Financial Savvy – Do You Have a Clue?

With the costs of automobile and homeowner’s insurance on the rise, it’s important to be aware of the factors that insurers use in pricing policies. Insurers classify each policyholder according to risk and pool them with similar-risk policyholders, charging each a premium related to the average-loss for that pool. The goal is for everyone to pay a premium that is fair relative to their risk. People with a low risk of losses pay less, and the high risks pay more.

Many insurer rating factors are at least partially within your control, so you can take steps to ensure that they don’t impact you negatively. Others are hard to avoid. If you have teenaged drivers in your household, for example, auto insurance premiums will be higher. If you live in a fire-prone area, you’ll pay more for homeowner’s insurance.

In deciding how to price a policy, insurers commonly examine historical data to look for factors that do a good job predicting losses. Some are used to identify which policyholders are more likely to make claims. Other factors are used to estimate the amount of loss, given that there is a claim. Based on analysis of past losses, insurers know that teenagers are more likely to have car accidents and that these accidents are more likely to involve alcohol and to result in fatalities. Experience (as well as common sense) also tells them that some houses have greater fire risk, and that, if there is a fire, the house is likely to burn to the ground when it is far from fire hydrants and fire fighters. It makes sense for these policyholders to pay higher premiums. Accurate risk classification also means that low-risk policyholders pay less.

Two more controversial factors in use today are CLUE reports and credit scores. The Comprehensive Loss Underwriting Exchange is a loss history database maintained by ChoicePoint. It includes information on insured assets, claims made and paid, and contacts to participating insurers. Evidence suggests that people who have made claims in the past are more likely to make them in the future, so insurers use this information in underwriting and rating policies. You can request a copy of your own report by calling ChoicePoint toll-free at 1-866-527-2600.

You should think twice before reporting small losses to your insurer, and you should seriously consider increasing your homeowner’s and auto deductibles. After all, if you aren’t going to make the small claims anyway, why pay for the insurance on them?

Your credit rating is also likely to impact your premium. Perhaps surprisingly, insurers have found that credit is the single best predictor of policy losses – people with low credit ratings have more losses, and people with high credit rating have lower losses. (Incidentally, it’s not your raw FICO score they use. Instead, they have their own private scoring system based on elements of your credit report that are deemed to be related to your loss probability.)

It’s not entirely clear why credit is so important, but my logic is twofold: first, carelessness in your finances may imply carelessness in other aspects of your life as well. Second, people in financial trouble are under a lot of stress, and this may distract them from taking care.

Clearly, improving (or maintaining) your credit rating should be on your list of financial goals. Not only will this help keep your auto and homeowner’s premiums lower, but you’ll have the added benefit of lower borrowing rates. If you have recently taken some actions to increase your credit rating, you should call your insurance agent and point that out. It might improve your rating and lower your premium.

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Vickie Bajtelsmit, Professor of Finance

Colorado State University College of Business

bajtelsmit@yahoo.com

(970) 226-1473