- Posted by Admin on December 21, 2010
Hopefully this post will add some meat to the potatoes of our last post. Part 1 of this 2-part post provided a brief discussion of the emotion, both pro and con, swirling around the use of credit in personal lines insurance rating. It then drew a distinction between the use of credit in insurance rating and how credit is used in the financial sphere. Basically, it set the stage for this follow-up post, which gets into the meat of how credit-based insurance scores have performed since the economic downturn.
Before getting started, let’s briefly review the key concept from our last post. In building credit-based insurance models, modelers first review all credit attributes in order to identify those which show a positive correlation to insured losses. Only these attributes are used in the development of credit-based insurance models, while all other credit attributes are ignored. Whether or not the predictive models combine these positively correlated credit attributes with non-credit data, they produce credit-based insurance scores that are predictive of insured losses, not of credit worthiness. Credit-based insurance models are separate and distinct from credit models such as the FICO score.
OK, so the question at hand is this: did these insurance scores tank along with the economy, thereby increasing premiums and providing a windfall for insurers at the expense of their insureds? The short answer is “no” (that’s the funny thing that happened on the way out of the recession, in case you didn’t figure it out). And the facts behind this answer are more logical than one might expect.
There can be a fairly broad range of credit attributes that enter into the development of insurance scores, but we will focus on five that are widely used: inquiries (which represent a search for more credit), age of accounts, actual utilization of credit (outstanding credit balance as a percent of credit limit), late payment history, and bankruptcies/foreclosures.
Let’s look at these credit attributes, keeping an eye on what we’ve read and heard about the recent recession. We’ll start with the last attribute. There is no doubt that bankruptcies and especially foreclosures rose to unprecedented levels in the recent downturn, certainly to higher levels than previous historical averages. From the beginning of 2007 to the end of 2009 (the time frame of all references in this article) total bankruptcies and foreclosures rose by roughly 7%. Clearly this attribute has penalized insurance scores, especially in those states with the most distressed housing markets, since we know the actual number varied widely around the 7% average in different geographic areas.
Bankruptcies and foreclosures are the headline grabbers, and are commonly cited by those who fear that credit-based insurance scores unfairly penalize helpless victims. However, even acknowledging their impact, let’s take a logical look at what happened to the overall fiscal behavior of most individuals during these hard times: they became more conservative with their money. What’s a fundamental by-product of conservative fiscal behavior? People use less credit, and that’s a good thing from the standpoint of credit scores. (Note that I said “people” use less credit; it’s been in vogue for politicians to use more credit in an attempt to stimulate people to be less conservative with their money management. Then they wonder why they get the adverse economic results they do.)
More specifically, reduced spending kept delinquencies flat and outstanding balances down by about 1% during the recession. In other words, more responsible economic behavior offset the greater difficulty people had in meeting their financial obligations. As a result of this behavior modification, these two attributes didn’t look any worse during the recession than they previously had.
The more impactful items were average account age and especially inquiries. Since people were tightening their belts as they grew more defensive in their money management, spending was down. As a result individuals didn’t need any more credit, and there was slightly more than a 30% decline in the number of new credit applications. Reduced new credit applications were the biggest impact of the poor economy on personal economic behavior, and it was a very positive modification from the perspective of insurance modeling. A byproduct of the reduced number of credit inquiries was that individuals used in-force accounts rather than new ones for their credit purchases, increasing the average account age by about 16%. This further benefited insurance scores.
In short, for the most part people saved more, spent less and paid down debt to the extent they could instead of borrowing more. Different models apply different weights to the various attributes they use, and models can use more or fewer attributes than the five mentioned above. They also may include non-credit related items such as accidents, violations, family profile, and numerous other variables. Therefore, not all models would have behaved the same. For the models referenced for this article, average scores actually rose between 2007 and 2009.
Interestingly, when times were "good” before the recession, the same models showed either no change or actual deterioration in insurance scores. This is for the same reasons as the improvement, only with the logic reversed. When individuals liberally take advantage of the credit resources at their disposal, such activity tends to penalize insurance scores. If you think of credit-based insurance models as a reasonable proxy for responsible behavior, this all makes sense. There generally isn’t an increased cry about the unfairness of credit models because of their adverse impact during boom times, however.
Through both good and bad economic times, the correlation between these credit-based models and insured losses has remained consistently strong. The models do what they are intended to do – higher risk drivers pay more, and lower risk drivers pay less. Most arguments against the use of credit-based insurance models do not dispute this, but are based on perceptions. A presumed unfairness attributable to tough economic times is one such perception. While it is undeniable that certain individuals did get penalized for recent economic events, the masses benefited because of their natural defensive reaction to those same events.
Credit-based insurance models will remain controversial due to the emotion involved. However, insurers use them for one reason only – they lead to more equitable pricing of insurance products, refining the alignment between premiums and losses. Whether that alignment is contrary to the overall public benefit is not an insurance question, but a political one. Putting it in that arena may not add confidence to the results, but it certainly will make the controversy more entertaining (to those who don’t have a stake in the game).
Insurers use credit-based insurance models for one reason only – they lead to more equitable pricing of insurance products, refining the alignment between premiums and losses. If we want to be honest, the question of whether that alignment is contrary to the overall public benefit is not an insurance question, but a political one. Because this issue really is political rather than insurance-related, credit-based insurance models will remain controversial due to the emotion inherently involved in any political issue. That’s the real arena credit-based insurance rating belongs in. Putting it in that arena may not add confidence to the results, but at least the public would know what game really is being played.