Montemayor Sees No Basis for Credit Scoring Ban

February 2, 2005

Texas Insurance Commissioner José Montemayor recently delivered to Gov. Rick Perry and the Texas Legislature the final report on a credit scoring study conducted by the Texas Department of Insurance.

In a letter introducing the study, Montemayor told lawmakers that after reviewing the study results he concluded the use of credit scores in insurance rating “is not unfairly discriminatory as defined in current law because credit scoring is not based on race, nor is it a precise indicator of one’s race.” He added that “credit scoring significantly improves pricing accuracy when combined with other rating variables in predicting risk” and he had no “legal basis” upon which to support a ban of the practice.

Following is the text of Montemayor’s letter to Gov. Perry, Lt. Gov. David Dewhurst and Texas House of Representatives Speaker Tom Craddick:

“It is my honor to present the remainder of the credit scoring study mandated by Senate Bill 14, 78th Regular Session.

“The first phase of the analysis, published December 31, 2004, indicated that credit scoring is correlated to risk. The first phase also indicated that certain age, income and race groups tended to have worse credit scores, though not all minorities have bad credit scores. Because the Texas Insurance Code does not prescribe a precise threshold or legal definition for determining disproportionate impact, I expressed disproportionate impact in terms of a relationship, i.e., over or under-representation in the various credit score categories.

“The second phase of the study evaluates if, and to what extent, credit scoring enables an insurer to more accurately predict losses when used in conjunction with other variables. Overall, the second phase indicates that credit scoring significantly improves pricing accuracy when combined with other rating variables in predicting risk.

“To approach the development of a credit scoring policy, it is important to understand the distinction between unfair discrimination, intentional discrimination and disproportionate impact. The Texas Insurance Code defines unfair discrimination to be the unequal treatment of individuals in the same class or hazard. Underwriting or rating classifications are not unfair, though, if they are actuarially supported. On the other hand, overt classifications or discriminations based on race, color, religion or national origin are intentional discrimination and are prohibited by law, regardless of actuarial support.

“Disproportionate impact is a lack of symmetry, or unequal percentages. In other words, disproportionate impact is an uneven distribution of each racial group within a given risk factor, although the uneven distribution is not caused by one’s race. Also, disproportionate impact changes over time. For credit scoring, the disproportionate impact changes as economic conditions and population distribution change. By the nature of risk-based pricing and underwriting, all factors used in insurance have a disproportionate impact to some extent. One could make a convincing argument to ban the use of all risk-related factors based solely on disproportionate impact. Effectively, we would ban risk-based pricing and underwriting and revert to a pricing system where we homogenize the risk and essentially charge everyone the same price–regardless of risk. That would be a set-back to all Texans, of all races, especially those of moderate to lower income whose risk remains low.

“As Commissioner, I have the authority to end a practice that is either unfairly or intentionally discriminatory. However, I do not have a legal basis to ban a practice that has a disproportionate impact if it produces an actuarially supported result and is not unfairly or intentionally discriminatory. Prior to the study, my initial suspicions were that while there may be a correlation to risk, credit scoring’s value in pricing and underwriting risk was superficial, supported by the strength of other risk variables. Hence, there would be evidence that credit scoring was a coincidental variable that served as a surrogate for an unlawful factor in rating and underwriting. If this were proven to have been the case, I would have had a legal basis to make the connection between disproportionate impact and intentional discrimination, and either ban credit scoring outright or adopt an allowable rate difference of zero, meaning no rate differences due to credit scoring.

“The study, however, did not support those initial suspicions. Credit scoring, if continued, is not unfairly discriminatory as defined in current law because credit scoring is not based on race, nor is it a precise indicator of one’s race. Recall that not all minorities are in the worst credit score categories. Further, its use is justified actuarially and it adds value to the insurance transaction. Without a change in statute that disallows credit scoring as a matter of public policy, any action to ban may be tied up in court for several years, further frustrating public expectation.

“Be advised, however, that banning credit scoring overnight, by rule or law, creates pricing and availability disruptions in a market that has just stabilized and begun a rebound. The same effect would occur if a narrow rate limit, or collar, due to credit scoring were adopted with immediate effect. Premiums would go up for a very large number of policyholders if the collar on credit scoring (or any other risk variable for that matter) is set too narrow, because it would force an immediate price shock that would be unrelated to a change in risk. Further, I believe that, based on the analysis, a collar would have only visual effect, giving the public the impression that any disproportionate impact had been corrected once and for all. A collar would simply be a guess about what is publicly acceptable, and I have no valid, objective way of determining that number. Therefore, any action to ban or restrict the use of credit scoring must allow for changes in the pricing and underwriting systems to occur over a period of time, ensuring that all Texans pay a rate that is fair and based on risk.

“Modern insurance pricing relies on the law of large numbers, which assumes that the more observations one makes, the greater the certainty. Credit scoring allows for a finer level of observation, but measuring propensity for risk strictly by the numbers can seem callous. Unlike other risk-related factors, credit scoring does not have that readily discernable, causal link to risk, such as driving record. As a result, credit scoring has earned the outward appearance of being a surrogate for something sinister. Unfortunately, there is no formula that reconciles economic reality with the public perception of fairness; it is a matter of guessing the right answer for the times.

“Allowing credit scoring to be used, as contemplated under SB 14, 78th Regular Session, will ensure its link to risk under some of the strongest consumer protections in the nation, especially for people that suffer hardship. However, if the presence of credit scoring in insurance will only feed suspicion and divide us as Texans, its continued use to any degree may simply not be worth it. If the Legislature determines that credit scoring should be eliminated, then I recommend that it be phased out over time. I hope the analysis and my thoughts on this matter help in your deliberations. As always, I remain at your service.”

A link to the credit scoring study is available on TDI’s Web site at

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