The goal of every insurance company is to correlate rates for insurance policies as closely as possible with the actual cost of claims. If insurers set rates too high they will lose market share to competitors who have more accurately matched rates to expected costs.
If they set rates too low they will lose money. This continuous search for accuracy is good for consumers as well as insurance companies. The majority of consumers benefit because they are not subsidizing people who are worse insurance risks—people who are more likely to file claims than they are. The computerization of data has brought more accuracy, speed, and efficiency to businesses of all kinds. In the insurance arena, credit information has been used for decades to help underwriters decide whether to accept or reject applications for insurance. New advances in information technology have led to the development of insurance scores, which enable insurers to better assess the risk of future claims. An insurance score is a numerical ranking based on a person’s credit history. Actuarial studies show that how a person manages his or her financial affairs, which is what an insurance score indicates, is a good predictor of insurance claims. Insurance scores are used to help insurers differentiate between lower and higher insurance risks and thus charge a premium equal to the risk they are assuming. Statistically, people who have a poor insurance score are more likely to file a claim. Insurance scores do not include data on race or income because insurers do not collect this information from applicants for insurance.
The Poor Economy Has Not Had a Negative Impact on Credit Scores:
According to an April 2009 Property Casualty Insurers of America (PCI) release, the recent economic downturn did not have the negative effect on credit scores that some people predicted. Major consumer credit reporting agencies such as Fair Isaac and TransUnion have reported that average scores remain steady or have improved, possibly because consumers are saving more and paying off debt. Despite the economy and credit crisis, no state has made regulatory changes to insurers’ use of insurance scores, PCI notes.
Federal Activities: The Federal Trade Commission (FTC) has asked nine of the largest homeowners insurance companies to provide information that it says will allow it to determine how consumer credit data are used by the companies in underwriting and rate setting. The Fair and Accurate Credit Transactions Act, passed in 2003, directed the FTC to consult with the Office of Fair Housing and Equal Opportunity on how the use of credit information may affect the availability and affordability of property/casualty insurance, whether the use of certain factors by credit scoring systems could have a disparate impact on minorities and, if so, whether the computer models used could be modified to produce comparable results with less negative impact. The study is expected to be finalized sometime 2010. In a similar study, the FTC found that auto insurers’ use of insurance credit scores leads to more accurate underwriting of auto insurance policies in that there is a correlation between insurance scores and the likelihood of filing an insurance claim. The FTC report, Credit-Based Insurance Scores: Impacts on Consumers of Automobile Insurance, released in July 2007, also states that credit scores cannot easily be used as a proxy for race and ethnic origin. In other words, credit scoring predicted risk for members of minority groups in much the same way that it predicted risk for members of nonminority groups. The Fair and Accurate Credit Transaction Act of 2003 directed the FTC to address the issue of whether the use of credit had a disparate impact on the availability and affordability of insurance for minorities. Based on a poll of consumers, the General Accountability Office has recommended that the Treasury and FTC take steps to improve consumers’ understanding of credit scoring and how credit histories are used, targeting, in particular, those with less education and less experience in obtaining credit. The Federal Reserve also studied the use of credit scoring. Although looking at credit scoring to quantify risk posed by a borrower rather than an applicant for insurance or a policyholder, the Federal Reserve said in a report issued at the end of August 2007 that credit scores were predictive of credit risk and were not proxies or substitutes for race-ethnicity or gender, underscoring the FTC study.
Insurance Scores: Insurance scores are confidential rankings based on credit history information. They are a measure of how a person manages his or her financial affairs. People who manage their finances well tend to also manage other important aspects of their lives responsibly, such as driving a car. Combined with factors such as geographical area, previous crashes, age and gender, insurance scores enable auto insurers to price more accurately so that people less likely to file a claim pay less for their insurance than people who are more likely to file a claim. For homeowners insurance, insurers use other factors combined with credit such as the home’s construction, location and proximity to water supplies for fighting fires. Insurance scores predict the average claim behavior of a group of people with essentially the same credit history. A good score is typically above 760 and a bad score is below 600. People with low insurance scores tend to file more claims. But there are exceptions. Within that group, there may be individuals who have stellar driving records and have never filed a claim just as there are teenage drivers who have never had a crash although teenagers as a group have more accidents than people in other age groups.
Credit Report Information—Who Wants It? It is becoming increasingly important to have an acceptable credit record. Whether we like it or not, society equates the ability to manage credit responsibly with responsible behavior, even if individuals have a bad credit record through no fault of their own. Landlords often look at applicants’ credit records before renting apartments to see whether they manage their finances responsibly and are therefore likely to pay their rent on time. Banks and other lenders look at the credit records of loan applicants to find out whether they are likely to have loans repaid. Some employers also look at credit records, especially where employees handle money, and view a good credit record as a measure of maturity and stability. In some insurance companies, underwriters have long used credit records in cases where additional information was needed. Before the development of automated scoring systems, underwriters would look at the data and make decisions, often erring on the overly cautious side that disadvantaged much more people. Automated insurance scoring and underwriting systems eliminate the weaknesses inherent in someone’s personal judgment and have allowed more drivers to be placed in preferred and standard rating classifications, saving them money. With the development of these scoring models, the use of credit-related information in underwriting and rating for many insurers has become routine. Insurers use insurance scores to different extents and in different ways. Most use them to screen new applicants for insurance and price new business.
Why Insurers Need It: Insurers need to be able to assess the risk of loss—the possibility that a driver or a homeowner will have an accident and file a claim— in order to decide whether to insure that individual and what rate to set for the coverage provided. The more accurate the information, the closer the insurance company can come to making appropriate decisions. Where information is insufficient, applicants for insurance may be placed in the wrong risk classification. That means that some good drivers will pay more than they should for coverage and some bad drivers pay less than they should. The insurance company will probably collect enough premiums between the two groups to pay claims and expenses, but the good drivers will be subsidizing the bad. By law in every state, insurers are prohibited from setting rates that unfairly discriminate against any individual. But the underwriting and rating processes are geared specifically to differentiate good risks from bad risks. Since insurance is a business, insurers favor those applicants that are least likely to suffer a loss. One of the key competitive aspects of the personal lines insurance business is the ability to segment risks and price policies accurately according to the likely cost of claims generated by those policies. Insurance scores help insurers accomplish these objectives.