It seems like an odd request when your insurance broker asks if they can do a “soft hit” credit score check to see if you qualify for an additional discount on your insurance premiums doesn’t it? I mean, what does credit score have to do with insurance? Quite a bit actually!
Before I get into the nuts and bolts about why credit scoring is used, its important to outline a few key components of insurance and unpack some of the jargon. I will start by explaining a couple of principals of insurance, and then the jargon, which will lead us right into the point at hand.
First of all, what you need to know about insurance is that it is all about diverting (getting away from) risk. Essentially, when an insurance policy is purchased, there is a contract that is put in force between and insurance company (the insurer) and the policy holder (the insured). The nature of that contract is one where a premium (money) is paid for guarantees (promises) to cover risk (losses) in the event that there is a peril (event) that is agreed to be covered within the terms of the contract. The perils (events) that are agreed to are listed in the wordings (fine details) of the policy that you buy. This whole process is summarized in an insurance term called “transference of risk” which simply means that you are transferring the risks that you face to a third party to absorb. To break it down further- if you own a house, you face the risk of the house burning down and it could cost a large amount of money to fix or replace. So, to mitigate this risk, you buy an insurance policy that contains the promise to pay for the fire damages to your home in exchange for payment of that contract. The transaction has taken the risk you face, and transferred it to a third party. The only risks you have now are the insurance premiums and a deductible.
So, I have rambled on about the basic premise of insurance and what it does, but there is still more to dive into. We established that insurance transfers risk away from the consumer, but the flip side to that equation is the risk that the insurer takes on, and the cost of the contract to do so.
“Surprise” is a dirty word in the insurance industry.
One element of the word “risk” that we need to unpack further is defining what types of risks are insured. There are two types of risk that you can have- speculative risk, and pure risk.
Speculative risk plays on probabilities and odds. Rolling a die and hoping for a six lest you lose the game contains risk, but it is speculative. We know the mathematical probability of rolling a six and we can speculate odds based on math. Speculative risk contains a foreseeable event that can be managed and controlled.
Pure risk is a different animal altogether. Pure risk is an unforeseeable event that is not guaranteed to happen. There is no way to speculate if and when the risk may occur- case in point- a house fire is not a foreseeable event. Sure, there might be factors that can lead up to a fire, but whether or not a fire occurs is a complete guessing game.
Insurance companies insure pure risk only. They don’t cover risks which can be predicted, and they don’t cover risks which are malicious in nature. Arson- not covered (willful), wear and tear- not covered (predictable), criminal acts- not covered (malicious)
So getting back to that dirty word “surprise”…
Insurance companies are excellent record keepers. They document every loss, when it happens, how much it costs, and the conditions surrounding the event which triggered the loss. Every type of coverage (theft, fire, vandalism, explosion, water, etc) has a coverage code associated with it in their systems, and every time a loss is triggered by one of the coverages, they document everything about it. This gives the insurance company data that they can use to figure out an acceptable rate of premium for a given peril. The rate is determined by using two factors- frequency (how many times does the loss occur) and severity (how much does the loss cost). There are more factors at hand in determining rates, but in the most basic sense, insurance companies use this data to help establish appropriate rates of premiums for insurance.
Here is an example of data collection companies would use:
- Cover Code- Fire
- Frequency- 3 fire losses per year
- Severity- $100,000 per loss
So, in a given year, for fire alone, insurance companies need to pay out $300,000 in claims, which means they need to collect enough premium to cover these losses. This data helps the companies know how much to charge each policy holder so that they don’t go bankrupt, and it also helps them know how to price their policies in a competitive manner. Policy holders don’t just want to pay exorbitant amounts of money for policies, they want the best deal possible
Back to the point- Credit Scoring
Insurance companies have made a connection between credit scoring, and losses associated with varying levels of credit scores. The lower the score, the more likely the insured will suffer a claim. Why? Well, if someone is in tough financial condition, it is likely that they will put in claims more frequently than someone who is financially stable because chances are good that the insured may not have the resources to look after, replace, or repair property that they own. On the flip side, if someone has a good credit score and has money in the bank, they are less likely to submit a claim due to being able to afford their own losses, thus reducing the frequency of claims.
I talked about surprise being a dirty word earlier- this is another method to remove the word “surprise” from an insurance company’s risk. They have made another correlation between what causes risk, and what mitigates risk. If an insurance company can insure someone with less likelihood of putting in a claim, they will. Just like any other business in the world, insurers are in business to make money and remain financially solvent.
Credit scoring- it might seem random, but insurance companies know what they are doing, and they want to do it well. When better risks are accepted by an insurance company, there are less claims. Credit scoring is just one more method that is used to measure the quality of the risk that is presented to them on paper. The higher the quality of risk, the lower the cost. The lower the cost, the more competitive an insurance company can be.
If you have questions about anything in this blog, or if further clarification is needed on risk or the terms used, please contact one of our brokers and we would be happy to help any way that we can!