How an Insurance Company Determines Your Premiums

Do you know your insurance score? Most people don't even realize they have one until they receive an adverse action notice in the mail notifying them that, based on their insurance score, they don't qualify for the lowest pricing available from their insurance provider. To help you decipher what all this means, we'll go over what the insurance score is, how it's calculated and some things you can do to improve it.

Solving the Mystery of an Insurance Adverse Action Notice

If you ever receive an adverse action letter, determining the circumstances behind your low score requires more perseverance than most people are willing to put forth.

The adventure begins by following the letter's instructions to call a 1-800 number to receive a free copy of your credit report, which affects your insurance score. You may wait several weeks for a reply, only to be sent a consent form that requests a detailed proof of identification, including photocopies of your driver's license, your Social Security number and your insurance information.

If after gathering all of that information you are brave enough to send it in the mail, the packet you get back will simply summarize your credit rating, with absolutely no information about your insurance score. If you inquire further with the credit reporting agency, you will likely be told your credit report contains information used to calculate your insurance score, but that the credit-reporting agency has no access to your actual score.

If you contact your insurance company, it will likely tell you that 99% of its clients do not qualify for the company's lowest rate, and to qualify, your credit must be absolutely perfect. In other words, even if you carry no balances on your credit cards, own your home, are completely debt-free and have a credit rating in the high 700s, you're still unlikely to have an insurance score that qualifies you for the lowest available insurance rate. So what exactly is this mysterious insurance score, and what is its purpose?

What Your Insurance Score Is and How It Is Calculated

An insurance score is a rating used to predict the likelihood a customer will file an insurance claim. This score, as noted above, is based on an analysis of a consumer's credit rating, and the method for calculating it varies from insurer to insurer. While many companies use proprietary formulas to calculate the scores, the factors used in the calculation include the customer's outstanding debt, length of credit history, payment history, amount of revolving credit versus amount of credit in the form of loans, available credit and monthly account balance.

Unlike a credit rating, which uses personal financial information to determine your ability to repay debts, insurance scores do not factor in your income. This omission means it is very possible for you to be penalized for taking out a large loan or charging a large amount on your credit cards each month even if your income is more than enough to cover the expenses. (For related reading, see: 12 Car Insurance Cost-Cutters.)

Why Insurance Scores Are Used

Insurance companies justify the use of insurance scores by citing studies showing a positive correlation between credit scores and insurance claims. At some level, this may seem to make sense. At the level of minor traffic accidents, for example, it is reasonable to argue that individuals with poor credit are more likely to file claims, if for no other reason than because they lack the funds to make repairs on their own.

Of course, if we look at the logic behind insurance scores we might want to look at it also from a business perspective: insurance scoring is quite profitable, especially since almost nobody qualifies for the lowest pricing tier. Keep in mind insurance premiums are a recurring revenue stream for insurance companies, and the scores help justify higher premiums.

How to Minimize the Impact on Your Wallet

A perfect insurance score, in the eyes of an insurance company, represents a client with the lowest possible risk of filing a claim, so since the probability of filing a claim is based on credit, good credit is the key to a high score. A good credit report can have such a large impact on your insurance premium that you can, for example, have a flawed driving record but good credit and pay less for your car insurance than a driver who has a perfect driving record but bad credit. Keep in mind, however, that your insurance score is not the only factor that determines your premium (you can ask your insurer for more details on what the other factors are).

While it is unlikely your insurance score will ever be perfect, there are a few relatively painless steps you can take to improve your score. To keep your insurance score high, be sure to pay all of your bills on time and limit the number of credit cards that you apply for and open. (See: The Importance Of Your Credit Rating.)

But, paying your bills on time isn't enough. As mentioned above, your insurance score is adversely impacted by large monthly credit card expenditures, even if you pay off your entire balance each month. To help your insurance score, you can minimize your credit card use. While it can prove unreasonably inconvenient to stop using your credit card entirely, most of us can find ways to cut down.

That said, be sure to evaluate whether the costs of changing your financial spending patterns is worth it. You may find the effort needed to perfect it is not worth what may amount to relatively small savings in premiums.

The Insurance Score Is Here to Stay

The use of credit history to determine insurance premiums is quite alarming to many consumers, particularly to those who have never filed an insurance claim but still don't qualify for the lowest available pricing. Unfortunately, insurance scoring is a standard practice among the nation's largest insurers. With that in mind, the best way to help keep your insurance premium low is to keep your credit score high. Take the same amount of caution with your credit score as you would with your driving—being responsible with both can save you serious amounts of money in insurance premiums.

(For related reading, see: 5 Money-Saving Insurance Tips for Couples.)