Insurance Credit Scoring. The effect of Credit Scoring on Pricing

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1 Insurance Credit Scoring The effect of Credit Scoring on Pricing Abstract The primary objective of every insurance company is to compare rates for insurance policies as closely as possible with the actual cost of claims. This constant search for accuracy is mutually beneficial for consumers as well as insurance companies. New developments have led to the pricing of insurers using Insurance Scoring, which facilitate insurers to better assess the risk of future claims. An insurance score is an arithmetical level based on a person s credit history. Insurance scores are a second-hand way to help insurance providers categorize between lower and higher insurance risks and thus charge a premium equal to the risk they are assuming. Previous statistics show people who have a poor insurance score are more likely to file a claim. On the other hand individuals that have good insurance scores are least 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. Thus, our empirical research will show that even with the positive effects of credit scoring, it still has a negative effect that needs to be mitigated under the state regulation. Hamad Almashary Abdulgaffar Erbek Willie Reddic 1

2 Introduction Insurance scores are confidential rankings based on credit history information. Insurance scores are used to provide insurers with a snapshot to provide service to consumers. The score is derived from the consumer s previous credit history. This data allows the insurers to price insurance premiums/rates more accurately. The data shows that individuals with low insurance scores tend to file more claims. The persons that benefit from Insurance Scoring usually know how to manage their debt well and therefore have good credit scores 1. Positive effects on Insurance Scoring Insurance companies have been using credit scoring with other rating factors as a way to price their clients. In fact, there are many benefits from credit scoring. Credit scoring enables insurers to better assess the risk of future claims 2. In fact, insurance credit scoring helps insurers to differentiate between higher and lower insurance risk. Thus, insurers will charge a premium that is based on the information provided by the credit score. Statistically, people who have a good insurance score are least likely to file a claim. A recent study by the Texas Department of Insurance related to automobile insurance confirmed that Insurance Scoring based on credit information is correlated with risk. In fact, the study shows that the average loss per vehicle for people with the worst credit scores is double that of people with the best credit scores 3 (as shown below). 1 Insurance Information Institute, Inc., Credit Scoring, February Claire Wilkinson, The Use of Credit Information in Personal Lines Insurance Underwriting, June Texas Department of Insurance, Overview of the Texas Credit Study: Texas study confirms that credit scoring accurately assesses the risk of future claims, December 30,004 2

3 Furthermore, the study shows that drivers with the best credit record are involved in about 40 percent fewer accidents than those with the worst credit record (as seen below). On the other hand, the same result applied to homeowners insurance. In fact, the same study shows that homeowners insurance loss ratios for people with the worst credit scores are triple those of people with the best scores 4 (as seen below) 4 Texas Department of Insurance, Overview of the Texas Credit Study: Texas study confirms that credit scoring accurately assesses the risk of future claims, December 30,004 3

4 Insurance scores also 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. In fact, a June 2003 study by EPIC Actuaries conducted for the insurance industry also found that overall, insurance scores significantly increase the accuracy of the risk assessment process. For example, for property damage liability coverage, those with the worst insurance scores had expected losses of 33 percent above average. Those with the best had losses 19 percent below average. Furthermore, most people benefit from Insurance Scoring because the majority of people manage their debt well, which is reflected on their credit score. In addition, creditrelated activities within the last 12 months are given the most weight. Thus, people will reduce their insurance by improving their credit information. Another advantage of credit scoring is that credit records are generally more accurate relative to motor vehicle records (MVRs). In fact, much of that data is missing from motor vehicle records. A 2002 Insurance Research Council study found that MVRs are typically inaccurate. One in five convictions may be missing. Another study found that only 40 percent of reportable accidents appeared on MVRs. Therefore, the credit scoring may be a more appropriate measure for the insurance risk than MVRs. 4

5 Finally, there are some theories that may support credit scoring as a measure for insurance risk. The first theory assumes a positive relationship between financial stress and accidents. According to Clarence Smith of Conning's insurance-research division, Someone having financial problems could be under more stress, which could lead to more accidents. Others theorize that someone who handles personal finances well is likely to be conscientious about other aspects of life, including driving and car maintenance. Negative Effects of Insurance Scoring The use of credit scoring in the insurance industry is considered a positive improvement by a vast majority of the community. However, there are also some critics about the use and the effect of credit scoring on some groups. In this part of our study we highlight views pertaining to this consideration. According to a survey done by S. Ramdas and N. Kaithwal, 5 Insurance Scoring is defined as follows: Insurance Scoring can be defined as the use of certain aspects of a consumer s credit history in combination with relevant behavioral and descriptive parameters, to help determine whom to insure and at what price. This definition of scoring combines many other pieces of relevant information. Nevertheless, this does not decrease the great effect of credit scoring in the overall scoring process. Insurance scoring has been criticized mainly for reasons of unfairness, lack of transparency, and discrimination. 5 Insurance Scoring About Time!, Using Credit History to Manage Insurance Risk,Ramdas, Shrikkant and Kaithwal,Nikhil, August

6 Unfair usage is the biggest criticism area, with arguments along several points including: concerns about inaccuracies in credit history, lack of clarity regarding consumers who don t have a reasonably long credit history, perceived harshness against bankruptcy filers, and that most filings are due to major and often sudden medical or economic catastrophes to the consumer s family such as job loss, disease, divorce, etc. Another criticism is the effect of Insurance Scoring on the increasing cost of insurance. According to this assumption, the redistribution of premiums collected is seen as a significant increase in rates for some groups. An increase in the cost of administering the scoring process is likely to be passed on to the consumer. Lack of transparency is another problem with the scoring process. The issue itself is a difficult concept to explain to agents and it is resulting in reduced sales and consequently their commissions. Due to variations in the application of scoring across different states, there seems to be a lack of clarity on how credit variables are used to determine the score. Another aspect of this problem is about the transparency of the overall process. Scoring model vendors refuse to divulge the methodology of these studies, the underlying data for independent verification, or the details of the study results. They claim these models are a "trade secret" and 'fear' that disclosure would lead to outside infringement. 6 Discrimination is a potential problem for some groups. It possibly penalizes minorities and socially disadvantaged groups, such as those from lower income groups. It 6 Insurance Scoring About Time!, Using Credit History to Manage Insurance Risk,Ramdas, Shrikkant and Kaithwal,Nikhil, August

7 could be viewed as another method to redline on the basis of geographical areas against certain minority groups. 7 Some problems in pricing premiums may arise as a result of Insurance Scoring the ability of the insurance companies to raise or lower the insurance credit score they will accept at will! The use of credit scoring models allows for insurance companies the ability to raise rates without ever applying to the department of insurance for a rate increase. Rates are regulated, underwriting is not. Companies can adjust the underwriting models by changing the cutoff points for the credit tiers. So, if they want to write more business, they lower the score the will accept; less business, they raise the score. As insurance credit scores are also run on existing customers, they are at the mercy of the insurance companies and are exposed to rate increases, moves to subsidiaries and losing their insurance altogether. 8 There is also a problem with the accuracy of the model. Without evidence of reckless driving, (speeding tickets, etc.) and prior losses, there is no proof that any insurance consumer will have an accident and file a claim or will be hit by a hail storm. The insurance company does not have a crystal ball. 9 The critiques about the very existence and the philosophy behind the insurance companies are also valuable. "Insurers no longer want to take risks on uncertain things like weather losses or major lawsuits, but instead want to finance cars and homes. The way to get good loans is by pre-qualifying auto and homeowners policyholders. If a 7 The Truth behind, Insurance Credit Scoring, June The Truth behind, Insurance Credit Scoring, June The Truth behind, Insurance Credit Scoring, June

8 customer doesn t have excellent credit, regardless of a clean insurance record, the carrier quotes higher rates because it will presumably be unable to finance the client s car or sell him/her a mutual fund. All the major insurance companies have their own banking sources, many of which have been established in the last two years." 10 The use of the credit scoring information is another point of criticism. "Consumer advocates also decry the use of CBUP (credit based underwriting and pricing) because the practice forces consumers to divulge private and sensitive information that may not serve to measure risk in order to apply for insurance. Credit information is highly marketable, falls under the relatively lax financial privacy protection provisions of the Gramm-Leach-Bliley Act. Leading consumer advocates point out those insurers may collect credit information for resale, or cross-marketing value alone." 11 According to some arguments, the magnitude and the depth of information on the hands of insurance companies is vast because of the existence of Auto Insurance. It is a legally required insurance by law in most states. Due to this and the practice of insurance credit scoring, the insurance industry has one of the most complete files on any individual. This information includes: name, address, beneficiaries, social security number, family member information, assets, income, property locations and values, transactions with insurer, account balances, policy coverage, payment history, the premium, claims information, method of purchases, reports from consumer reporting agencies, motor vehicle and driver data, loss history reports, additional driver data, and in some cases, medical and employment information. 10 Insurance Journal Online, Credit Based Underwriting and Pricing, February Insurance Journal Online, Credit Based Underwriting and Pricing, February

9 In addition, there are some qualms about the real link between scoring and loss probability. Insurance credit scoring has been used for close to six years now and still they have not proved the link between credit history and driving skill or ability. Scholars in such fields as psychology, safety engineering, occupational medicine, consumer research, and risk perception have been studying this link and have yet to offer a plausible explanation. 12 There are some doubts about the efficiency of legislation, such as the lack of addressing some specific issues. When there is an error in your credit report and it is corrected, insurance companies are not obligated by state or federal law to reverse any adverse action against you. 13 Consequently, the negative effect of credit scoring in the insurance industry is an issue that needs some consideration/possible solutions. There may be a need for some amendments in federal and states legislation. Insurance companies might seek to bring clarity to the transparency of the process. The use of personal information also may need some additional attention in order to determine what information should be used to determine insurance worthiness. Finally, precautions might be taken in order to assure those some groups do not feel they are being discriminated against or redlined. On a positive note, insurance scoring may also create competition in pricing among companies. Insurance companies may use different scoring models so that they create different price levels in premiums. As a result, consumers may have more choices to determine what s best for them. Scoring also may create new products and new markets which could result in more customized products being to consumers. Custom 12 The Truth behind, Insurance Credit Scoring, June The Rough Notes Company, Inc, Personal Insurance Worthines, March

10 scores may help an insurer better differentiate itself from the competition in terms of cost, product and market segmentation which may have an overall effect in increasing business volumes. Those possible improvements may create positive or negative results for insurance customers. It is predictable to say that those improvements will create positive results for groups who have a good credit score but it is not that easy to make the same prediction for less advantageous groups. Lower income Americans are more likely to have less disposable income and resources to cover an incident themselves and may/will need compensation from the insurance industry. Thus, there will probably be more claims filed by lower income Americans making them more likely to be penalized by the insurance companies. 10

11 In conclusion, this paper showed that credit scoring has some positive and negative effects. One of the positive effects is to help insurers to better assess the risk of future claims. Also, our empirical study shows that people who have a poor insurance score are more likely to file a claim. However, Insurance Scoring also negative effects which include unfairness, lack of transparency, and discrimination. In light of these effects, more than 40 states in the US have passed laws that have restricted the use of credit scoring in order to mitigate these negative effects. For example, Illinois allows credit scores to be used, but not as the sole factor in insurance decisions. 11