OAKLAND, Calif., Oct. 1, 2009—With unemployment and high prices plaguing the economy, many are looking for ways to reduce costs as they struggle to cover everyday expenses. While cutting back is never easy to do, it’s impossible when the expense is mandatory. Unlike health insurance (at least for now), car insurance isn’t optional. If you don’t have it, it is illegal to drive. Traditionally, age, gender, driving history, and geography have been used to determine premiums, but credit scores are gaining recognition as one of the most reliable indicators of a person’s potential insured losses. Although this practice is disputed, a new Independent Policy Report clarifies both sides of the debate and provides an intriguing analysis of what it could mean for the future of insurance markets.
In Credit-Based Scoring in Insurance Markets (October 2009), Independent Institute Research Fellow Lawrence S. Powell responds to the controversy surrounding the use of credit histories in insurance price determination. In his study, Powell (Whitbeck-Beyer Chair of Insurance and Financial Services and Assistant Professor of Health Services Research at the University of Arkansas at Little Rock) discusses the accuracy and appropriateness of credit-based scoring—also known as insurance scoring—and its effect on insurance markets, focusing on its value in the automobile insurance industry.
The author explains that the link between credit history and insurance claims has been recognized in academic literature since 1949. The correlation is one of financial habits: those who make timely debt payments in order to avoid higher interest rates are less likely to file insurance claims, thereby preventing higher premiums. Credit-based scoring has been empirically proven to provide information with the highest predictive accuracy. As Powell notes, “When insurers cannot accurately classify applicants for insurance, they must either decline applications, or charge the same premium to high-risk and low-risk drivers.” In the case of the latter, “low-risk drivers must over-pay to make up for underpaying high-risk drivers.” Although simply refusing to insure too-risky drivers may seem like an easy solution, individuals who cannot find private coverage fall into the problematic residual insurance market, a system that exists solely because car insurance is compulsory.
This market depends on coerced cross-subsidization between the private and public sectors. The state, acting as an insurer of last resort for anyone who can’t afford private coverage, undercharges for premiums and—to make up the difference—mandates that private insurers surcharge their clients and subsidize the same drivers they previously had refused to insure. Using credit scores to improve the accuracy of risk predictions allows insurance companies to take on clients who they would have rejected had they been unable to determine an appropriate premium. In effect, credit-based scoring can reduce the size of the residual market and also the prevalence of burdensome cross-subsidization.
Professor Powell’s report draws on research conducted both nationally and within single states and uses uni- and multivariate statistical tests to demonstrate the accuracy of insurance scoring, the positive effect it has on reducing residual market share, and the way in which it promotes fair treatment of insured drivers. In addition to providing insight on past studies, Powell expands upon current literature to combat the misconception that credit-based scoring increases the average premium. He argues that one of the benefits of including credit history in pricing models is that it decrease costs for insurers. Credit information is relatively inexpensive and accessible, and “because the market for insurance is competitive, this savings is passed through to consumers as lower premiums.”
Ultimately, Powell finds that, “because scoring produces more accurate loss estimates, it results in outcomes that are more equitable for individuals and society as a whole.” Although this method is often misunderstood, Credit-Based Scoring in Insurance Markets sets the record straight by providing an engaging and well-researched explanation of the current use of credit scoring and the potential that it has to provide value to both insurers and consumers.
# # #
