Risk-Based Homeowners Insurance Under Siege: The Slippery Slope From Redlining Charges To Disparate Impact Claims
For nearly three decades, fair housing activists have campaigned to limit insurance companies’ use of risk-based methods for underwriting and pricing homeowners insurance. Recently, the campaign has entered a new phase. In the past, groups such as the Association of Community Organizations for Reform Now (ACORN), the National Fair Housing Alliance (NFHA), and Consumers Union accused insurance companies of “redlining” – practicing “unfair discrimination against a particular geographic area.” Increasingly, however, the assault on many forms of risk-based insurance is facilitated through the jurisprudence of “disparate impact,” a legal doctrine which holds that a policy or practice based on race- neutral criteria may nevertheless constitute illegal discrimination if it has a disproportionate adverse impact on racial minorities or women and cannot be justified by a showing of “business necessity.”
An examination of the methods used by insurers to underwrite and price homeowners insurance policies reveals that insurers do indeed “discriminate” among their customers – on the basis of risk. Such discrimination is reasonable, in that it results in decision-making that is economically sound from the standpoint of insurance companies, and fair from the standpoint of insureds, whose coverage and premiums are a function of their insurer’s costs. Nevertheless, one consequence of the universal application of risk- based insurance criteria is that, compared to other homeowners, residents of predominantly minority inner- city neighborhoods often pay more for homeowners insurance, while frequently receiving less coverage. The fundamental reason is risk. These urban areas have much higher rates of crime, more abandoned buildings, a greater incidence of arson, more older homes with substandard heating and wiring components, and greater experience of losses.
Inasmuch as risk-based insurance “redlining” operates to the detriment of predominantly minority communities, the problem of insurance availability and affordability in such areas has taken on the trappings of a civil rights issue. The Clinton administration, acting through the Department of Housing and Urban Development (HUD) and the Department of Justice, has used the 1968 Fair Housing Act to bring formal charges of illegal racial discrimination against several major insurance companies. In March 1995, the Justice Department entered into a consent decree with the American Family Insurance Company in which the insurer agreed to pay $14.5 million to hundreds of unnamed minority residents of Milwaukee, Wisconsin. Significantly, the decree calls upon the insurer to abandon many traditional risk-based underwriting and pricing standards, insofar as they appear to operate to exclude inner-city blacks disproportionately from access to premium homeowners insurance policies, or cause them to pay more than predominantly white suburban homeowners.
Examination of the terms of the American Family consent decree, as well as internal HUD memoranda and the public statements of HUD officials, indicates a determined effort on the part of the Clinton administration and fair housing advocacy groups to apply disparate impact analysis to the business of homeowners insurance. A pending federal court case, Canady v. Allstate Insurance Co. et al., would use disparate impact analysis to invalidate traditional risk-based underwriting standards employed by 23 named insurance companies. An amicus brief filed by the Justice Department strongly endorses this approach.
If HUD, the Justice Department, and their clientele of federally funded fair housing advocates succeed in formally codifying the disparate impact approach to allegations of insurance redlining, the result will be a radical transformation of the nature of homeowners insurance. One can imagine a future in which insurers will be required to document a precise cause-and-effect relationship between each underwriting and pricing variable they use and its associated level of risk of losses. They will then be required to show that no “less discriminatory” risk assessment technique is available. Where it is not possible – or too costly – to meet this burden, insurers will have no choice but to abandon the use of those risk selection practices and cost-based pricing mechanisms that yield a disparate racial impact.
In such an event, an insurer would have, in theory, two options. It could distribute the expected, more frequent, and higher claim-costs of one group of homeowners among another group of homeowners who present lower risk, in effect creating a cross-subsidy. That, however, would lead inevitably to “adverse selection.” Alternatively, the insurer could ignore economic reality and treat high-risk insureds as if they presented low risk. This strategy eventually would either drive the insurer from the market or cause it serious solvency problems. Continuing to do business in a market that demands underpricing of risk would over time threaten not only the insurer’s profit levels, but its very ability to stay in business.