Kucera.Credit

Reading: “NAIC Public Hearing on Credit-Based Insurance Scores,” American Academy of Actuaries, April 30, 2009.

Author: Kucera, J.,

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BA Quick-Summary: Credit-Based Insurance Scores At an NAIC hearing in 2009, Jeff Kucera (AAA member) discussed credit scoring as a rating variable. Although credit scores can be distorted by downturns in the economy, he felt that credit score is a good rating variable.

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Based on past exams, the main things you need to know (in rough order of importance) are:

• how an economic downturn relates to the use of credit scores
• arguments for and against use of credit scores (arguments against are covered in McCarty.Credit)

reference	part (a)	part (b)	part (c)
E (2017.Fall #1)	economic downturn: - response to regulator	see McCarty.Credit	credit scores: - actions limiting use
E (2016.Fall #2)	economic downturn: - regulator concerns	economic downturn: - response to regulator	economic downturn: - rate caps & pricing principles
E (2014.Spring #5)	credit scores: - arguments for	see McCarty.Credit	economic downturn: - impact on stakeholders

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In Plain English!

Definition of Credit Score

This is a pretty easy paper. An insurance score is a numerical score assigned to an insurance risk based on a risk's underlying characteristics. And a credit score is an example of an insurance score that uses attributes found in a credit report.

When I hear the term credit score, here is what pops into my head:

Credit scores are highly predictive of claims costs, but many people think their use is unfair. The use of credit scores as a rating variable is banned in many jurisdictions.

Let's try to understand what this is all about. First, what specifically would insurers like to use credit scores for:

• as an U/W criterion
• for assignment to tiers
• as a rating variable

So, if you have a low credit score, you may be outright rejected or you may be charged a high rate. But it also works the other way: If you have a good credit score, you'll likely get a lower rate. The issue that regulators have is that credit scores may be unfairly discriminatory and that would violate one of the main principles of actuarial pricing (Principle #4)

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Social Concerns

The use of credit scores can have an impact on the aggregate premium a company collects, and/or the individual premium of a specific customer. (Keep this distinction in mind.)

Question: what are some arguments for and against the use of credit scores

for: [Hint: SMORe]

Statistical significance (in predicting expected loss costs)

Manipulation (credit scores are difficult to manipulate because they are calculated by 3rd party companies, not self-reported)

Objective (credit scores are based on numerical data so they are objective)

Removal (removing credit scores won't change aggregate premium, provided an off-balance is applied)

e (doesn't stand for anything, I needed the "e" to spell Alice's favorite snack)

against: [Hint: FEED]

see McCarty arguments against use of credit scores

Alice's joke of the day: FEED me a SMORe and I'll give you credit for being awesome.

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Economic Downturns

An interesting question concerns the effect of an economic downturn on credit scores. (See Battletable for relevant exam questions.) Downturns will happen from time to time because of the cyclical nature of the economy. In a downturn, an individual may lose their job and be unable to pay their bills. Obviously this would have a negative impact on their credit score and may cause their auto rates to increase, but would their accident frequency increase? Probably not. In fact, if they didn't have a job and didn't have to drive to work, their accident frequency would likely decrease.

Question: what concerns might a regulator have regarding credit scores in an economic downturn

• an unwarranted increase in aggregate premiums if the average credit score got worse
• a distributional shift in individual premium that doesn't reflect true cost differences (losing you job doesn't mean you'll have more car accidents)

Of course, the actuary always has a great response to regulators! Alice the actuary would simply tell them:

1. We can apply an off-balance factor to keep the aggregate premium unchanged.
2. Regarding individual premiums, we can stop using credit score (at least temporarily) and redo the classification analysis after the economy has stabilized (this may incur a significant lag time however)

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