To give credit where credit is due, this post was triggered by an article at SmartMoney, 10 Things Credit Scores Won’t Say.
In 1996, I got a call from a recruiter suggesting there was a real opportunity with the Philadelphia-based corporation Advanta.? They were looking for an actuary with investment knowledge that could help them in their joint venture with The Progressive to use credit scores in underwriting auto insurance.? Since I was local, and known to be a “nontraditional actuary” with some degree of talent, and my situation at Provident Mutual was deteriorating because of a management change, I accepted the interview.
Being a life actuary, I didn’t know much about P&C insurance, but my career had been one of growth.? I may not know everything there is to know about a given topic, but I learn rapidly, and bring allied knowledge to the table that others may not possess.? The interview was interesting.? If you are a life actuary, you don’t expect interviews like Advanta. Credit cards were reaching their apex, and some clever people were trying to figure out other ways to apply the data from individuals using credit cards.? I ended up being Advanta’s “second choice.”? Bad for them, good for me.? Two years later, I would join the St. Paul’s Investment department in Baltimore.
The key idea was that credit scores were highly predictive regarding personal insurance losses, particularly when combined with traditional underwriting metrics.? The idea was a surprise to me when I first ran into it, but it quickly made sense to me.? Let me explain.
Honoring agreements that you have entered into is an important indicator of your personality.? Those who do not repay are on average less moral than those that repay.? Those that are net creditors on average made efforts that net debtors did not.
Credit scores are important.? In a specific way, they measure your willingness to keep your word.? Anytime you enter into a debt contract, you make a promise to repay.? If you fulfill your promise to repay, you impress others as one of good moral character.? If you don’t repay, it is vice-versa, you appear to be of low moral character.? (Note: I am excluding those that got hoodwinked by lenders that defrauded borrowers in a variety of ways.? That said, if you can be hoodwinked, that says something else about you, and that may have an impact on your creditworthiness as well.)
Now, before I continue, these concepts work on average, and not always in particular.? I have helped some at the edge of society with gifts and loans.? In some cases there is a cascade of bad events that the most intelligent would have a hard time facing.? Being wise helps, but there are some situations that would tax the soul of anyone, and be difficult to claim that they were blameworthy; it’s just the way things happened.
That said, that concept of a “credit score” traveled rapidly to insurance, because moral character is highly correlated with how a person drives.? People who are sloppy with their debts tend to be sloppy with their driving.? As with everything in this post, this is only a general tendency.? It applies on average, it does not always apply.
Some US states were offended at P&C companies using credit scores, and so the companies moved to use “insurance scores,” which were little different from what they aimed to replace.? The insurance companies took the disaggregated data behind the credit scores, did a little more research, and discovered which variables were most predictive of insurance claims, in concert with their own data.
The same is true for many other uses of credit data.? Different parties want different aspects of the underlying data.? Whether it is employers, lessors, lenders, insurers, etc., in an impersonal world, where there are fewer shared ethical values than in the past, economic actors rely on semi-public data to get comfortable about who they are dealing with.
Two final notes:
1) It’s easier to go down than up with credit scores.? But that is similar to many things in life.? One big mistake can undo a hundred lesser things done well.
2) Those who pay off debts rapidly are rewarded with discounts, as many companies want to avoid bad debts.? You might remember my piece, Build the Buffer.? Be wise, and have enough cash around to get discounts over those that pay things monthly/quarterly.
I am happily debt-free aside from paying off the debts regularly on my few credit cards.? The simple truth is that living within your own means, and having enough of a buffer to deal with minor crises is the best place to be.
Interesting. As I read your post I kept thinking mortgages where credit scoring was highly used and I would argue a lousy predictor of future performance , in light of various market abuses such as using thin file scores and self documented income(aka stated doc). Anyway, back to credit scores, my sense is that attitudes have changed and over-borrowing to over consume is no longer a taboo and credit companies are much quicker to provide credit versus two generations ago, where one had to graduate college and have that first job before getting an Amex or being a college senior before getting that Visa. These days it’s far easier to get that credit and not uninteresting banks seem to prefer borrowers who do not pay in full each month.
As Conscience of a Conservative already pointed out, credit scores were heavily used by lenders / underwriters during the mortgage bubble. Many people with “good” scores have defaulted, many with “bad” scores continue to pay.
Most of the municipalities that have filed for bankruptcy have(had) AA or better credit ratings. All the CDOs that defaulted had AAA ratings based on AIG’s guarantee.
The church has a few problems with pedophiles. Most big city police departments have internal affairs divisions.
Almost every person involved in car accidents has a driver’s license and passed a driver’s exam somewhere.
Those lovable characters in the US congress have a AAA “risk free” rating, but are perhaps the most immoral members of our society.
Trying to quantify a person’s character with a numerical score is a case of a person with a hammer looking for a nail. Today, we have big corporations with big computers looking to sell big databases filled with data that is marginally correlated at best with the events they are used to forecast.
Perhaps the ultimate insult to common sense is the proposed use of credit scores to help screen passengers at airports… did Osama Bin Laden have a social security number and a credit file at Experian?
Lets not even mention the poor data quality of many credit records.
Its one thing to take a very large population set of data, hand it to a properly trained actuary, and draw general conclusions about a broad population.
Its quite a different thing to ask a computer to look at a limited (seven years or less) sequence of credit card purchases and conclude something meaningful about your character.
If you are a total deadbeat or always pay in full, credit scores are “accurate” but useless. If you are anywhere between the extremes, credit scores are random numbers.
The four c’s of good underwriting–Collateral, Capacity, Credit & Character are well known. Unfortunately Capacity and Credit have become conflated ideas of late, probably by design by those looking to mis-price debt; A credit score speaks to Credit and not Capacity to repay a loan. If I want to know whether the borrower can repay a credit score is useless, I need to know his assets and income. The credit score only speaks to whether historically he has met those debts he has taken on over some time period.