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How Are Insurance Premiums Determined?

Insurance is often said to rely upon the law of large numbers in which a large number of people facing a common risk come together to share the costs of that risk. It’s really fairly simple – everyone pays a premium, and when you have a “covered” loss, you collect from the pool of money that everyone has paid into.

But how do we determine how much premium each person pays? Generally, insurers use actuarial studies and other information to determine how likely you are to have a claim. Your premium is based on a lot of factors, but most of them revolve around assessing how likely each person is to have a loss, and how much they stand to recover from the pool.

Many of the factors are simple to understand. If a person has had a lot of auto accidents, then it is generally likely that that person will have another. Therefore the pool will charge that person more than his neighbor who has never made a claim. Likewise, a teen-aged male will pay much more auto insurance premium than a 55-year old married woman. This is not because every male teenager is a worse driver than every 55-year old married woman, but as a group, male teenagers have more accidents.

How Does an Insurance Credit Score Affect Premiums?

One of the many factors that insurance companies may consider in determining your insurance premium is your “insurance score” which is based on portions of your credit rating. Studies have shown that those who have higher insurance scores will be less likely to have claims than those with lower scores. See here for a summary of those studies as well a summary of some of the latest developments in this area.

The facts show that insurance scores are very good predictors of future claims activity, and should therefore be considered as one among many factors in determining a person’s premium. Again, as with the teenaged male and the 55-year old married woman, not everyone with lower scores will have more claims than everyone with higher scores, but as a group those with higher scores are less of a risk.

Most Consumers Benefit from the Use of Insurance Credit Scores

The facts also show that most people benefit from good insurance scores. Depending on the company, people with higher insurance scores often receive a discount on their premium while those with poor scores tend to be charged more, just as a teen driver will get a discount for good grades. If the use of credit scoring were eliminated from consideration in setting premiums, the majority of people would see their premiums rise.

In a July 2007 report to Congress, the Federal Trade Commission released the results of a study that they completed on insurance scoring. The report is titled “Credit-Based Insurance Scores: Impacts on Consumers of Automobile Insurance” and a link to the report is here. The report had several findings and conclusions, and the main points are summarized below:

• Insurance companies increasingly are using credit-based insurance scores in deciding whether and at what price to offer coverage to consumers.
• Credit-based insurance scores are effective predictors of risk under automobile policies. They are predictive of the number of claims consumers file and the total cost of those claims. The use of scores is therefore likely to make the price of insurance better match the risk of loss posed by the consumer. Thus, on average, higher-risk consumers will pay higher premiums and lower-risk consumers will pay lower premiums.
• 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.
• Use of credit-based insurance scores may result in benefits for consumers. For example, scores permit insurance companies to evaluate risk with greater accuracy, which may make them more willing to offer insurance to higher-risk consumers for whom they would otherwise not be able to determine an appropriate premium. Scores also may make the process of granting and pricing insurance quicker and cheaper, cost savings that may be passed on to consumers in the form of lower premiums. However, little hard data was submitted or available to quantify the magnitude of these benefits to consumers.
• Credit-based insurance scores are distributed differently among racial and ethnic groups, and this difference is likely to have an effect on the insurance premiums that these groups pay, on average.
• Credit-based insurance scores appear to have little effect as a “proxy” for membership in racial and ethnic groups in decisions related to insurance.
• After trying a variety of approaches, the FTC was not able to develop an alternative credit-based insurance scoring model that would continue to predict risk effectively, yet decrease the differences in scores on average among racial and ethnic groups. This does not mean that a model could not be constructed that meets both of these objectives. It does strongly suggest, however, that there is no readily available scoring model that would do so.

Kentucky Law

Kentucky law does prohibit the declination, non-renewal, or cancellation of insurance based solely on credit scoring. It is still permissible, however for insurers to base premiums at least partly on insurance scores, so Kentucky companies can continue to offer discounts to those with good scores. IIK will continue to educate the public and to advocate for the use of credit scoring as well as other factors that are a legitimate means of differentiating risk.

More Information

The Insurance Information Institute, the American Property Casualty Insurance Association, and the National Association of Mutual Insurance Companies each have good information on the use of credit scoring, including what is happening in other states.