Do insurance rates depend on credit scores?

Question

When reading up on credit scores, I came across this article. It contains this paragraph:

A bad score can become a black mark that leads to missing out on the home you want (credit checks are a common aspect of apartment applications), higher car insurance rates, or even difficulty getting a cell phone, according to Nerdwallet.

It links to this other article as a reference.

I find that shocking. Is it true?

I mean the cellphone part already seems like a lie because the second site says it only applies if you try to get a phone via a contract that obligates you to pay part of the phone each month. I'd call that "funding a purchase with a fixed-term debt", not "getting a cell phone".

But the statement about insurance rates is backed up by the second site. Is it true? If not, why do they think it's true? If it is true, why do insurance companies do that?

The articles are about the U.S. I care about Germany in particular (because I live in Germany) but also about how it generally is around the world (because I might want to move).

Answer 1

Ok So I worked some time in the insurance industry, in Germany, so here is what´s relevant for you:

Car insurance is mainly priced by 4 factors:

1. Your track-record "Schadenfreiheitsklasse" - you can take that with you whenever you change the insurance company. It will be lower the more years you drive and go up if you have an accident. The old company is required by law to give that information to the new company.
2. Vehicle statistics. "Typenklasse". The performance of the specific make and model in the insurers database. Info about type classes
3. Regional factor. "Regionalklassen" In different areas there are different hazards (rural or city, snow and ice etc...) More info about regional classes
4. Estimated kilometers per year. Most insurance companies have brackets for every 3.000 km/pa so it may be the same price no matter if you give 10k or 12k a year, but the step comes at 13k etc ..

Then there are several modifications, depending on the insurer, like:

• is the car parked at a garage or on public ground
• Can the insurance dictate the workshop which does the repairs
• Additional drivers, age of the youngest driver.
• Rebates for fleet or other types of insurance with the same insurer
• ...

Credit score does not play a role in the pricing in Germany. Remember, the company pulling a credit score "schufa auskunft" has to have your agreement to do so. So when they don´t ask you to give that agreement it is a clear sign that this information does not matter.

Answer 2

I find the possible answers to your specific question fascinating:

If it is true, why do insurance companies do that?

In the US there have been studies that show a correlation between higher credit scores and lower risk to the insurance company (and vice versa). Here are some examples:

Texas Business Review, 2003

Federal Trade Commission, 2007 with the full report here.

Of particular note, the FTC report references (on page 21) an EPIC Actuaries study from 2003 which showed an interesting breakdown of types of claims:

[The study] also showed: (1) no correlation between scores and the size of liability coverage claims; (2) a weak correlation between scores and the size of collision coverage claims; and (3) a strong correlation between scores and the size of comprehensive coverage claims.

Note that "comprehensive" coverage are for claims that are beyond the policy holder's control, such as weather damage, theft, etc. The following possible explanation for this is offered on page 27:

The different result for comprehensive coverage may be attributable to a correlation between having a lower score and a higher probability of being a victim of automobile theft, because theft claims are larger than claims resulting from most other events that this type of insurance covers.

The FTC report also addresses why the overall correlation between credit score and higher claims exists, with the following (wise) disclaimer on page 3:

Several alternative explanations for the source of the correlation between credit-based insurance scores and risk have been suggested. At this time, there is not sufficient evidence to judge which of these explanations, if any, is correct.

On page 31 the FTC report offers some explanations:

A strong credit history, however, might indicate that a consumer has taken care in managing his or her financial affairs - avoiding loans that might be difficult to repay, avoiding high balances on credit cards, making sure that bills are not misplaced and are paid on time, etc. A consumer who is prudent in financial matters may also be cautious in other matters related to insurance, such as being more likely to put time, effort, and money into things like car and home maintenance, cautious driving habits, etc. An overall inclination to be prudent may lead a consumer both to have a strong credit history and file fewer insurance claims.

Similarly (also page 31):

Researchers have studied attitudes toward risk, as well as behavior, in financial settings and driving, as well as a range of other areas including smoking, occupational choice, and migration. ... Many of the psychological studies surveyed in that article analyze the relationship between psychological factors and risk-taking in a single aspect of life. The authors connect these results between financial behavior and driving from studies on separate groups of people, and posit the theory that credit-based insurance scoring works because scores reflect the psychological makeup of the individual in ways that affect insurance risk.

And also (page 32):

Others have suggested that credit history provides information about a consumer’s circumstances and those circumstances affect the likelihood or size of claims. One example is that a driver with a low credit-based insurance score may be in a distressed financial situation. This may cause stress that makes the consumer a less attentive driver. Being in a distressed financial situation also might give the driver a greater incentive to try to obtain payment under an insurance policy. For example, he or she may be more likely to file a claim for a small amount of damage to an automobile rather than paying for those expenses out of pocket.

Due to the emotional nature of this topic I feel it's extremely important to reiterate the FTC disclaimer here: "At this time, there is not sufficient evidence to judge which of these explanations, if any, is correct."

And also please note that all of these explanations are provided for groups and not individuals.

Answer 3

Is it true?

Yes, in the US, as indicated in the articles you have found. Many auto insurers use credit score in their underwriting process as part of the function that determines the cost of your policy. They are allowed to do this because there is substantial evidence that people with lower credit scores present a higher risk of loss and a risk of not paying their bills on time.

It's hard to answer with respect to your question about "generally around the world" because insurance regulation varies significantly.

Answer 4

Because there is a correlation between credit scores and accident rates. Meaning that people with bad credit scores tend to get into more accidents. There's not necessarily a causation, and it may not apply to you, but it is one factor that insurance companies use to set rates more equitably.

Also, I wouldn't expect it to be a huge factor. Your driving record is going to be much more impactful that your credit score.

Answer 5

Its company dependent and might change in the future. Insurance companies use whatever means necessary to rate their customers accurately. To me, the correlation that people with bad credit scores are poor property and casualty insurance risks, is not overreaching.

The "bad" part is important. How hard is it to keep your credit score above some minimal value, like 500? Not hard. Additionally these people might had difficult maintaining their vehicles which could lead to additional accidents and therefore claims.

However, there is unlikely to be a difference with relatively high credit scores. Imagine three people with scores like 675, 720, and 820. Which of those will lead to higher claims? Probably the person that is more likely driving a late model expensive car and then only because those cars are costlier to repair.

Many use "credit score hacking" to justify the purchases of things they cannot afford. The best way to hack your score is to simply pay your bills on time and borrow as little as possible and preferably none.

Answer 6

I just came across a recent paper that discusses the US car insurance practices:

Kiviat: The Moral Limits of Predictive Practices: The Case of Credit-Based Insurance Scores, American Sociological Review, 84(6), 1134–1158

Abstract Corporations gather massive amounts of personal data to predict how individuals will behave so that they can profitably price goods and allocate resources. This article investigates the moral foundations of such increasingly prevalent market practices. I leverage the case of credit scores in car insurance pricing—an early and controversial use of algorithmic prediction in the U.S. consumer economy—to unpack the premise that predictive data are fair to use and to understand the conditions under which people are likely to challenge that moral logic. Policymaker resistance to credit-based insurance scores reveals that contention arises when predictions depend on mathematical distinctions that do not align with broader understandings of good and bad behavior, and when theories about why predictions work point to the market holding people accountable for actions that are not really their fault. Via a de-commensuration process, policymakers realign the market with their own notions of moral deservingness. This article thus demonstrates the importance of causal understanding and moral categorization for people accepting markets as fair. As data and analytics permeate markets of all sorts, as well as other domains of social life, these findings have implications for how social scientists understand the novel forms of stratification that result.

While I haven't yet read it in detail, two points that I find highly enlightning are:

• Different types of insurance follow different fairness principles. In particular there is actuarial fairness meaning that risk is shared among strata (groups of people) with similar overall risk. This seems to be the predominant mode of operation for car insurance. Other insurance types focus on solidarity instead, thus deliberately making people with lower risk pay for those with higher risk (on average).

• Further along this line of thought, the paper discusses that credit scores are good for predicting costs for insurances (so actuarial fairness) but do not necessarily allow moral conclusions (whether someone with a bad credit score deserves to be charged more). Good prediction needs only sufficient correlation, whereas moral judgment needs knowledge about causation.

Part of the answer to "why do insurance companies do this [use credit scores]" seems to be that a certain amount of legislation in the US that actually prescribes actuarial fairness for car and similar insurances*. And credit scores have been shown to be sufficiently good for predicting insurance events.

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* Kiviat paper, p 1137-38 (my emphasis):

 In the United States, car insurance companies gather data about individuals to actuarially predict how likely they are to file insurance claims and otherwise cost companies money. Insurers then charge different people different prices in line with these expected costs.

That this is a fair way to price insurance is institutionalized in law, regulation, and the standards of the actuarial profession. In the early twentieth century, most states adopted statutes to govern property and casualty insurance, of which auto policies are one type (homeowners’ insurance is another). These statutes prohibit “unfair discrimination,” which exists if “price differentials fail to reflect equitably the differences in expected losses and expenses” (NAIC 2010:5; see also Schneiberg and Bartley 2001).2 In other words, for insurance to be fair, companies must charge customers for their predicted costs. These laws evolved from industry efforts to prevent insurers from destructively undercutting each other on price (i.e., from engaging in unfair competition). Over time, regulators, actuaries, and members of industry embraced the idea that pricing in line with predicted costs was also a form of fairness to consumers (Crane 1972; Wortham 1986b). Scholars of insurance refer to this as “actuarial fairness,” a term that companies, regulators, and other practitioners occasionally use as well.