MEMORANDUM

TO:                        Mr. Ted Jankowski

FROM:                  Rep. Lee Gonzales’ Office

DATE:                  January 11, 2005

RE:                        Insurance use of Credit Scoring

How do insurance companies use credit information?

The scores used by insurance companies are derived by running information obtained from people’s credit histories through a special mathematical formula either created by or purchased by the insurance company.  Generally, the lower the credit score, the higher the premium.  In Michigan, while insurers are barred from using this information to set base rates or deny an individual insurance under the Essential Insurance Act, the insurance company may use the information to offer those with “better” scores a discount on their premium. 

State insurance regulators and other organizations have examined the use of credit scores since the insurance industry began using them in the 1980s. While the evidence shows that (as noted by Michigan Office of Financial and Insurance Services (former commissioner Frank Fitzgerald)) a correlation exists between a credit score and the likelihood that a person will file a claim, it should be noted that the language used here is important – the correlation that the insurance industry has found and wants to use in setting their rates is NOT a correlation between one’s credit history and the likelihood that he or she will be in an accident – it is a correlation between credit history and the likelihood that the person will file a claim.   This is a significant difference as a person who has a claim against his or her insurance has two options – to file the claim and ask the insurance company to cover the loss or to pay for the loss themselves.  The use of a person’s credit score helps the insurance company to know whether or not the person will actually file the claim (not whether they will be in an accident). 

It does not take a genius to understand why people with good credit file fewer claims than those with poorer credit records. Drivers with better credit histories (more money) are far more likely to cover the costs of a minor accident or homeowners’ claims themselves – even when those claims exceed the deductible, to avoid notifying the insurance company and getting hit with a higher premium.  Conversely, someone whose finances are in disarray, whether from excessive spending, a lost job or medical bills, is more likely to file a claim for that same minor accident. In essence, insurers want to obtain and keep the business of the customers who can best afford not to use the very product they are providing.  Customers who would actually file a claim when the insurance company owes them money are considered undesirable or at the very least less profitable. 

The over arching problem with the use of credit to determine insurance rates is its lack of connection to the purpose of insurance.   Credit scores reflect much more than your debt and payment history. Just having a credit history checked too often can result in a worse credit score. Losing health insurance, seeking credit counseling, paying debt early, never having had credit, using a debit card, or having a large amount of available credit are all known to hurt a person’s credit score, and therefore can increase the cost of insurance.  Yet none of these factors has any common sense connection to one’s likelihood of being in an automobile accident or having a homeowner’s claim.  Is it fair to deny insurance to a woman with a clean driving record simply because a divorce changed her credit status? Is it fair to raise the premiums of a man with a clean driving record whose medical bills affected his credit history? 

Another fundamental problem with credit scoring is that the credit information upon which the scores are based is often wrong.  The insurance companies offer no explanation of how their formulas can be effective in light of the tremendous inaccuracies in the credit report industry which provides the information used to calculate scores.  If, as the insurance industry claims, the use of notoriously inaccurate credit information is a more effective means of determining who will make a claim than the other methods that have been historically used by insurers, then those methods must be even more grossly inaccurate and cast doubt on the validity and fairness of any sort of premium discount or other means of price setting that would give a price discount to one would-be customer over another.

What is going on with credit scoring in Michigan?

After several hearings around the state, the former insurance commissioner (the late Frank Fitzgerald) issued a bulletin (2003-01-INS) (effectively, an order from the commissioner) placing some restrictions on insurers’ use of credit scores.  Under the bulletin’s terms, insurers that use credit scores are required to file the formula they use and the specific credit classification factors they use with OFIS.  They are also required to provide a yearly actuarial certification to OFIS justifying the discount levels and discount tiers used.  In addition, companies are required to annually actuarially certify the discount granted to people with no credit history or insufficient credit history from which to calculate a score.  In other words, they have to show that these people are being given an actuarially justified discount.

Insurers are also required to inform their customers that they use credit information to calculate a discount.  They also must tell each customer which discount tier he or she falls under and recalculate each person's score annually (with new credit information).  In addition, if a person successfully disputes the credit information used by the insurer, the insurer must recalculate the score and apply the appropriate discount.

During the 2003-2004 legislative session, a number of proposals were introduced in both the House and Senate to make further changes to the use of credit scores by insurers.

In fact, a work-group was chaired by Representative Mary Ann Middaugh to discuss what sort of restrictions on the use of credit scores could be enacted with the support of the insurance industry.  Particularly, the goal was to find a common ground that would protect consumers without completely blocking the use of credit information.   Whether or not the work-group could have come up a plan that would have contained any real consumer protections while still meeting industry approval is another matter.  However, that never became necessary when the Insurance Commissioner, Linda Watters, chose to issue a ban on insurance company use of credit scores through the administrative rules process. 

The insurance commissioner is empowered (under MCL 500.210) to create “rules and regulations in addition to those now specifically provided for by statute as he or she may deem necessary to effectuate the purposes and to execute and enforce the provisions of the insurance law of this state.”     

After much review (outlined in the agency report to the Joint Committee on Administrative Rules at http://www.mi.gov/documents/JCAR_Agency_Report_10-01-04_113192_7.pdf), the Insurance commissioner concluded that the only statutory provision that could justify or authorize the use of insurance credit scoring in Michigan law was MCL 500.2110a – a section of the insurance code which allows insurance companies to establish and maintain premium discount plans as long as the premium discount plan is uniformly applied, consistent with the purposes of the act, and reflects reasonably anticipated reductions in losses or expenses. Insurers typically offer premium discounts for safety equipment such as anti-lock brakes, smoke alarms, or security systems, and other items that might actually reduce losses.

However, even the insurance industry’s arguments in favor of the use of insurance credit scoring invariably assert a correlation between low credit scores and increased frequency of claims  - occasionally they extrapolate that correlation to another claimed correlation between low credit scores and the increased cost of claims, but no insurer and or entity conducting studies of credit scoring for insurers has presented any data that even suggests, much less proves, that the use of insurance credit scoring results in a reduction in losses.

Furthermore, the commissioner’s report also noted that because Michigan’s Essential Insurance Act prohibits insurers from using this credit information to set their base rates, many insurers were increasing their base rates to cover the expected premium discount.  In other words, the insurers, anticipating giving most customers a premium discount, increased their starting rates to cover that discount – much like the store that doubles is prices and then offers customers 50 percent off.  The commissioner concluded that this practice merely selectively apportions premiums among policyholders, without reducing losses, and thus it was in clear violation of the Essential Insurance Act’s provisions (MCL 500.2110a).

In light of this fact, and in the face of continued consumer complaints and insurance companies’ refusal to comply even with the limited directives in the 2003 OFIS bulletins, Commissioner Watters concluded that action was necessary to protect Michigan consumers.

Under the proposed rules[1], insurance companies would be prohibited from using a customer's credit rating as a basis for insurance rates for new or renewal policies effective on and after July 1, 2005, nor would an insurer be allowed to use an insurance score as a basis to refuse to insure, refuse to continue to insure, or limit coverage available for new and renewal policies effective on and after July 1, 2005.  The rules also require companies that have been using credit scores to reduce their base rates by the difference between the premium they collected in 2004 and what they would have collected without the credit score discounts.  This will result in a significant decrease in the base rates for all customers.  While those who have received lower premium discounts under the current system will likely see the greatest decrease, all but a few customers will see some decrease in their rates.  Some rates may in fact stay stagnant, as some insurers have not been increasing their base rates to cover the costs of a premium discount, and others may increase, if the amount of the discount they were receiving was higher than the average premium discount.

The rules have been through most of the administrative process required for their approval.  On January 12, 2005 the rules were submitted to the Joint Committee on Administrative Rules, the final step before the rules are filed and effective.  The Joint Committee on Administrative Rules (JCAR) is the legislative body responsible for reviewing proposed administrative rules that have been issued by executive branch agencies to implement statutes.  The committee is comprised of ten legislators, five Senators and five Representatives.  Of the five members from each chamber, three represent the majority party in that chamber and two represent the minority party.  Committee members are appointed to the committee in the same manner as other committees. 

Once filed with JCAR, the committee has 15 session days to review the rules.  If the committee wishes to object to the proposed rules, it must do so by filing a notice of objection.  A notice of objection must be approved by a concurrent majority of the committee (that is a majority of the committee members of each house).   

Even so, the committee’s ability to object to proposed rules is fairly limited - a notice of objection may be filed only if the committee concludes that the agency lacked statutory authority to create the rule, the agency is exceeding the statutory scope of its rule-making authority, there is an emergency relating to the public health, safety, and welfare that warrants disapproval of the rule, the rule is in conflict with state law, there has been a substantial change in circumstances since enactment of the law upon which the proposed rule is based, the rule is arbitrary or capricious, or the rule is unduly burdensome to the public or to a licensee licensed by the rule.

If JCAR does not file a notice of objection to a proposed rule within 15 session days (days that both the House and Senate are in session), the Office of Regulatory Reform may immediately file the rule with the Secretary of State, and the rule takes effect immediately after its filing, unless a later date is indicated within the rule.   If JCAR files an objection to a rule, the Office of Regulatory Reform (ORR) (which is responsible for final filing of rules) could not file it with the Secretary of State until 15 session days after the notice was filed, or until JCAR rescinded its notice of objection, whichever was earlier.

However, even if JCAR files a notice of objection, each house must take legislative action to stop the implementation of the rule by passing a bill that either rescinds the rule upon its effective date, repeals the statutory provision under which the rule was authorized, or stay the rule's effective date for up to one year.

While Michigan has taken no legislative action on this issue, 26 states have adopted general regulatory requirements – allowing the use of credit scores, but requiring disclosure or notification of their use, setting specific reporting requirements, or requiring that decisions be based on objective and measurable standards.  The states that have done this are –  AZ, CA, DE, FL, GA, ID, KS, MA, MD, ME, MO, MT, NE, NH, NJ, OH, OR, RI, SC, TX, UT, VA, WA, and WV. 

Twelve states have laws actually restricting the use of credit scoring information AR, GA, HI, ID, IL, LA, MN, MO, MT, OK, WA, and WI.  (GA, ID, and WI also have more general laws and are included above as well.)

Hawaii has the strongest law - a prohibition on auto insurers using information from a person’s credit history to establish rating (pricing) plans.  Maryland prohibits auto and homeowners insurance from using credit information to increase premiums or to refuse coverage.  Washington also prohibits the use of credit information to support a denial or cancellation of insurance coverage and restricts the use of credit scores as a basis for establishing either premium levels or eligibility unless the scoring methodology has been filed with the state’s insurance commissioner.  

Some have argued that states may not implement a complete ban on the use of credit scores as a means of rating (pricing) or underwriting (deciding whether or not to sell) insurance because the Fair Credit Reporting Act (FCRA) allows insurers access to credit information.  However, the FCRA does not mandate use of the information it merely allows the credit reporting agency to pass on the information.  In fact, the portion of the act that applies to insurance specifies that a person’s credit information may be reported to insurers for use in underwriting (not rating).  Thus, the argument that the FCRA would preempt any state law that barred insurers from using credit scores is clearly inaccurate when looking at the clear wording of the act.  The language of the FCRA does not give carte blanche to insurers to use credit information as they please regardless of state law to the contrary.  If it did, then Michigan’s Essential Insurance Act’s (EIA) provisions which bar underwriting decisions based on factors not listed in the act would be invalid when applied to credit scores.  So far the insurance companies have not sought to claim that they have the right, in spite of the EIA, to deny insurance applications due to their credit scores (perhaps they recognize the potential political fallout that might accompany publicly stating such a position).   Furthermore, insurance is in the unusual situation of being a national business that is not subject to a federal regulatory framework.  In the 1940’s, the federal McCarran-Ferguson Act left regulation of the insurance industry to the states.  Ever since, the insurance industry has been subject to state-to-state regulation without national regulation.