November 16th, 2010
The Truth Behind Insurance Scores: Do They Really Work?
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The next time you shop for insurance, you may be new to the fact that credit history—from credit score to debt ratio to past delinquencies—is on hand for most insurers to use to determine how much you will pay. In our last post on auto insurance scores, we discussed what exactly an insurance score is; this week, we’re breaking down the logic and truth behind it.
Here’s the simplified process that connects your credit background to your insurance: your credit background is examined, your predicted risk is calculated based on your credit, you’re placed in an insurance score bracket accordingly, and your insurance score will help price your premiums.
The biggest question in most consumers’ minds is whether or not credit-based scoring actually helps to predict and evaluate insurance risk, and if their premiums are being priced fairly. So, do insurance scores really work?
The Argument for Insurance Scores
In 2007, the FTC issued a report on credit-based auto insurance scores that gives insight into why insurers insist there is a correlation between credit history and insurance risk.
The report analyzed data from several insurance companies that included the credit history and history of claims of insured consumers. According to their insurance score, consumers were placed into different insurance score brackets, and each bracket was analyzed for average number of claims, size of claims, and total amount paid for claims.
Check out the graph below. The key takeaway here is that there is a correlation between credit-based insurance scores to number of claims: as insurance scores increase, the risk of loss in number of claims and claim size consistently decreases, and vice versa.
In another example, the FTC reports that insurers paid out nearly twice as much on property damage liability policies of customers with the lowest insurance score as customers with the highest insurance score. According to these numbers, credit-based insurance scores actually predict an individual’s claims as well as how much the insurer will pay in claims.
Conclusion #1: Insurance scores DO work
Insurers aren’t looking at your credit history to determine the likelihood that you’ll pay your premiums on-time; they are interested in how much you will cost to insure. If you have a high insurance score, your expected losses are lower and thus insurers can reduce your premiums; if you have a low insurance score, you have a higher expected loss so insurers adjust your premiums higher accordingly.
Insurers argue for the use of insurance scores because these studies show there is a consistent correlation of credit history (as represented by insurance scores) to potential claims. And since there is a statistical explanation, insurers will continue to price premiums accordingly. Ultimately, it helps to minimize expected losses from risky consumers and maximize appealing premiums to low-risk consumers.
Conclusion #2: Insurance scores DON’T predict responsibility
A common conclusion drawn about insurance scores is that insurers perceive consumers with good credit history to be generally more responsible and stable. They are less likely to file fewer insurance claims and cost insurers less money. However, insurance scores do not claim to predict overall responsibility or creditworthiness—again, that isn’t what insurers are looking for here. Insurance scores predict expected claims and losses, which is a significant factor when determining premiums.
So, what do you think, is it fair for insurers to determine your insurance premiums according to credit-based insurance scores?
Join us on next week’s post as we discuss whether or not insurance scores are a fair practice, and what consumers can do about it.