No matter what form of media you use to stay current with the news, you are probably aware that the fast food industry has been sued because it makes us fat, the tobacco industry has been sued because it kills us and the technology industry has been sued because it gouges us. Ironically, "consumer protection" litigation has become a multi-billion dollar industry. Editorials opining over the problems with our tort system are as common as the lawsuits they criticize. My intent with this piece is not to pile on, but to draw your attention to an emerging trend in complaints against the insurance industry alleging that the methods insurers use to price and underwrite their products amount to schemes of illegal discrimination. If this trend continues, it will certainly raise the cost that most Americans pay to insure their homes and cars.
Insurance Rating Primer
The basic idea behind insurance is to group similar risks together and distribute the projected future losses for each group among its members.1 The insurance industry calls the grouping of risk "risk classification" and the pricing of risk "ratemaking." Risk classification benefits the members of the group because each person increases their ability to take on financial risks like driving a car or buying a home by sharing their potential losses with others who have approximately the same likelihood of experiencing an insured loss of approximately the same magnitude. Insurers also use underwriting guidelines to set parameters on the types of risk they are willing to accept. To make rates, an insurer must analyze historical losses and predict what those costs are likely to be in the future so that it will have enough money to pay for future claims, overhead and other business expenses with the goal of generating a surplus. Premiums are calculated by applying rating factors that account for the unique characteristics of an individual risk like the age of a house, a person's driving record, a person's credit score, a driver's age or the number of miles a person drives to work and measuring their mathematical relativity to a baseline rate.
This process culminates in an insurance system where individuals that present lower risks of loss pay less per unit of insurance than individuals who present higher risks of loss. The trick for a company is to remain competitive by not overcharging, which leads to selling too few policies, and not undercharging, which leads to selling too many policies to bad risks without enough premiums to cover losses. Insurance companies invest huge amounts of money and resources into analyzing loss data and developing pricing strategies to remain competitive.
Because the states regulate the insurance industry, there are minor variations in the way that regulators oversee rating; but as a general rule, rates must not be inadequate, excessive or unfairly discriminatory, which is to say that risk classifications must be based upon supportable actuarial evidence. Insurance actuaries rely on accepted principles and standards of practice to make these determinations. Ratemaking is just an elaborate process of risk discrimination; if this were not so, we would all pay the same rates. In the words of one federal court, "risk discrimination is not racial discrimination."2
Credit Scoring Litigation
The financial services industry has used credit-based information for many years. With recent advancements in the ability to perform computerized analysis of credit information and insurance loss histories across millions of people, actuaries have determined that a person's credit history is highly predictive of his or her insurance risk. Indeed, a Tillinghast-Towers Perrin study demonstrated that there is a 99% probability of a relationship between a person's credit rating and the likelihood of that person filing an insurance claim. Vendors have since developed pricing models that allow insurance companies to transform a person's personal credit information into a numeric value, which is highly predictive of whether an individual presents a high or low insurance risk. Many companies now use these credit scoring models as a tool to assist their underwriting and rating operations.
Credit scoring has become extremely controversial as regulators and consumer groups grapple with how and why it works. Proponents contend that the use of credit scoring is an objective and efficient way to provide consistent, accurate and more complete underwriting and pricing by automating underwriting decisions and more fairly matching rates with actual losses. Among critics' chief complaints is that the use of credit scoring disproportionately impacts poor and minority consumers, which has prompted a number of class action lawsuits around the country.3
In DeHoyos v. Allstate, plaintiffs are asserting claims under federal anti- discrimination law, alleging that Allstate uses credit scoring as a pretext to charge minorities higher insurance premiums. Allstate has urged the federal courts to dismiss the claims, arguing that the application of federal civil rights law is prohibited because it would impair the state-based regulatory system set in place by the McCarran-Ferguson Act of 1945.4 Last month the United States Supreme Court refused without comment to hear Allstate's petition to review the lower courts' refusals to dismiss the case. The DeHoyos precedent arguably knocks down the regulatory hurdles that often frustrate a plaintiff's ability to sustain rating complaints against insurers and arguably settles jurisdictional issues for these complaints. For this reason, the DeHoyos case is the most significant credit scoring case in the country at this time and will likely encourage other plaintiffs to initiate similar suits.
Regulators And Credit Scoring
In the last few years, credit scoring has become one of the most controversial topics in recent memory among state regulators. Consequently, the National Association of Insurance Commissioners ("NAIC") has created a Credit Scoring Working Group as a forum for regulators to discuss methods for studying and regulating the industry's use of credit scoring. At recent meetings, the Credit Scoring Working Group has generated much debate by suggesting that the NAIC promulgate "best practices" standards for the use of credit scoring. This move is controversial because the actual regulation of credit scoring is up to the individual states, and some think the NAIC should not opine where it has no jurisdiction. During calendar years 2002 and 2003, thirty-five states took some form of legislative or administrative action to put rules in place for the regulation of credit scoring.5 Critics of the push for "best practices" standards argue that such a move by the NAIC would confuse consumers and potentially contravene individual state laws. This issue is far from resolved and is fueling the ongoing national debate over credit scoring.
In another controversial move, a number of state insurance regulators recently decided to join forces for the purpose of conducting a multi-state examination of the insurance industry's use of credit scoring, with the stated goal of determining the impact it has on certain groups of consumers. Although the exact number is uncertain, it appears that up to fifteen separate departments of insurance may be participating in the multi-state examination. In May of this year, these regulators began issuing data calls to insurers to collect information that will be used in the study. The general concern among the industry is that these regulators appeared to be preparing to replicate the findings of a Missouri Department of Insurance study from earlier this year, which found that credit scoring disproportionately impacts poor and minority populations. The State of Missouri has used the Department's study to support its position that credit scoring should be banned. The Missouri study has come under extreme criticism from industry groups for using demonstrably flawed statistical methods.
California ZIP Code Litigation
The geographic location of a risk is among any number of rating factors that insurers commonly use when creating risk classifications for the purpose of setting rates for both homeowners and automobile insurance. As a general rule state regulators permit the location of a risk to be considered in ratemaking as long as such classifications can be actuarially justified.
In 1988 Californians passed Proposition 103, which was a referendum directed at overhauling the state's insurance regulatory system. Although Proposition 103 was at least partly aimed at steering insurers away from using the geographic location of risk as a primary rating factor, subsequent regulations permitted the practice if it could be justified actuarially. In the mid-1990's, the California Insurance Department passed additional regulations that required large automobile and homeowners insurers to provide regulators with detailed information regarding their books of business broken down by ZIP code. After years of litigation, which has heretofore protected this data from public disclosure as trade secret information, the California Supreme Court released a decision on April 26, 2004 stating that Proposition 103 permits the Insurance Department to release the insurers' ZIP Code information to the public.6
Given the energy plaintiffs have exerted to litigate the issue of public disclosure, once the California Insurance Department releases this data to the public, it will almost certainly generate a number of consumer class actions alleging the industry has been engaging in a pattern of illegal discrimination.
Territorial Rating Complaints Before The Ohio Civil Rights Commission
A fair housing group filed complaints with the Ohio Civil Rights Commission last year against a large number of homeowner's insurers doing business in the State of Ohio alleging that their use of territorial rating methods is a pretext for illegal discrimination.7 This group has alleged that these insurers use territorial base rates to "redline, target and intentionally discriminate against" protected classes living in Ohio's urban areas; the complaints also make allegations of unintentional, or disparate impact, discrimination. The complaints are based solely upon alleged violations of Ohio law and do not involve claims under federal anti-discrimination law. The group is seeking compensatory, punitive, injunctive, and affirmative relief for itself and on behalf of the homeowners who purchased what this fair housing group has dubbed "discriminatory policies" to recoup what it calls "racial profits."
After a year-long investigation into the allegations raised in the first wave of complaints, the Ohio Civil Rights Commission issued a public 38-page Letter of Determination in February dismissing the complaints as lacking merit. In its findings, the Commission stated in part, "there is not a scintilla of evidence to suggest that the differences in rating territories and assigned insurance rates are based upon anything other than sound actuarial principles and widely accepted and approved insurance practices."8 Complainants have appealed this decision in state court.9
This confluence of recent developments indicates that consumer groups and the plaintiff's bar will continue to probe the insurance industry's rating and underwriting practices for issues of discrimination. Consequently, the industry should be prepared for increased litigation in this area. 1 These comments are only meant to discuss "personal lines" insurance products that individual consumer purchase, like homeowner's, automobile and renter's insurance.
2 N.A.A.C.P. v. American Family Mut. Ins. Co., 978 F.2d 287, 291. (7th Cir. 1992).
3 See, Miprano v. Progressive Hawaii Insurance Corp., et al. (Hawaii state court litigation involving the discriminatory use of insurance scores in the rating of insurance policies); Hoffman v. State Farm Mutual Automobile Insurance Co., Inc. (Illinois state court litigation involving the use of insurance scores in the underwriting of policies); Leibold et al. v. Amica Mutual Insurance Co. (Rhode Island federal court litigation involving the use of credit scores in underwriting and rating); DeHoyos v. Allstate Corporation et al. (Texas federal court litigation involving the discriminatory use of credit scores); Owens v. Nationwide Mutual Insurance Co. (litigation involving the discriminatory use of credit scores); and, State of Texas v. Farmers Group, Inc. and Farmers Insurance Exchange v. Texas Commissioner of Insurance (Texas state court litigation involving the discriminatory use of credit scores). For further discussion of these cases and status updates on credit scoring, please visit our website at www.nldhlaw.com.
4 The McCarran-Ferguson Act of 1945 created the current state-based insurance regulatory system by specifically exempting the "business of insurance" from federal anti-trust law.
5 For an updated national compendium of credit scoring laws and regulations, contact the author.
6 See, State Farm Mutual Automobile Insurance Company et al. v. Garamendi et al., 2004 WL 877355.
7 Our law firm is currently representing two insurers who have been named in this litigation.
8 See, Ohio Civil Rights Commission Letter of Determination, The Housing Advocates, Inc. v. Erie Insurance Exchange, Farmers Insurance Company, State Automobile Mutual Insurance Company, State Auto Insurance Company of Ohio, State Farm Fire and Casualty Company, Nationwide Mutual Insurance Company and Nationwide Mutual Fire Insurance, at page 34. You may download a copy at www.ohio.gov.
9 We believe these cases are the first cases in the country to directly attack the insurance industry's use of territorial base rates.
Published June 1, 2004.