The History of Using Credit Scores to Price Insurance Premiums
Insurers have been using credit information to make decisions regarding their applicants since at least since 1970 when the practice was first declared legal. Before that, considering an insurance application was a subjective and inconsistent process; an insurance adjuster would look for clearly bad signs on a credit report such as a bankruptcy, foreclosure or collections.
Shortly after introducing the first credit scores based on credit bureau information Fair Isaac decided to also market scores to insurance companies in the eighties. The company was instrumental in promoting the idea to insurers that credit information can be useful in predicting future losses.
Fair Isaac introduced its first credit-based insurance score in j1991 and hired the actuary consultants Tinghhast-Towers Perrin to study the links between credit history and insurance losses. The results proved that people with bad credit ratings were also expensive prospects for insurers.
This business of checking out credit scores to predict insurance risk got another boost in 2000 when an actuary from MetLife name James E. Meaghan published a study that compared 170,000 auto policies to the credit histories of the drivers. He found a correlation between black marks on credit reports and higher loss ratios for consumers. For those of you who don’t know, a loss ratio measures how much an insurer pays out in claims for each dollar collected in premiums.
Loss ratios in his data rose steeply in tandem with the number of collection accounts appearing on a driver’s record. Those who had no collection accounts cost the insurers an average of 74.1 cents for each dollar collected. Drivers who had one collection account had 97.5 cents in claims for each premium dollar collected whereas those who had three or more collections on their accounts cost insurers about $1.19.
In the end Monaghan came up with a complex series of analytical chars to compare credit risk to insurance risk. One of the easiest of his charts to comprehend is the one below which looks at the total amount of Past Due accounts on a person’s credit history…
Keep in mind when looking at this chart below that it describes the likelihood of a loss for the insurer according to the amounts past due amount in a credit history is
Amounts Past Due Loss Ratio For Insurer
0 70.20%
$100 to $199 95.9%
$200 to $499 92.7%
$500 to $999 107.2%
$1,000 to $2,000 97.2%
$2,000 to $5,000 100.5%
$5,000 to $10,000 106.1%
$10,000 plus 99.8%
Monagham also found a relationship between the number of collection accounts in a credit history and a higher loss ration.
Number of Collections Accounts Loss Ratio
None 74.1%
1 97.5%
2 108.4%
3 or more 118.6%
From looking at the above correlations you can plainly see how insurers became convinced that your credit report could become a valuable tool when it came to assessing insurance risk and also justifiably charging higher rates for insurance.