Insurers need a fallback plan

It seems that insurance companies can do no right. This is especially true when it comes to setting rates. Customers demand high quality insurance coverage, but don’t want companies to be able to factor in certain personal details about policy holders that would allow them to charge higher rates to higher-risk policy holders while giving a discount to customers that represent less of a risk–all of which simply means that everyone gets charged more.

One of the most controversial factors insurers use in rate-setting is credit history. Most policy holders can’t understand what their credit score has to do with their ability to drive a car and many states, such as Maryland and Michigan, are on the verge of passing laws or courts rulings that would ban or limit an insurance company’s ability to use credit-based rates. Perhaps it is so controversial because even the insurance companies themselves do not understand why there is a correlation between low credit and higher rates of losses, but there is.

Insurance companies work like forecasters. They predict the number of accidents and how many people will make claims on their policies and how much of it they will use. In order to predict the likely amount of loss each insured represents they use a wide range of factors that together add up to the most accurate assessment of risk. The more accurately an insurer can predict the less they need to charge-the less of a financial cushion they need for unforeseen accidents. The less clearly the prediction, the more they need to charge to make sure they can pay claims. Despite what many consumers believe, insurance companies aren’t looking to make a profit by charging exorbitant rates for safe drivers who never get in an accident-on the contrary.  Insurance companies simply want to get as close to breaking even as they can; this allows them to charge less than the competition, keep customers, and invest their funds in interest bearing assets. The more customers they have, the more money they have to invest and the more profit they can take in…so long as they don’t lose money by miscalculating how many accidents a policy holder gets into.

Some consumer advocates and insurance commissioners argue that use of credit history or scoring unfairly discriminates against minorities and low-income policy holders-though the insurance companies insist that they are “blind” to income and ethnicity because they do not ask about those factors when writing a policy. Some argue for a ban on rates based on credit not because it is inaccurate or flawed, but simple because insurers can’t identify why poor credit history correlates with a higher insurance losses. In fact in Florida insurance companies were told that they would need to prove that the use of credit scoring did not disproportionately affect consumers of a specific race, religion, marital status, age, gender, income, national origin, or place of residence-regardless of whether or not there was a correlation between any of these factors and poor credit history.

If consumer advocates want to convince insurance companies to stop using credit history and they want them to offer lower rates the only way to do this is by showing them a way to more accurately predict the risk of each customer. Simply forcing companies to ignore evidence that allows them to get closer to accurate predictions will simply raise the premiums and rates for everyone-good credit or bad.