Insurance Credit Scoring and Consumer Welfare: Should Some Consumers Carry the Risk of Others?

Insurance companies use consumer credit scores as one factor in determining consumer insurance premiums.  Overwhelming research finds that credit scores are highly correlated to insurance claims, which helps insurance carriers align premiums with expected losses.  However, some policymakers have questioned the “fairness” of credit scores as a partial determinant of insurance premiums.  This ConsumerGram finds that credit scoring improves consumer welfare, by efficiently differentiating the market and aligning prices with expected losses.  In short, credit scoring is not only fair, but it keeps premium lower than otherwise, thereby benefiting consumers.   

 

 

Setting Price Requires Knowing Expected Costs

               Consumers buy insurance to protect themselves against what is generally a small probability of a catastrophic loss, effectively transferring risk to insurance carriers.  In turn, insurance carriers spread the risk they assume over a large pool of policyholders, using premiums and capital reserves to shoulder any reimbursement costs to policyholders who incur losses.  The task for insurance carriers is to set their insurance premiums before they incur losses.  To do this, insurance carriers must estimate the expected loss of the risks they are insuring.  For setting automobile insurance prices, this often includes consideration of variables such as age, driving experience, type and year of vehicle, driving record and other factors that have been shown to correlate with expected losses.  In this way, insurers are able to more accurately assess the level of risk posed by different drivers.  Similarly, setting homeowners insurance premiums often includes consideration of variables such as location, attributes and value of the home.  By segmenting the market in this way, prices are better aligned with expected costs, thereby heightening price and service competition.    

Insurance Credit Scoring

While different from credit ratings that summarize a consumer’s ability to take on credit and make payments, insurance credit scores use similar data to indentify which consumers are more likely to be costly “claims problems” for insurance carriers.  By one estimate, consumers with high insurance credit scores are 40% more likely to file insurance claims, making insurance credit scores are one of the best predictors of loss and insurance claims.

 

 In fact, the statistical correlation between credit scores and loss is highly significant, even after accounting for other typical predictors of loss.  This means that insurance credit scores are an important, and arguably the most important, factor correlative factor in determining accurate insurance prices and efficiently segmenting the market.  These sentiments were echoed recently by Professor Lawrence Powell before Congress.  In his testimony, he referred to over one dozen studies on the correlation between credit scoring and loss in the last ten years, noting that these “studies produce very similar evidence and reach nearly identical conclusions.”  The indisputable fact is that credit scores are a significant predictor of property and liability losses, and they are used to price consumer services for virtually all automobile policies and increasingly more homeowners policies.     

 

Price Segmentation Maximizes Consumer Welfare

Because the use of insurance credit scores improve the risk assessment and accuracy of insurance pricing, insurance carriers can better differentiate between high and low risks, such as drivers who are more likely to cause insured losses and those who are less likely to do so.  The consensus among mainstream economists is that price segmentation of this kind is compatible with effective competition and economic welfare maximization.  Price segmentation among customers is common throughout American industry, is quite lawful, is widely supported by welfare economics and analysis, is necessary for efficiency and improves overall consumer economic welfare. 

 

Other Consumers Benefit from Credit Scoring

Besides improving consumer welfare, there are other benefits from the use of insurance credit scores to determine premiums.  Credit scores are an inexpensive means for insurance carriers to improve the accuracy of their pricing.  Without credit scores, the cost to maintain accuracy would increase and lead to higher prices for all insurance consumers.  Professor Powell’s testimony cites studies indicating that between 61% and 91% of consumers (depending on the study) would see higher insurance premiums in the absence of insurance credit scores.    

 

Credit scores better align prices with expected costs.  When prices are not aligned with costs, they can result in adverse consequences that add costs to consumer insurance policies.  In the case of automobile insurance, premiums would be far less accurate without the help of credit scores.  Inaccurate pricing would mean that some risky drivers would pay too little, while other drivers would pay too much.  When risky drivers pay too little, they are encouraged to drive more, which, in turn, results in more accidents, property and liability losses, and deaths – all of which would ultimately drive up insurance costs for all consumers.  Likewise, when less risky divers are overcharged for insurance, they are discouraged from being fully insured, which increases the pool’s risk and, again, drives up costs for all. 

 

What is Unfairness?

Credit-based insurance scoring is one of the most important factors in allowing insurance carriers to accurately predict and target risk.  Given the level of competition in the industry, if credit scoring did not improve accuracy, rivals would have a competitive advantage in not using credit scores.  But, that is not the case, as evidenced by the nearly ubiquitous use of credit scores to accurately align risks with premiums. 

 

In summary, credit scores improve the accuracy of insurance premiums and keep consumer rates lower.  Therefore, calls for the elimination of credit scoring would be anything but fair to average consumers and, in particular, low risk ones.     

 

Suggested Readings:

·         William Baumol, Regulation Misled by Misread Theory, AEI-Brookings Joint Center, 2006.

·         Michael E. Levine, “Price Discrimination without Market Power,” Yale Journal on Regulation, v. 19, no. 1, winter 2002.

Lawrence S. Powell, “The Impact of Credit-Based Insurance Scoring on the Availability and Affordability of Insurance,” testimony before the subcommittee on Oversight and Investigations Hearing, House Committee on Financial Services, United States House of Representatives, May 21, 2008.

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