sent letters to property customers last year indicating that the firm would start using credit scores in its underwriting practices. Reporters for daily newspapers got wind of it, and started asking questions.

“We weren’t crazy about being the poster child for using credit scores, but at the end of the day… it raises the issue,” says Leonard Sharman, The Co-operators’ media relations specialist.

Credit management and how well you manage your financial situation is a good indicator of how you’ll manage everything else in your life.

Public Interest
Here’s another potential pro–getting the public interested in insurance.

Since sending those letters, The Co-operators has had plenty of opportunities to explain to policyholders (and reporters) just what this issue is all about. According to Sharman, that helped set a few things straight.

He notes that it’s a tricky subject. “It’s just not intuitive. Among the concerns we’ve got is, ‘I’ve always paid my insurance on time. Why would you think my credit score is more important than that?’ They assume we’re checking their credit score to see whether they’re going to pay their premiums on time. That’s not the case. We’re checking their credit score 100% because it’s predictive of whether or not they’ll have claims, and how big those claims will be.”

Others think it’s related to fraud–that the insurance company figures the lower the credit score, the greater the risk that the customer would try to swindle the carrier. But that’s not it either. “The reason we use it and other companies use it is… it’s predictive,” Sharman says.

But predictive of what? It all leads back to risk, explains Kevin John Leonard, a professor in the Department of Health Policy, Management and Evaluation at the University of Toronto. A former employee of Fair Isaac Corp. in Minneapolis, he witnessed how FICO–the decision management powerhouse that created the FICO score so often used in credit risk analyses–came to view credit ratings as solid risk indicators across various aspects of everyday life.

“We saw the relationship between people’s credit history and their likelihood of cheating on their taxes, the likelihood of them having a car accident, the likelihood of them having a claim on their house insurance, and the likelihood of having their wallet lost or stolen,” Leonard says. “Credit management and how well you manage your financial situation is a good indicator of how you’ll manage everything else in your life.”

It wasn’t always thus. As Leonard explains, before credit scoring became common–before the 1960s–“a lot of decisions were made subjectively. Unless people had the right profile, when they came into a bank for a loan or to apply for credit, they’d be turned down based on a lot of subjective stuff.

“Credit scoring allowed a number of things to happen,” he says. “Once the data was captured, you could build reliable models; it allowed you to build better decision tools and it made it fair for everybody.”

Over time, that changed. “Fastforward to the early 2000s…. Organizations had very large credit card portfolios, mainly in the U.S. And they became very greedy. The only way to expand your market share was to amass more and more customers.

“They started dipping below the line beyond where you really should extend credit, to people who couldn’t afford it.”

We’re living the fallout, Leonard says. “Boom. Everybody goes bankrupt. Now we’re in this massive economic decline driven by credit greed in the U.S. of about five to 10 years ago.”

This is Equality?
The picture Leonard paints depicts equality–as long as companies use credit scores responsibly, we have a level playing field built on fair assessments, rather than subjectivity. But is that really the case? Carroll argues it isn’t. If anything, credit scores skew the industry such that the poor subsidize the rich.

“When we go back and ask brokers to look at the files to see who’s been affected most, it’s single-parent families, new Canadians, the unemployed, and small business owners that have extended their personal credit to keep their businesses afloat.”

That last one is particularly sticky. Small businesses are the engines of Canada’s economy–more than 90% of the businesses in this country count as “SMBs”–small and mid-sized, according to Statistics Canada. But these mom and pop shops are struggling because of the economic downturn already–and here we have a case where the insurance industry might be hurting them even more by applying credit scores to their policy rates.

Yet–as Sharman says–credit scores are predictive; they’re good tools that reward low-risk customers and punish high-risk customers; inasmuch as a poor driving record indicates high risk, a poor credit score is just another tool that helps carriers manage risk.

“You will not get me arguing that fact at all,” Carroll says. “Do we want to subject the affordability and availability of insurance based on somebody’s credit? Do we want this to become a social issue?”

Leonard suggests this may have already become a social issue. For one thing, it brings credit scores–largely an aspect of discretionary spending–into insurance, a necessity by law in most cases.

“Credit is somewhat voluntary,” Leonard says. “I don’t really need that new sofa, or the big-screen TV…. You need insurance. This isn’t something you can choose.”

In the U.S., companies aren’t allowed to incorporate non-payments from medical bills into people’s credit scores. Sickness isn’t discretionary; health care is mandatory. “It’s something they didn’t choose to do,” Leonard says. “Credit modelling is based on people’s willingness and their use of credit in their lives.”

So should credit scores be allowed in insurance–or not? “I don’t have the answer,” Leonard says.

Carroll seems to think the IBAO does. The organization is calling on the Ontario government to ban the use of credit scores in all lines. Carriers in Ontario are allowed to use credit scores in their property lines, but not in auto. If the IBAO gets its way, credit scores would be banned across the board.

“We think government will respond favourably,” Carroll says.

How will consumers react? It’s difficult to say–as Sharman points out, The Co-operators have heard more from customers whose rates went up because of their poor credit scores, but people who’ve witnessed lower rates seem contentedly silent.

“Those folks don’t seem to have the same concerns,” he says.

© Copyright 2010 Rogers Publishing Ltd. This article first appeared in the April 2010 edition of Canadian Insurance Top Broker magazine.

This story was originally published by Canadian Insurance Top Broker.