COVID Payment Deferrals: Should Sureties Ignore Credit Scores?

7-14-2020

Despite major upheaval to the global economy caused by the policy response to the 2019 coronavirus, surety underwriting and rates have remained surprisingly stable. While the surety underwriting cycle typically lags the economic cycle, one major reason for the lack of tightening in recent months is the relative resilience of credit scores in the face of an unprecedented decline in economic activity. Unfortunately, credit scores may be holding up for political rather than fundamental economic reasons, setting the stage for a major increase in the perceived credit risk of principals in the months ahead.

Recent legislation added accommodations to the Fair Credit Reporting Act requiring lenders to report deferred accounts as “current” to the credit bureaus if the consumer has been affected by COVID-19, significantly impacting the calculation of the credit score. According to the Wall Street Journal and TransUnion, over 100 million accounts in the United States were in “financial hardship” by mid-June versus roughly 66 million reported at the end of April. We believe that little of this massive increase in missed payments is captured in credit scores, dramatically altering the credit picture for millions. While certainly well-intended, this portion of the legislation does not improve the creditworthiness of the affected applicants but does reduce the informational value of their credit score. With credit scores a key factor in so many surety bond rate filings, we expect a wave of programmatic rate increases towards the fourth quarter when the information restriction is lifted. Much more important, as these obligations ultimately come due against a backdrop of high unemployment and reduced economic activity, surety principals in aggregate will likely experience heightened financial pressure, ultimately leading to an increase in unreimbursed claims payouts.

Surety underwriters are trained to evaluate the risk of a surety bond contract and the bond principal to determine a premium rate that will be profitable for the insurance company on average for similar bond principals; however, this task is becoming increasingly difficult as rapidly changing economic conditions are amplified by market distorting legislation. Given that consumer credit reports serve as a primary tool in a surety underwriter’s arsenal for many bond requirements, the accuracy of credit scores must be examined thoroughly. This article provides a blueprint for underwriters seeking to better understand the information currently contained in credit reports and how they can adjust their process to compensate for the recent economic and regulatory changes that affect the risk model scores for the three major credit bureaus.

How Has COVID-related Legislation Impacted Credit Reports?

While credit bureaus utilize several categories of data to determine an applicant’s credit score, which we detail in the section below, payment history and amounts owed dominate. In a less politically managed economic environment, credit scores serve as a useful tool to determine the credit worthiness of the applicant. Now more than ever surety underwriters must also evaluate the underlying data in the credit report to ensure the credit score accurately reflects current economic conditions in the face of legislation that can skew the score.

Passed in late March, The Coronavirus Aid, Relief, and Economic Security (CARES) Act included several provisions that impact consumer credit scores, including reporting requirements for lenders on deferred payments, requiring forbearance on Federally-backed mortgages, and temporary student loan debt relief due to COVID-19. Of particular concern to surety and credit underwriters is the provision that deferred payments be reported as current so as to not affect consumer credit scores for a minimum of 120 days after termination of the national emergency declared on March 12, 2020. While President Trump has hinted at ending the emergency declaration, as of the writing of this article, the emergency declaration is ongoing, meaning some payments may have already been deferred for nearly 4 months with at least another 4 months of accommodation available. Whether or not the missed payments are captured in the applicant’s credit score, deferred balances on over 100 million accounts will eventually become due and result in larger balloon payments that could wreak havoc on credit scores if left unpaid.

TransUnion reports a drastic increase of accounts in “financial hardship” between March and April. Auto loans in hardship more than quintupled from 0.64% in March to 3.54% in April. Credit cards in hardship display a much more dramatic trend increasing to 3.22% in April from just 0.01% in March as financial hardship deferrals were seldom seen in the credit card industry prior to COVID. Mortgage products also show a dramatic increase of accounts in hardship from 0.48% in March to 5.00% in April, which includes forbearance programs. Mortgage balances account for the lion’s share of U.S. consumer debt. The CARES act allows for forbearance on all Federally-backed loans, so repayment agreements, many of which come due within 12 months of the forbearance, may account for significant foreclosure activity in the near future. While TransUnion executive Matt Komos cautions that it may still be too early to tell long-term implications for credit-markets, there is little question that, in aggregate, the ability of principals to indemnify sureties has been diminished.

As the rapidly changing economic and legislative environment impairs the value of credit scores, surety underwriting practices must evolve to understand the key factors that would traditionally make up the score.

How Is the FICO Sausage Made?

Consumer credit reports are one of the most common surety underwriting tools. The reports provide surety companies with an understanding of how principals and other indemnitors repay their debts. There are three reporting bureaus through which surety companies can review consumer credit reports: Equifax, Experian and TransUnion. Each reporting bureau compiles their own data, which they input into their menu of models that output scores based on the payment history of the consumer and other factors. The two most common scoring model companies are Fair Isaac Corporation (FICO) and VantageScore.

While many surety and mortgage companies continue to utilize older versions of the FICO scoring model for underwriting consistency, the most current model is the FICO 8, which weights the data as follows to provide an applicant’s credit score:

Payment History – 35%
Amounts Owed – 30%
Length of Credit History – 15%
New Credit -10%
Credit Mix – 10%

VantageScore is the only model to incorporate trended data from all three credit reporting bureaus. The model reviews information similar to FICO, but weights it differently in determining the applicant’s credit score:

Total credit usage and balances owed – Extremely influential
Credit mix and experience – Highly influential
Payment history – Moderately influential
Age of credit history & new accounts – Less influential

The intricacies of how these models weigh information is important to note as it can lead to variance in the overall credit score. Moreover, different models, say a FICO Score 2 vs the VantageScore 4.0, express data in ways that speak differently to the type of underwriter reviewing them. FICO Score 2 is still widely used in the mortgage, insurance and health industries, while VantageScore has been more widely used in bankcard and auto industries. Reporting models have evolved over the years, with claims of improvement in consistency, viability and capability to improve lending performance over previous versions. With that being said, VantageScore’s consistency in reporting due to trended credit data from all three national credit bureaus has proven to provide stronger performance for auto lenders.

Beyond the score, credit reports provide a wide range of information surety underwriters can use to augment credit scores. Generally, one will find the following information on a consumer credit report:

Name, Address and Employer
Public Records, i.e. bankruptcy filings, civil judgments and liens
Installment Accounts – Mortgages, Auto Loans, Student Loans, etc
Installment Balances
Revolving Accounts – Credit Cards
Past Due Amounts
Number of Inquiries
Total Tradelines
Satisfactory/Delinquent Accounts
Credit Score
Factors Determining the Score

Surety underwriters should make use of all of the information presented to ensure a full understanding of potential risk. Underwriters have long used the score as a composite of the applicant’s credit profile, but analyzing the factors that make up the score is equally, if not more important. Taking note of types of installment accounts, total past due balances and total inquiries will give underwriters an understanding of what the principal is financing, how quickly they repay their debts, and how often they need to extend their credit lines. All of this information is important for consideration and ultimately, is a driving force behind how different carriers establish underwriting criteria.

Use the Data, Not the Score

Traditional surety underwriting, sometimes referred to as “standard markets”, typically requires a minimum credit score along with other pass/fail factors. With deferred payments currently not affecting scores, surety underwriters may need to leverage underlying data found in credit reports. Payments in deferred status will be notated as such on the credit report. Although the reported date of deferral is not provided, underwriters should consider this account status in their analysis. Utilizing prior payment history, current past due values and revolving availability (just to name a few) surety underwriters may be able to create more accurate rate structures, rather than relying on a score whose meaning has been diminished by recent legislation.

Underwriters should continue to look for a clean report with few to no past due amounts, multiple established tradelines with a few years of credit history, and no public records, but should not place as much weight on the strength of the score itself. Instead, we recommend using credit score ranges as a starting point, augmented by an internally developed analysis of factors found in the credit report. Models including criteria in addition to the underlying credit score provide sureties with the ability to address a larger principal base, while assessing rates commensurate with the risk assumed. When the payment deferral legislation expires we expect credit scores to drop in line to what is typically seen with delayed payment history, but until that time underwriters should be leery of relying on the score in a vacuum.

Where Can Surety Underwriters Find Alternative Sources of Data?

Surety underwriters could also consider reviewing business credit reporting models. Dun & Bradstreet, Experian and Equifax provide commercial credit reporting models with Dun & Bradstreet PAYDEX report being the most widely used. Experian’s Intelliscore Plus is the second most popular, and has the capability to integrate consumer & business credit data. Each report scores the business’ ability to make timely payments and manage their debt appropriately.

While the models for each report can vary, the information displayed is fairly uniform. One can expect to see the business’ identifying information (Business Name, Address and Date of Incorporation), a summary of legal filings, collections and trade information, payment trends and totals, number of inquiries and the company’s background information (State of Origin, Key Personnel, Status, etc).

Surety underwriters will want to review the legal filings to ensure there aren’t any UCC Filings, tax liens, judgments or bankruptcies appearing on the report. With consumer credit reports no longer identifying tax liens and judgments (more on this topic below), these reports can be extremely helpful to underwriters in determining a business’s qualifications.

Surety underwriters should continue to take economic and legislative conditions into account when reviewing consumer credit data. Credit scores are empty numbers in the absence of quality data. As legislation surrounding consumer credit models continue to evolve, surety companies will need to expand their underwriting tools to adapt.

CARES Act Wasn’t the First to Weaken the Value of Credit Reports

Another change affecting credit pulls was the reporting of tax liens and civil judgments. In 2015, the three major reporting bureaus came into a settlement agreement with The Office of the Attorney General of the State of New York to extend consumer protections in credit reporting. Experian, Equifax and TransUnion established the National Consumer Assistance Plan (NCAP) in response. The settlement required extensions in the reporting of medical debts, removal of debts that did not arise from a contract or agreement by the consumer and additional attention for fraud victims. In addition the settlement agreement required removal of the reporting of tax liens and civil judgments on consumer credit reports.

Tax liens and judgments can have significant impact on credit scores and, in the context of surety bonding, allow underwriters to better identify adverse risks. Liens and judgments are essential to the underwriting process because lien holders might possess a priority right of payment ahead of the Surety in the event of a claim on the bond. Because this information has been removed from the report, surety companies have had to find new ways to search for liens and judgments, such as tools from companies such as LexisNexis and Thomson Reuters, or forgo this essential information.

Compared with the current legislation, which is temporary and somewhat limited, the 2015 Agreement might have had a more harmful effect on the surety underwriting process as underlying information was permanently removed from the credit report, necessitating the use of alternative information sources as described in the section above.