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Report Discusses Accuracy, Appropriateness of Credit-based Scoring

Source: Independent Institute Research

Posted on 07 Oct 2009

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With unemployment and high prices plaguing the economy, many are struggling to cover everyday expenses. While cutting back is never easy, it's impossible when the expense is mandatory. Unlike health insurance (at least for now), car insurance isn't optional. 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.

In his new report, "Credit-Based Scoring in Insurance Markets" (October 2009), Independent Institute Research Fellow Lawrence Powell discusses the accuracy and appropriateness of credit-based scoring, also known as insurance scoring. Professor Powell examines its effect on insurance markets, focusing on its value in the automobile insurance industry.

The correlation is one of financial habits, says Professor Powell: those who make timely debt payments in order to avoid higher interest rates are less likely to file insurance claims, thereby preventing higher premiums. He notes, "When insurers cannot accurately classify applicants for insurance, they must either decline applications," or charge high- and low-risk drivers the same. In the latter case, low-risk drivers overpay to compensate. Although simply refusing to insure too-risky drivers is a solution, individuals who cannot find private coverage fall into the problematic residual insurance market, a system that exists solely because auto insurance is compulsory.

This market depends on cross-subsidization between private and public sectors. The state, acting as an insurer of last resort, undercharges for premiums. It then mandates private insurers to surcharge their clients to subsidize the same drivers they previously refused to insure. Using credit scores to improve 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.

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.

Contact: Wendy Honett The Independent Institute 510-632-1366


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