The controversial practice of using credit scoring to determine pricing of insurance actually saves insurers money, thus lowering the cost of premiums for the consumer, a professor of insurance suggests.

Lawrence S. Powell

Because car insurance coverage is mandatory, the system necessitates the need for credit scoring, argues Lawrence S. Powell, an Independent Institute research fellow and Whitbeck-Beyer chair of insurance and financial services at the University of Arkansas at Little Rock.

Critics of credit scoring say it unfairly hurts the poor and disadvantaged by increasing their rates.

Powell looks at references to credit scoring, which date to 1949.

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, according to Powell. The correlation is one of financial habits: those who make timely debt payments in order to avoid higher interest rates are less likely to file insurance claims, thereby preventing higher premiums.

“When insurers cannot accurately classify applicants for insurance, they must either decline applications, or charge the same premium to high-risk and low-risk drivers,” Powell said in a statement. “Low-risk drivers must over-pay to make up for underpaying high-risk drivers.”

Although simply refusing to insure too-risky drivers may seem like an easy solution, individuals who cannot find private coverage fall into the problematic residual insurance market, a system that exists solely because car insurance is compulsory, Powell argues.

Powell notes that the auto insurance market depends on “coerced cross-subsidization between the private and public sectors.” The state, acting as an insurer of last resort for anyone who can’t afford private coverage, undercharges for premiums and—to make up the difference—mandates that private insurers surcharge their clients and subsidize the same drivers they previously had refused to insure, he noted.

Using credit scores to improve the accuracy of 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 and also the prevalence of burdensome cross-subsidization.

Powell argues that one of the benefits of including credit history in pricing models is that it decreases costs for insurers. Credit information is relatively inexpensive and accessible, and “because the market for insurance is competitive, this savings is passed through to consumers as lower premiums.”

“Because scoring produces more accurate loss estimates, it results in outcomes that are more equitable for individuals and society as a whole,” Powell said.