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Testimony by Peter J. Molinaro, Senior Deputy Superintendent of Insurance, before the New York State Assembly Standing Committee on Insurance and the New York State Assembly Puerto Rican/Hispanic Task Force on the use of Personal Consumer Credit Information to Underwrite and/or Rate Personal Lines Products

October 22, 2003

I. Introduction

Good morning. I would like to thank you, Assemblyman Grannis and Assemblyman Rivera, and members of the Committees, for the opportunity to testify at this hearing.

Today, the Insurance Department has been asked to testify on a topic that has been hotly debated over the last few years by consumer groups, insurance regulators and the insurance industry alike. Few issues in the past have sparked as much interest and discussion as the insurance industry’s use of personal consumer credit information to underwrite and/or rate personal lines products. There are several reasons for the attention given to this issue.

The question that is raised most often during these debates is whether there is a significant correlation between a person’s credit history and that person’s loss propensity. Secondly, there are many questions about the fundamental fairness of the use of credit scores and the disparate impact of this practice on low-income and minority groups. Thirdly, even if there is a correlation, the use of credit information is extremely difficult to explain to the consumer. How does one explain the relationship between a bounced check and denial of coverage or higher policy premiums? Finally, the "black box" aspect of credit scoring models, where the utilized criteria and computations are generally proprietary, results in lack of transparency for regulators and consumers alike.

Insurers, however, contend that studies show a correlation between credit scores and loss propensity. The insurance industry argues that the use of credit history is fair and benefits consumers whose good credit scores indicate lower risks. Insurers also assert that using consumer credit history is non-discriminatory because it is "color blind" and because there is no consistent correlation between income level and credit score.

The states, the District of Columbia, members of the National Association of Insurance Commissioners (NAIC), as well as the NAIC itself, and other groups representing state insurance policymakers, have been hotbeds of activity in the areas of evaluating and regulating the use and protection of consumer credit information. While many states have either prohibited or curtailed the use of credit scores for underwriting and/or rating purposes, there are others that permit this practice recognizing the notion that credit history has a role to play in the procurement and price of insurance. Through the underwriting process, an insurer decides whether to write a new piece of business and the placement of the risk in an appropriate rating tier if the risk is accepted. In New York, insurers are permitted to have rating tiers in the same company, and many insurers have such tiers to accommodate a range of risks. Rating, in contrast to underwriting, refers to subsequent changes in premiums, including tier movement, that occurs after an insured has been accepted by an insurer and placed in a particular rating tier. In New York, use of credit scores has not been permitted for rating purposes, including tier movement upon renewal. However, inasmuch as the Insurance Department does not have the statutory authority to regulate an insurer’s underwriting practice, credit scoring can be, and is, utilized by many insurers in New York to underwrite applicants, including initial tier placement of accepted risks. It is important to note, though, that if an insurer uses credit information to take any adverse action, such as refusal to issue a policy, it must comply with the disclosure requirements of Insurance Law Section 3425, Regulation No. 90, the Federal Fair Credit Reporting Act and the New York Fair Credit Reporting Act.

The common thread running through the actions of the NAIC and its members, and the state legislatures, of course, is the Fair Credit Reporting Act (FCRA). With its articulated goals of preserving fairness and equity for consumers in the ways that businesses utilize consumer credit information and its objective of maintaining uniformity for ease to both business and consumer alike, the FCRA has been the core of all regulatory and enforcement activities undertaken in recent years.

The Insurance Department also recognizes that the FCRA provides an important tool to insurers and consumers by requiring accurate and complete credit reports. FCRA specifically applies to credit report information used to determine eligibility for insurance and defines certain parameters under which that information can be used and disclosed. In addition, FCRA preempts state laws to the extent they conflict with the federal law and explicitly prohibits states from enacting laws and regulations on issues already covered by FCRA even if they do not conflict.

Consumer groups, while conceding that credit scoring may not be intentionally discriminatory, claim the practice may nonetheless produce a disparate impact that unjustly harms minorities and the poor. Consumer groups also contend that the data in credit reports can be inaccurate and that the process for correcting inaccuracies is cumbersome and time-consuming. Moreover, credit scoring models and how they are used vary from one insurance company to another. Therefore, it can be difficult for consumers to know how they are affected when credit scores are used as one element in a complex formula for determining rates or assigning consumers to risk pools.

The debate on this issue continues at state legislatures, the U.S. Congress, National Conference of Insurance Legislators (NCOIL) and the NAIC. Regardless of the outcome of these debates, the Insurance Department stands ready to protect the interests of the insurance consumer in New York State.

Today, I will provide an update on the current debate over insurers’ use of credit scores in the underwriting and rating of insurance, and the legislative and regulatory approaches the states are using to ensure credit scores are used fairly.

II. What is Credit Scoring?

Over the past several years, insurers have begun using consumer credit information, along with other information, to decide whether, and at what rates, to issue or renew a homeowners or private passenger automobile insurance policy. Insurers, employing modeling techniques, then use this credit information to create a credit score. A credit score is a snapshot of an individual’s credit at a point in time. The credit information from a credit report is entered into a mathematical model that assigns weights to the various factors and reduces the credit information to a three-digit number ranging from 000 to 999. Typically, the higher the number, the more financially responsible the consumer. The factors that generally determine a credit score include, but are not limited to, outstanding debt, past payment history, length of credit history, inquiries for credit, etc. An insurer generally uses a consumer’s credit score in combination with traditional factors for measuring risk such as loss history, construction type, driving record, prior accidents, geographic area, age and gender of the consumer.

For the most part, insurers do not develop the credit scoring model themselves. They purchase commercially developed models from other firms such as Fair Isaac or ChoicePoint. The inner workings of these models are proprietary, and in most instances, even the insurer that purchases the model does not have access to the "inside" of the model. Insurers simply have access to the input and the output modules. Needless to say, the details of the model are generally not revealed to the regulator as well.

Since the mid-nineties, insurers’ use of credit scoring has increased and so has the intensity of the public policy debate about this practice. While FCRA allows insurers to use credit reports in determining eligibility for insurance, the states are integrally involved in this issue because, as the regulators of the business of insurance, the states regulate the use of such information as part of their oversight of insurers and to ensure the protection of consumers.

III. The Debate

Key issues that fuel the debate on the use of credit scoring are whether there is any correlation between credit scores and risk of loss, whether credit scores should be used in underwriting, including initial tier or company placement, whether credit scores should be used for rating purposes, the "black box" aspect of credit scoring models which results in lack of transparency for regulators and consumers alike, and the need to educate consumers regarding the use of credit information by insurers.

Earlier this year, a study released by the Bureau of Business Research at the University of Texas at Austin concluded that there is a significant statistical relationship between a person’s credit history and incurred losses. In general, the study found that those with lower credit scores incurred more losses and conversely those with higher credit scores incurred fewer losses. Similarly, the American Academy of Actuaries, at the request of the NAIC Credit Scoring Working Group, evaluated four studies on insurance credit scoring. The studies are:

  1. The Impact of Personal Insurance Credit History on Loss Performance in Personal Lines by James E. Monaghan (2000);
  2. Insurance Scoring in Personal Automobile Insurance - Breaking the Silence by Conning & Company (2001);
  3. Predictiveness of Credit History for Insurance Loss Ratio Relativities by Fair Isaac (1999); and
  4. Use of Credit Reports in Underwriting by the Commonwealth of Virginia, State Corporation Commission, Bureau of Insurance (1999).

Based on their review of the four studies and their expertise in the development and review of rating models based on credit history, Academy members that reviewed the studies believe that credit history can be used effectively to differentiate between groups of policyholders. Therefore, they believe credit scoring is an effective tool in the underwriting and rating of personal lines of insurance. Having said that, they also concluded that none of the four studies contained the necessary information to enable an evaluation as to whether credit-related insurance scoring results in a disproportionate impact for protected classes or for low-income policyholders.

The insurance industry, therefore, contends that these types of studies demonstrate that a person who properly manages his or her financial affairs, thereby producing a higher credit score, is a better risk than a person who generates a lower credit score.

But while these studies show a correlation between credit history and risk of loss, it is difficult to demonstrate a causal relationship between credit scoring and an insurer’s ability to predict insurance losses. Consumers groups argue that even if a correlation exists, a statistical causal relationship must be demonstrated before credit history may be used as underwriting or rating tool. The industry counters that while causality may be desirable, it has never been a statutory requirement for rating variables in personal lines products. For example, sex and marital status have long been used, and similar to credit, these variables have little direct bearing upon a person’s ability to drive. This issue, though, is further complicated because much of the information which proves the correlation between credit history and risk of loss is proprietary in nature. As noted above, credit scoring is based on models that utilize credit data, and the details and methods used to establish the credit score are proprietary to the vendor. The "black box" approach makes it difficult for the Department to discharge its rate approval functions since neither the Department, the insurers, nor the consumer can be certain how the score is established, or even the variables used in the determination of the score.

It is precisely for this reason that the New York Insurance Department, with one exception, has not approved the use of credit information for rating personal lines policies.

The one filing that was approved allowed credit information to be used for the purpose of granting a discount to insureds possessing what the insurer determined to be "good" credit characteristics. This discount differed from the usual "credit score" proposals in that it did not use the "black-box" approach based on a model. Rather, the filing contained selected, specific credit characteristics that appear to be correlated with the loss experience of insureds. The Department approved this insurer’s use of credit reports in the determination of a discount on automobile insurance rates on an experimental basis, provided the insurer complied with the disclosure requirements for an "adverse action" under Federal and State law, whereby the insurer agreed to provide an appropriate notice to any affected insured.

As insurers continue to rely on the use of credit scoring for underwriting purposes, consumers must be made aware of this practice and be educated on its use. It is imperative that consumers ask their insurer whether their credit score will be used for underwriting and/or rating purposes. Consumers should also be aware that not all insurers utilize credit scores in the underwriting or rating processes, and shopping around for best coverage and price remains a very good idea. In addition, consumers should periodically check their credit report to verify its accuracy because errors can, and do, occur. If there are errors in the credit report, the consumer should take corrective action immediately.

IV. Legislative and Regulatory Actions

The majority of state legislatures have either introduced or passed legislation that regulate or restrict the use of credit scores in private passenger automobile and homeowners insurance. Many states have introduced the National Conference of Insurance Legislators (NCOIL) Model Act or some version of it. The NCOIL Model Act prohibits insurers from using credit information as the sole basis for increasing rates or denying, canceling or non-renewing coverage. The Model Act requires insurers:

The Model Act also prohibits a consumer reporting agency from providing or selling information submitted in conjunction with an insurance inquiry about a consumer’s credit information or a request for a credit report or insurance score.

In 2003, 14 states passed legislation limiting the use of credit scoring for personal lines products, 10 of which passed legislation that closely tracks the language in the NCOIL Model Act.

In New York, there are a number of bills pending in the Legislature, limiting or prohibiting the use of credit scoring in an insurer's underwriting criteria, including a version of the NCOIL Model Act. Other than the NCOIL Model, these bills generally prohibit an insurer from using a person's credit history in the setting of rates for homeowners' insurance; prohibit an insurer from using a person's credit history in determining whether or not to issue or renew a motor vehicle liability insurance policy; and prohibit an insurer from using a consumer's credit history in the determination of rates and premiums and in determining whether to cancel, deny or non-renew any kind of insurance policy.

While many states continue to take actions limiting the use of credit scoring, the federal government is beginning to weigh-in on the issue of credit scoring. Earlier this year, the U.S. House of Representatives passed the Fair and Accurate Credit Transactions Act which permanently re-authorizes the expiring uniform national standards of the FCRA (H.R. 2622). In 1996, FCRA was amended to create a uniform national standard for consumer protections governing credit transactions, and those provisions are scheduled to expire on January 1, 2004. Included in the House version of the Fair and Accurate Credit Transactions Act, is a provision requiring the General Accounting Office (GAO) to conduct a study of the credit system to determine the extent to which, if any, discrimination exists with regard to the availability, and the terms, of credit and which has a disparate impact on the basis of race, color, income/education level, geography, age, sex, sexual orientation, national origin or marital status and the nature of any such discriminatory effect. The bill directs the GAO to complete the study within two years along with any recommended legislative or administrative action. In addition, the House bill directs the Federal Trade Commission (FTC) to conduct a study of the accuracy and completeness of information contained in consumer reports prepared or maintained by consumer reporting agencies and methods for improving the accuracy and completeness of such information. The report, which must also be completed within two years, must contain a detailed summary of the findings and conclusions along with recommendations for legislative and administrative action.

The U.S. Senate also has their own version to permanently reauthorize the expiring uniform national standards of the FCRA. Similar to H.R. 2622, the Senate bill includes a study on the use of credit scoring. The bill directs the FTC to conduct a study on the use of credit information by financial services companies, including insurers’ use of credit scoring. The study will evaluate whether the use of credit information has an effect on the affordability and availability of financial services products and the degree to which it may have a "disparate impact" on various demographic groups. The bill requires the FTC to make recommendations for legislative or administrative actions and to complete the study within 18 months of the bill’s passage.

Since both the House and Senate versions prescribe a study on the use of credit scoring and the potential disparate impact of the practice, the study is likely to be included in the final draft of a conference committee reported bill. In addition, passage of this bill should occur sometime before the end of the year as the state preemptive provisions of FCRA are set to expire on January 1, 2004.

V. Conclusion

Generally speaking, an insurer’s classification system should make sense, be easy to understand and explainable to consumers, and be operationally feasible. The question then becomes how far should the insurance industry be permitted to go in terms of classifying insureds. The various studies conducted so far indicate that there is some correlation between a person’s credit score and loss propensity. The issue before this committee is the extent to which a person’s credit score should be used in the underwriting or rating of personal lines insurance. As you proceed with your deliberations, I urge you to keep in mind what I stated earlier - the central purpose of the New York Insurance Department is to protect consumers. Making sure this complicated system is used fairly and for the benefit of consumers, and helping consumers understand their rights and responsibilities is our ultimate goal. Whatever the final result is, either in Washington, D.C. or in New York, the Department stands ready to ready to work with the Legislature to ensure that all New Yorkers are protected and treated fairly when their personal credit information is utilized by the insurance industry.

Thank you and I will be happy to take any questions.