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Some states give troubled consumers a break on use of credit scoring for insurance rates

A spouse’s death, a job loss or a catastrophic illness are among the most traumatic events in life. These kinds of tragedies account for nearly 90 percent of family bankruptcies – usually walloping the credit scores of their unfortunate victims.

Yet some insurance companies, where permitted by state law, use credit information in determining your rates for auto and home insurance.

“This results in pretty significant impacts on certain consumers,” says Birny Birnbaum, executive director of the Center for Economic Justice, a nonprofit advocacy group. “The difference between two consumers who are other similarly situated – one having bad credit and the other having good credit – can be 100 or 200 percent more in terms of premium differences.”

credit_scoringIs the law on your side?

In response to what Birnbaum and others think is an inherently unfair way of calculating insurance risk, a growing number of states have passed laws directing insurance companies to provide reasonable exceptions for a number of these “extraordinary life circumstances.”

So far, 15 states have passed laws based on a model law from the National Conference of Insurance Legislators. Those states are Connecticut, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Montana, Nevada, New Hampshire, New Jersey, New Mexico, Rhode Island, Texas and Virginia.

These extraordinary life events can include the loss of a primary breadwinner’s income; a serious illness or injury of an immediate family member; a catastrophic illness; the death of a spouse, child or parent; divorce; interruption of alimony and child support; identity theft; or overseas military deployment.

Kathy Donovan, senior compliance counsel at Wolters Kluwer Financial Services, says these laws allow insurance companies to still use credit information to determine rates, but require them to take into account unexpected life events. “This really started taking hold after the financial crisis a few years ago,” Donovan says.

These new provisions come as lawmakers in many states have introduced bills that would impose credit scoring restrictions on insurance companies. For example, a bill in Illinois would require insurers to recalculate a consumer’s insurance score upon request. Meanwhile, a bill in Maryland would prohibit insurance companies from rating risk based on the credit history of an applicant.

About a decade ago, insurance companies first started using credit information to determine a consumer’s level of risk before selling or renewing auto, home or renter’s insurance policies. The insurance companies argue there’s a direct correlation between a consumer’s financial stability and his risk of filing an insurance claim.

Insurers: Credit scoring improves accuracy

Dave Snyder, vice president and associate general counsel at the American Insurance Association, an industry trade group, says the use of credit-based insurance scores has widely been widely embraced by state legislators and insurance regulators, with a few exceptions. Every year, Snyder says, state lawmakers around the country introduce measures regarding credit-based insurance scoring, but the “overwhelming trend” is to continue to permit the practice.

“The majority of policyholders receive discounts as a result of credit-based insurance scoring, and auto insurance and homeowner’s insurance are more available because credit-based insurance scoring has improved the accuracy of underwriting,” Snyder says. “Insurance is more affordable to more people and is generally more available because insurers have an objective measurement of risk that has increased the accuracy of underwriting over the more traditional factors.”

In 2007, a Federal Trade Commission study found that credit-based insurance scores effectively forecast a consumer’s approach to insurance claims. Insurance companies use the scores to predict the number and cost of claims that consumers are likely to file, and determine the premiums they are charged. The study found the use of credit-based insurance scores is likely to make the price of insurance better match consumer risks. Therefore, the thinking goes, higher-risk consumers pay higher premiums and lower-risk consumers pay lower premiums.

Opponents: An ‘unsound’ practice

Robert Hunter, director of insurance at the nonprofit Consumer Federation of America, says use of credit-based insurance scores is “very troubling” – boosting insurance premiums significantly for those with dinged credit records.

“The problem with credit-based insurance scoring is simple: It’s actuarially unsound,” Hunter says. “What is the logic underlying this? If I lose my job during a recession and have trouble paying my bills, why am I suddenly a worse driver? (The insurance industry) can’t answer that question. They say, ‘We don’t know. We just know there is a correlation.’ That is a huge difference from the historical classification system.”

Birnbaum agrees. He says it’s unfair to charge higher premiums for consumers who have been victims of various catastrophic events.

“In our view, fairness means you don’t penalize somebody for a catastrophic event that is completely outside their control,” Birnbaum says. “You don’t penalize someone because they are low-income or a minority. Yet credit-based insurance scoring has a disproportionate impact for all those reasons.”

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