Casualty Actuaries Updated On Debate Over Industry’s Use Of Credit Scores

 

San Diego, CA – The use of credit by many insurance companies as a rating, tiering, or underwriting factor continues to come under intense scrutiny, strengthened by the current economic situation and a belief by many that resulting hardships have led to a worsening of credit scores, causing increased insurance rates by many companies.  A panel session at the Casualty Actuarial Society’s recent Spring Meeting discussed developments on the issue within the National Association of Insurance Commissioners (NAIC), reviewed points raised by the American Academy of Actuaries (the Academy) at NAIC hearings on the subject, and examined current industry viewpoints.

“The increasing use of credit-based insurance scores is one of the most important developments that has happened in automobile and homeowner insurance personal lines
underwriting and rating, and over time there has been increased use of credit-based scores as an analytical tool both for underwriting risk and for pricing risk,” said Eric Nordman, the NAIC’s director of regulatory services. 

During the past 20 years, many consumer groups and regulators have questioned the reliability and predictability of the scores and the possible disproportionate or disparate impact on minority and low-income populations, he said.  These have long been a cry of the consumer groups as a reason they challenge the use of credit-based insurance scores in insurance underwriting and pricing, Nordman said.

The controversy revolves around whether it is predictive and not everyone agrees that it is, he said.  Some are concerned that the weighting of the characteristics and the formulas that make up the scores are unknown to regulators and policyholders; others are concerned the scores may be correlated with income or other demographic traits that might otherwise be prohibited as risk classifications; while still others observe the recent economic downturn may have a detrimental effect on policyholders who have been adversely affected by the economy, he said.

Nordman said his organization held extensive public hearings and committee meetings on the issue during 2009-2010, explaining how insurers use credit-based insurance scores and discussing how current economic conditions have affected policyholder premiums related to the scores.

Gary Josephson, principal and consulting actuary with Milliman, Inc., discussed the comment letter and testimony provided by the Academy at the April 30, 2009 NAIC hearing available at http://actuary.org/pdf/casualty/scores_testimony_apr09.pdf .

Josephson explained that the Academy’s paper addressed the group’s role and provided a definition of credit-based insurance scores, along with the actuarial framework for their use in rating and risk classification.  The paper also discussed how insurers are using the scores and how the economic situation may have impacted premiums relative to scores.  “By bringing strong credibility the Academy is seeking to assist the NAIC in determining the effect credit-based insurance scores have on insurance and offer assistance on follow-up research,” he added.

“The NAIC committee on the issue is still active and exploring it,” Josephson said, “and while vendors of credit-based insurance scores are now subject to more regulation, the issue continues to be a hot topic and public advocates continue to be disappointed that credit is still being used.”

Providing an assessment and a view on consumer credit trends, Richard Babel, senior director of analytics for LexisNexis® Insurance Solutions, told the actuaries he would demonstrate that the economy didn’t have an adverse effect on credit-based insurance scores. 

“Insurance models use a mixture of attributes to rank loss propensity,” Babel explained, “These attributes are items such as age of a credit account, the number of credit inquiries, credit utilization, payment behavior and derogatory public records. Most insurance models use these attributes, which have been proven to correlate to the likelihood that an insurance claim will be filed.”

LexisNexis® data shows that the average credit account age increased from 2007 to 2009 because of credit tightening, creating better credit-based insurance scores that resulted in lower risk and lower insurance premiums. In addition, LexisNexis data shows average credit inquires significantly decreased between 2007 and 2009.

“We believe this is also a result of credit tightening, leading to better scores, lower risk and lower premiums for insurance consumers,” said Babel. “While these attributes improved scores we did not see a significant change in credit utilization, payment behavior or derogatory public records, which would have worsened scores.”

He said that examining the basics of credit models shows that scores for insurance models are developed based on historical insurance losses, while banking or financial models are developed using bad debt and delinquencies.  Insurance scores rank order policies based on a propensity for an insurance loss. Financial scores rank order credit problems, identifying which policies have a better chance to create a bad debt or delinquency. 

The Casualty Actuarial Society Spring Meeting was held May 23-26. The CAS fulfills its mission to advance actuarial science through a focus on research and education.  Among its 5,200 members are experts in property-casualty insurance, reinsurance, finance, risk management, and enterprise risk management.