A fierce debate is raging in Canada about whether auto and property insurers should be allowed to use credit scores to rate applicants. However, proponents argue that most Canadians would benefit from credit-based insurance ratings.

A controversial practice
Ontario banned the use of credit scores to classify auto insurance risks in 2005. Six years later, regulators in Newfoundland and Labrador prohibited insurance companies from refusing to provide fire and property insurance based on credit information.

Recently, the New Brunswick Ministry of Justice and Consumer Affairs drafted regulations that will forbid both auto and home insurers from screening out applicants with weak credit histories. According to consumer advocate for insurance Ronald Godin, many New Brunswickers are complaining about denied coverage or large premium increases after insurers reviewed their credit ratings.

However, credit scores are widely used in Québec to underwrite both auto and property insurance; and the Canadian Association of Direct Response Insurers (CADRI) reports that credit scoring hasn't negatively impacted either the availability or affordability of insurance in La Belle Province.

How credit scores affect premiums
The Canadian Council of Insurance Regulators (CCIR) has set up the Credit Scoring Work Group to gather research and feedback on credit-based underwriting practices from major insurance industry players, as well as from Canada's credit reporting bureaus, Equifax and TransUnion.

In an August 8, 2011 written submission to the CCIR, George Hardy of the Co-operators asserted that "... 66 per cent of Co-operators clients enjoyed lower home insurance rates because of their credit score."

Only 28 per cent of credit-rated applicants were assessed higher premiums, while rates for the remaining 6 per cent stayed the same. "The removal of credit scoring as a rating tool would result in increased premiums for the majority of our clients," argued Hardy.

A 2008 study from the Financial Consumer Agency of Canada (FCAC) showed that 75 per cent of Canadians have a respectable credit score of 700 or higher. Proponents of using credit scores in insurance decisions say that the majority of Canadian policyholders would receive premium discounts if their insurance rates were based on credit ratings.

Consumers have the option to opt out
Thanks to a voluntary Code of Conduct from the Insurance Bureau of Canada (IBC), Canadians have to expressly grant permission before an insurer can view their credit files. Prospects with weak credit scores can therefore opt out of releasing credit information and simply won't qualify for credit-rating discounts. Consumers can also choose to do business with insurers that don't use credit scores as an underwriting factor.

The Code also has special allowances for newcomers to Canada or youngsters who lack established credit histories and gives insurers discretionary power to accommodate consumers whose score is adversely affected by an extraordinary life event, such as the death of a spouse or identity theft. Many of Canada's biggest personal lines insurers have committed to the Code, thus protecting consumers from unfair insurance practices.

The proof is in the claims
Critics argue that credit scores are unrelated to claims. However, proponents point to at least a dozen actuarial studies in the United States and Canada that indicate that credit scores do correspond with actual claims experience.

Intact Insurance, Canada's largest property and casualty insurer, analyzed data from 2007 to 2009 and found that personal property policyholders with the lowest credit scores had 50 per cent more claims than those with average credit scores.

Similarly, Baron Insurance Services conducted an independent study based on policyholder data from five major Canadian insurers. That analysis concluded that superior credit scores strongly match with lower claim frequency and costs.

In a letter dated Aug. 14, 2011 to the CCIR, Equifax Vice-President John Russo confirmed that, "Equifax has determined through testing and research that there is a correlation between consumer behavior and the risks associated with insurance underwriting."

Clearer communication is needed, say advocates
Proponents of credit-based insurance ratings argue that Canadian insurers need to do a better job in explaining why and how they use credit scores -- particularly the benefits to individual consumers.

The stepping stones are in place, via the IBC's voluntary Code. For example, insurance companies have to immediately correct premium calculations after an applicant advises them of a credit file mistake. Consumers sensitive to privacy concerns can also rest assured that the Code safeguards the strict confidentiality of their personal credit information.

And if you have a low credit score, relax -- you have options. Credit scores are just one of many factors that insurance companies use to determine eligibility and calculate competitive premiums.

See related: 6 common credit score mistakes; 7 credit score ringtones for your mobile phone.