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One of the open secrets in the insurance industry is that many insurance companies use your credit score to help calculate your insurance payments. The insurance industry claims that a person's credit score is an excellent predictor of that person's overall level of responsibility. This, when combined with other factors, such as their age, health, job and the type of car they drive can be used by the insurance company's actuaries to deduce, with great accuracy, the level risk they present to the insurance company. That's the claim behind the insurance industry's use of your credit score as one of the determinants behind your insurance rates.

Is it true? Does your credit score really give an accurate prediction of your overall level of general responsibility? What about those who were downsized and lost their jobs, subsequently causing their credit score to decline. Or someone who had excellent credit, but was injured through no fault of their own, lost their job and started falling behind on their bills? Well, thankfully for those who have questioned weather or not the insurance industry has any business using credit scores to help set insurance rates, the FTC has commissioned another of their many studies. This one deals with exactly that question.

Completed in the summer of 2007, the Federal Trade Commission, in concert with the Federal Reserve Board and the Department of Housing and Urban Development (HUD), have brought us a 242 page study on how the use of credit scores affects consumer's auto insurance rates. Does it artificially inflate rates, enabling the insurance companies to pocket millions more of your dollars? Does it let the industry unfairly discriminate against certain groups? We'll see.

First used by insurance companies to help set rates about 15 years ago, this practice has become almost universal among insurers. They love it. In fact, they are so in favor of the practice when setting rates for new customers, that in 2006 they spent $3.7 million in an attempt to defeat an Oregon ballot measure against it. Oregon had earlier banned the use of credit scores in revising rates for existing insurance company customers.

To help ascertain the fairness of the practice, the Feds examined the following areas according to the report:
1 - How credit-based insurance scores are developed and used; and, in the context of automobile insurance the relationship between scores and risk;

2 - Possible causes of the risk / credit score relationship, if any

3 - The effect of scores on the price and availability of insurance

4 - The impact of scores on racial and ethnic minority groups and on low-income groups

5 - Whether alternative scoring models are available that predict risk as well as current models and narrow the differences in scores among racial, ethnic, and other particular groups of consumers.

Seems like the study was fairly thorough, but what did it determine?

Finding 1 -”Credit-based insurance scores are effective predictors of risk under automobile policies. They are predictive of the number of claims consumers file and the total cost of those claims. The use of scores is therefore likely to make the price of insurance better match the risk of loss posed by the consumer. Thus, on average, higher-risk consumers will pay higher premiums and lower-risk consumers will pay lower premiums.”

Finding 2 - “Several alternative explanations for the source of the correlation between credit-based insurance scores and risk have been suggested. At this time, there is not sufficient evidence to judge which of these explanations, if any, is correct.”

Finding 3 - “Use of credit-based insurance scores may result in benefits for consumers. For example, scores permit insurance companies to evaluate risk with greater accuracy, which may make them more willing to offer insurance to higher-risk consumers for whom they would otherwise not be able to determine an appropriate premium. Scores also may make the process of granting and pricing insurance quicker and cheaper, cost savings that may be passed on to consumers in the form of lower premiums. However, little hard data was submitted or available to quantify the magnitude of these benefits to consumers.”

Finding 4 - “Credit-based insurance scores are distributed differently among racial and ethnic groups, and this difference is likely to have an effect on the insurance premiums that these groups pay, on average.

▪ Non-Hispanic whites and Asians are distributed relatively evenly over the range of scores, while African Americans and Hispanics are substantially overrepresented among consumers with the lowest scores (the scores associated with the highest predicted risk) and substantially underrepresented among those with the highest scores.

▪ With the use of scores for consumers whose information was included in the FTC’s database, the average predicted risk (as measured by the total cost of claims filed) for African Americans and Hispanics increased by 10% and 4.2%, respectively, while the average predicted risk for non-Hispanic whites and Asians decreased by 1.6% and 4.9%, respectively.”

Finding 5 - “Credit-based insurance scores appear to have little effect as a “proxy” for membership in racial and ethnic groups in decisions related to insurance.”

Finding 6 - “After trying a variety of approaches, the FTC was not able to develop an alternative credit-based insurance scoring model that would continue to predict risk effectively, yet decrease the differences in scores on average among racial and ethnic groups. This does not mean that a model could not be constructed that meets both of these objectives. It does strongly suggest, however, that there is no readily available scoring model that would do so.”

So, there you have it. According to this study, credit scores work, just as the insurance industry said they do. There may be other reasons for the correlation, but we are unsure as to what they are. The use of credit scores to help calculate auto insurance rates may actually benefit consumers, but how much can't be determined at this time. This practice does, in fact allow the insurance companies charge different rates to different ethnic groups. Are we to infer that, because the use of credit scores as a predictor of risk is accurate, that these different racial and ethnic groups actually present different levels of risk? Or, should the companies dig a bit deeper to determine what factors within the groups are responsible for the differences in risk profiles, instead of taking the easy way out? The study also found that the scores have little affect on the company's willingness to offer insurance to different racial and ethnic groups. And finally the FTC determined that, although there may be a suitable alternative to using credit scores to help assess risk profiles, they were unable to determine exactly what those might be.

Once again, your tax dollars have helped to answer a question asked by many. Is the use of your credit score to help set auto insurance rates fair? It seems that the answer is, for the most part, yes.

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