Pros and Cons of ZIP Codes for Rating Territories

Many lines of business include ZIP Code-based rating territories for ease of establishing where an insured location is without depending on the agent's input or to facilitate online quoting. But is this really a good idea? This blog entry provides some information about the pros and cons.

Instituted in 1967, ZIP Codes are now part of everyday life in the US. The approximately 45,000 ZIP Codes come in four types:

1. Unique (assigned to a single high-volume address)

2. PO Box-only (used only for P.O. boxes at a given facility)

3. Military (used to route mail for the U.S. military)

4. Standard (all other ZIP codes)

PROS:

1. ZIP Codes are readily available and can be easily verified, assuming that the record has the correct location ZIP Code on it. Some locations may have the billing ZIP Code on the policy record which may be a PO Box or a separate location than the building location.
2. Territories assigned based on the true location ZIP Code are accurate and are not subject to manipulation by the agent, insured, or insurer.
3. ZIP Codes are commonly used in ecommerce, facilitating online quoting and policy sales.
4. ZIP Code is a good way to tie information from several sources together. Building code information, wind or flood zones, catastrophe model results, home construction values, census statistics, etc., may all link up through ZIP Codes.

CONS:

1. ZIP Codes do not really specify a physical boundary, but are actually a collection of addresses. As such they are frequently changed. In my experience, over a third of the codes change within a 5 year time frame. Since the “boundaries” change without changing the ZIP Code value, it makes tracking rating territory changes more challenging. City and County limits change less often and do involve a physical boundary that can be accurately mapped.
2. While some ZIP Codes are small and relatively homogeneous, some rural ZIPs are very large and diverse. If the ZIP contains parts of several different fire district or topology, rating variables may not be appropriate for the entire ZIP.
3. The Postal Service assigns place names to the ZIP Codes that are, at times, confusing or misleading. These problematic ZIP Codes cause confusion among policyholders about where their location ZIP really is.
4. Making changes in ZIP Code territory rating may be difficult to explain to regulators due to some of the CONS listed here and may delay or prevent approval of your filing.
5. Some states do not allow ZIP Code rating for one or more lines of business.

ANSWER:

If you are grouping ZIP Codes into two or more larger territories each of which includes a number of ZIP Codes, the CONS are largely mitigated. Boundaries don’t matter as much, the diversity within a ZIP would be replace with diversity of the territory and making changes will be easier to explain and quantify to the insurance departments.

If you are using individual ZIP Code rates, I think the problems are too big to ignore. Even if you publish and maintain ZIP Code rating information, it is my opinion that the work should be done on the census tract level or using groups of geocodes, though each of these has its own pros and cons.