The roar over credit scores: insurance companies love credit scoring, but consumer groups question who benefits from them. Legislators are looking at restrictions.

For insurers it seems like the perfect system a way to significantly reduce possible claims in a hard market made all the worse by the continuing effects of 9/11.

It's called credit scoring. And it is a process that claims to be able to predict, not the premium-paying potential for would-be insurance customers, but rather the likelihood of their having accidents and filing claims based, uniquely, on their past credit history.

"Insurers are always looking for the best ways to reduce risk. Credit scoring is that, a very important measurement tool," says David Snyder, assistant general counsel with the American Insurance Association in Washington, D.C. "And it is also a way that has been proved to have a very high correlation to future claims.

"This is a tool that focuses much more on individual risk and less on the old categories such as territory and age," he says. "It is very much moderated by individual factors, which means that it adds a lot of value and benefit to who is likely to have a claim in the future and who isn't."

THE CASE AGAINST CREDIT SCORING

Consumer advocacy groups, however, view credit scoring through a different prism. They argue that just because a system works for the insurance companies doesn't necessarily mean it works well for those with faulty credit records who are in treed of insurance.

"Credit scoring has any number of downsides," says Birny Birnbuam, executive director of the Center for Economic Justice in Austin, Texas. "It is inherently unfair, it penalizes people who are the victims of medical and economic catastrophes, and it does so in an entirely arbitrary fashion that ends up being more a predictor of possibilities, but not really, as the insurers say, of risk.

"The truth of the matter is that although the insurance industry likes to portray credit scoring as rewarding good financial managers, your credit history is in no way a measure of your financial responsibility nor of your likelihood of having an accident and filing a claim," Birnbaum says. "The only thing that credit scoring can really do is penalize people who may have had something bad happen in their life."

Increasingly for state lawmakers the task has become how to reconcile such dramatically opposing takes on a system that, by almost anyone's measurement, is confusing, mysterious, and--in an era when the vast majority of insurers employ some form of credit scoring--omnipresent.

Credit scoring has been around for decades; it was invented by a California firm called Fair, Isaac & Company in the 1950s. But it wasn't until the late 1990s that most U.S. insurance companies, worried about increased competition and ever-growing claims, began to embrace the concept.

Until then, notes Joel Ario, commissioner with the Oregon Department of Consumer and Business Services, most insurance companies were "comfortable with more traditional underwriting factors that they thought were adequate to put people into the appropriate risk pools. So they really didn't feel a need for a new tool like credit scoring."

But then more and more insurers began to see the advantage of segregating risk on what they felt was a scientific basis, leaving those companies who still refrained from using credit scoring holding the bag. "It meant that companies that weren't going to be using it would end up being selected by the people who had been rejected by the competition and really weren't good credit risks," explains Ario.

And then came 9/11, when at least 20 percent of the worldwide capacity for reinsurance was consumed in one day. The ultimate price tag to insurers eventually exceeded the $50 billion mark.

"The insurance industry has really been hit hard by a series of events in recent years," says Loretta Worters, vice president for communications with the Insurance Information Institute in New York. "And the result has been higher premiums all around, plus a concerted effort to find ways to reduce costs."

A COMPANY SECRET

The best way to reduce costs, insist insurers, is to detect where--and most important--with what kinds of clients, risk is most likely to occur. That's where the Fair, Isaac model, known as a FICO score, comes in, although there are now other companies that offer both insurers and bankers their own credit scoring services.

Exactly how a FICO score is achieved remains a company secret, although Fair, Issac has offered to show various state regulators only if promised confidentiality.

But according to a consumer information Web site called CreditInfoCenter, a score can be substantially determined by such things as whether or not consumers have filed for bankruptcy, their occupation and how long they've been at it, how long they have lived at their current address (the longer the better), how many credit cards they possess (the fewer the better) and their age (the older the better).

The Fair, Issac model has proved to be so popular that it is now regarded as the industry standard, although other companies use different forms of credit scoring, emphasizing different factors they regard as important.

"There is no single credit score," says Jeffrey Junkas, director of public affairs for the AIA. "There are literally hundreds of credit scores using thousands of characteristics.

"As these scores are developed and tested, these characteristics are taken in and pulled out until you find the right piece of the puzzle that gives you the predictive value you are looking for," he says. And these characteristics are going to hold true no matter what group you are in because they provide the answers to questions like: Did you pay your bill on time? or How many credit cards do you currently have?

But the problem with the credit scoring model, say critics, is that it leaves out the human equation--the circumstances by which a person may find themselves in financial difficulty.

"If a person just lost his job because, say, the company he worked for went under, that is no fault of his own, but it will negatively affect his credit score," says Birnbaum. "The same holds true for a widow whose husband may have paid all of the family's bills on time, but did so in his name. That means that she has no credit history, and so gets a bad credit score."

Scott Lakin, director of the Missouri State Department of Insurance, agrees. "You get into a system that might save some money as far as underwriting for the companies goes, but it is all surface underwriting" he says. "No one is digging deeper down to see why it is that a person has a low credit score. Was there a major health crisis in the family that caused them to get behind in their bills? These are the sort of things that are not taken into account."

Ario in Oregon says he has heard the same complaints. "Consumers do not necessarily accept the idea put forth by the insurers, which says, 'If I can find a better way to segregate risk, I should do it.'"

On the contrary, says Ario, consumers understand that insurers group people into pools based on factors that apply generally, but there are exceptions to the rule that makes the classification unfair in certain circumstances. "Why should I be penalized if I went through a divorce that was no fault of my own and as a consequence had credit problems or a medical emergency and was forced into bankruptcy?" he asks.

NO WAY TO TREAT A CUSTOMER

In one particularly well-publicized example of how credit scoring tends to overlook such exceptions, a major northwest insurance company decided to apply credit scoring not only to perspective clients, but clients it had for years.

The result? Many customers who had always paid their premiums on time and never even filed a claim were dropped. Even within the insurance industry, this was taken as a poor use of credit scoring, or at least one that left much to be desired in the way of public relations.

"They're not doing it anymore," says Junkas. "Everyone learned from that experience."

But Missouri's Lakin thinks that such problems with credit scoring are destined to reappear, primarily because it is a system where no one appears to be accountable. "We have talked to a lot of insurance companies about it, and they always say, 'Sorry, this is a third-party vendor, and we can't disclose the methodology they are using.'

"That makes it very difficult to try and find out why someone got a particular score," he continues. "It's all third-party stuff, and every company is using a different methodology. There is absolutely no standardization within the industry."

"Ultimately," says Lakin, "it makes it very difficult for regulators to know whether or not the credit scoring system a particular company is using is discriminatory or not. It has the potential of getting away from you."

RESTRICTING CREDIT SCORING

So far, more than 40 states have passed laws that, in one way or the other, restrict the use of credit scoring. Only one state, Maryland, has banned credit scoring for home insurance purposes.

California passed legislation in 2000 that allows for continued use of credit scoring in determining whether or not a person could get financing to purchase a house, but requires lenders to provide customers with their specific credit score and what factors led to the creation of that score.

"I actually had realtors who were complaining to me about it," says California Senator Liz Figueroa, author of SB 1607. "They told me they were running into more and more situations where clients could either not buy a home because of their credit score or were paying much higher interest rates. So we just felt that we had to do something."

Texas Representative Steven Wolens introduced legislation in 2003 that would have prohibited the use of all credit scoring for both underwriting and rating purposes. But the measure died in committee.

"The insurers said they could show a causal relationship between a person's credit score and the likelihood that they were going to have a homeowners' insurance claim," says Wolens. "But I was opposed to the notion that people who don't pay their bills on time are more likely to have something like hail damage to their roofs. It just didn't make sense. Does God only send hail to damage the roofs of people who are bad credit risks?"

Other lawmakers have expressed reluctance to tamper with credit scoring for fear of unintended consequences. This spring, when Michigan Governor Jennifer Granholm proposed banning insurance companies from charging higher premiums to motorists and homeowners based on a low credit score, Representative Larry Julian, the chairman of the House Insurance Committee, said such a ban could ultimately prove more damaging to consumers because it might result in higher rates for everyone--no matter what their credit score.

"Now, for good credit or a good driving record, you get a discount," Julian told the Detroit Free Press. "If everyone gets the same rate, then everyone's rates will go tip."

That argument has found favor with many insurers who say that in the long run credit scoring saves money for everyone because it reduces the total number of claims. And the fewer claims, the lower the premiums.

"An outright ban on credit scoring would actually end up being anti-consumer," says Snyder with the AIA. That's because companies can give breaks to people who are considered "good risks" based on their credit scores. When companies are able to accurately gauge risk and set prices according, it promotes a more competitive marketplace, which lowers prices and gives consumers more choices, he says.

Although about 30 states have passed laws since 2002 to restrict how insurers use credit scores and another dozen states have adopted regulations, the debate continues.

Most of these new laws are similar to Illinois HB 1640, which passed in 2003. It allows credit scores to he used, but not as the sole factor in insurance decisions. It also forbids insurers from considering the absence of credit and other factors in their models, requires that scores be recalculated every three years, and mandates that scoring models be filed with the state insurance department.

Representative Frank Mautino, who chairs the House Insurance Committee in Illinois, says that some lawmakers wanted to ban credit scoring outright, but the legislature decided to take the more measured step of regulating its use.

"We think that we passed a good law to address the problems with credit scoring, but if the abuse continues, we'll be willing to look at it again," he says.