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The hidden cost of low credit scores

Recently, a Red Tape reader named Katherine received a letter from her auto insurance company with an intriguing offer.

"Congratulations on being a preferred Geico customer," it read. "We may be able to offer you a lower rate that could save you up to an additional 10 percent."

Just sign this form, the letter urged, and give us permission to check your credit score. If it’s good, you’ll get a discount, it said. 

Katherine didn't know what to make of the letter.

"Since when do car insurance companies need your credit rating to determine if you are a good driver and deserve a discount?" she asked.

In fact, auto insurers have for several years been using credit scores to set rates.  It's just not well known.  Unless you live in a state like California or Hawaii, which legally bar the practice, your credit score probably affects what you pay for auto insurance.  Those with low scores pay higher rates; those with high scores presumably get a discount.

How much more might you be paying because of a low score? As a consumer, what score should you shoot for to know you're getting the cheapest auto insurance? I wish I could tell you, but I can't. The insurance industry considers such information as competitive intelligence.  Geico wouldn't discuss Katherine's letter with me, referring questions instead to an industry think tank.

The details remain a mystery, but the low-credit-score penalty is steep, consumer advocates say -- adding perhaps as much as 50 percent to an insurance bill, according Birney Birnbaum, an insurance expert for the Center for Economic Justice in Austin, Texas.

The practice is baffling to Katherine, who threw out the letter, electing to forgo the discount and keep her privacy.

"This is very disconcerting especially when you consider how many errors exist on the average credit report," she said.  "But what I would really like to know is what scale are they using here and what scientific fact they have that relates to necessitate them to send this letter out to all the people who have them as their car insurance?

Marcellus Andrews, an economist at The Insurance Information Institute, says there is, in fact, a tight statistical correlation between credit scores and future auto mishaps. Those with low credit scores tend to be more expensive customers, he said. Of course, no one can use scores to predict what's going to happen to an individual -- but the data do a good job of predicting what will happen in aggregate, he said. That allows the industry to more fairly distribute insurance costs.  After all, without such pricing structures, good customers tend to subsidize bad ones.

What do scores and expensive auto accidents have to do with each other? It's been speculated in the past that people with low credit scores are just careless people, and that carelessness spills over into all areas of life.  The reason for the connection, however, doesn’t matter, Andrews says.

"Insurers don't care about why things are correlated, just that things are correlated," he said.

Insurers use as much data as they can to find such correlations and assess risk.  As it happens, credit scores are the data most widely available on the most consumers. Nearly every adult consumer has one; and they are easy to buy and easy fit into an mathematical model.  Thanks to credit scores, instead of a few pricing tiers, many insurers have 30 or 40 tiers, says J. Robert Hunter, a spokesman for the Consumer Federation of America.

Of course, the obvious question is this: Are insurers using the data to more fairly distribute costs, or just as an excuse to charge some people more?  Katherine's letter promised that the offer was a no-lose situation for her -- Geico said her rates could go down as much as 10 percent, but would not go up if she consented to have her score used. 

Birnbaum found that hard to believe.

"It's an interesting representation, but that doesn't really make sense," he said.  "The only way they can give discounts is if they give other people a surcharge."

In fact, Birnbaum said, the 10 percent offer was paltry, compared to the 50 percent increase some consumers can see as a result of a poor credit score.  He is among those who believe insurers are raking in higher profits because of scores, instead of distributing costs better.  He cited one study showing overall costs for consumers rose when credit score pricing was introduced in some markets, but the studies are small and incomplete.  It's challenging to gather data for such a study because insurers are so tight-lipped about their pricing structures.

So we’re left to wonder just how much a bad credit score might be costing us. That’s particularly maddening when you consider several studies have shown as many as 50 percent of all credit reports have some error in them. And it’s terrifically unfair to people who suddenly face a life event that causes their credit score to plummet, such as the aftermath of Hurricane Katrina.

But there is reason to believe help might be on the way.

There are steps individual consumers can take to find out just how much their score impacts their rates; and thanks to a recent federal court ruling, consumers may have even broader rights soon.

The question every consumer should ask their insurer right now is this: What would my rate be if I had the highest possible credit score?  That would determine what your credit score penalty is.  The insurer may or may not comply with the request.  But refusing to do so runs afoul of the Fair Credit Reporting Act, a court has recently ruled.

When consumers are denied a loan or a job because of something in their credit report, they are entitled to notification by the company involved.  Consumers must be sent what's called a "Notice of Adverse Action."  The right, granted by the Fair Credit Reporting Act, stems in part from the fact that many credit reports have errors -- and the notice of adverse action alerts consumers that there is something in their credit file that is hurting their chances at a new car, home, or job.

Two lawsuits recently argued that getting charged extra by an insurer because of a low credit score is in fact an adverse action, and that consumers who don’t get an insurer’s best rate deserve an adverse action notice.  In August, the Ninth Circuit Court of Appeals ruled in favor of consumers suing Geico and Hartford Financial Services Group Inc. for mandatory adverse action notices, overturning an earlier ruling by a lower court. The court held that any time a company sets a price higher than would have otherwise been charged because of information in a credit report, that falls under the rules of the Fair Credit Reporting Act requiring notice.

Hopefully, you won't have to sue to get your notice. But you might consider it. Knowing what you best insurance rate would be is obviously a valuable piece of information. If you knew, for example, that another 100 points in your credit score could save you a few hundred dollars in car insurance, you might make different credit choices.  Perhaps you wouldn’t bother. But, at least, you should have the choice, not your insurance company.

All this sets aside the argument about whether use of credit scores in insurance is fair or not.  Some argue that doing so unfairly disadvantages the poor or minorities,who traditionally have lower credit scores. The practice at a bare minimum sounds unsavory, and smacks of an industry that may be a bit too married to data -- any data.

After all, just because there's a correlation doesn't mean it's fair to charge higher prices. What if there was a correlation between hair color and accidents? In fact, there is, says Hunter.  Several years ago, the California Department of Motor Vehicles ran a test and found that brunettes were more likely to have wrecks than blondes.

“(The industry) said, ‘That’s ridiculous and arbitrary,’  But is it  any more arbitrary than credit scores?” he said. 

But Andrews argues, convincingly, that Americans better get used to data-based pricing.  More and more information about all of us is collected and stored every day, and without strict controls on how it is used, it's bound to end up as part of complicated pricing models in all kinds of uncomfortable ways. What happens to health insurance rates when we find genes that predicts early illness, or long life?

"Consider the troubles on the horizon once the human genome is well understood and the miracles of modern mathematics and science make it possible to price genetic characteristics and connected risk factors separated by decades," he said.  "I should think that the opportunities and  challenges posed by an information-driven market economy will be with us for a very long time.”

For now, auto insurance consumers should know that credit scores are a fact of life.  That makes shopping around all the more important -- and that's something most consumers just don't do when it comes to insurance. Close to 80 percent of consumers just buy the first offer of insurance they receive, Hunter said. 

There are a few things consumers can still control, and shopping around is one of them.  In the end, such bad shopping habits can be even more costly than bad credit scores.