Price Optimization

Question 1

Price Optimization vs Traditional Ratemaking Techniques (3 differences)

Answer 1

○ Price optimization is a process that uses
§ Big data (data mining of insurance & non-insurance personal info where permitted by law
§ Advanced statistical modeling
○ Price optimization makes granular adjustments to indicated rates
§ Specific risk classifications, or even individual insureds)
○ Traditional ratemaking techniques were judgmental and applied only on a broad level
§ e.g. territory

Question 2

4 Principles in the CAS “Statement of Principles Regarding Property and Casualty Insurance Ratemaking”

Answer 2

1. A rate is an estimate of the expected value of future costs
2. A rate provides for all costs associated with the transfer of risk
3. A rate provides for all the costs associated with an individual risk transfer
4. A rate is reasonable and not excessive, inadequate or unfairly discriminatory if it is an actuarially sound estimate of the expected value of all future costs associated with an individual risk transfer

Question 3

Price Optimization

Answer 3

○ The process of maximizing or minimizing a business metric
○ Uses sophisticated tools and models to quantify business considerations

Question 4

Cost-based rate

Answer 4

The traditional actuarially derived rate based on loss costs, LAE, and other expenses

Question 5

Price elasticity of demand

Answer 5

○ The change in quantity demanded versus the price
§ High elasticity –> consumers will shop around even if prices only go up a little (savvy consumers)
§ Low elasticity –> price doesn’t have much effect on demand

Question 6

Ratebook optimization

Answer 6

Adjust factors in a cost-based rating structure using a demand model

Question 7

Individual Price Optimization

Answer 7

Build a pricing structure based on both cost and demand

Question 8

Hybrid Optimization

Answer 8

Insert a new rate factor based on demand (into an existing cost-based structure)

Question 9

Constrained Optimization

Answer 9

○ Setting minimum and maximum limits on a model’s output
○ Note that unconstrained optimization does not impose these limits

Question 10

3 Main differences between traditional ratemaking and price optimization

Answer 10

1. Difference 1
   i. Traditional: applied at class level
   ii. Price optimized: can be applied to individual policies
2. Difference 2
   i. Traditional: uses cost-basis pricing
   ii. Price optimized: incorporates non-cost-based considerations like propensity to shop around
3. Difference 3
   i. Traditional: deviations from indicated rates are subjective
   ii. Price optimized: deviations from indicated rates are based on quantitative models

Question 11

Other differences between traditional ratemaking and price optimization

Answer 11

○ TRADITIONAL RATEMAKING will assign the SAME price to identical risks, but PRICE OPTIMIZATION may assign DIFFERENT prices
○ TRADITIONAL RATEMAKING is generally accepted by regulators whereas PRICE OPTIMIZATION may not be accepted

Question 12

Benefits of price optimization

Answer 12

○ Provides more accurate pricing
○ If optimization is applied on a ratebook level, it is not unfairly discriminatory
○ Note that individual optimization MAY be unfairly discriminatory

Question 13

Drawbacks of price optimization

Answer 13

○ Regulators don’t have the data to independently verify rates based on price optimization
○ The models (often GLMs) can produce large individual rate swings (can be controlled by constraints)
○ No evidence of improved stability from using price optimization
○ Concern that ratemaking ASOPs may be violated (if rates are unfairly discriminatory)

Question 14

Possible regulatory responses to price optimization plans

Answer 14

• Possible regulatory responses to price optimization plans
  ○ Determine PERMISSIBILITY with respect to state laws
  ○ Define regulatory CONSTRAINTS (min/max rate swings, methods apply only to rate classes of at least a certain size)
  ○ Transparency: require FULL EXPLANATION of
  § DAM (Data/Methods/Assumptions)
  § Rate differences between customers with identical risk profiles (if any)

Question 15

Disclosures a regulator may require when price optimization is used in a rate filing

Answer 15

○ Rate adjustments that are not cost-based may include judgmental selections)
○ WHETHER price optimization was used
○ WHICH rating factors are affected by price optimization and their quantitative impact
○ WHETHER customers with the same risk profile have different rates
○ Data sources and models that affected the rate charged in any way

Question 16

Recommendations of the Task Force on Price Optimization regarding pricing methodology

Answer 16

○ Rates should be cost-based
○ Rates should comply with state law
○ Customers with identical risk profiles should be charged the same rate (aside from temporary differences)

Question 17

Rating considerations that the Task Force believes are unfairly discriminatory

Answer 17

○ Price elasticity of demand
○ Propensity to shop for insurance
○ Retention adjustment at an individual level
○ A policyholder’s propensity to ask questions or file complaints

Question 18

Recommendations of the Task Force on Pricing Optimization regarding state regulatory practices

Answer 18

○ ISSUE bulletin addressing use of non-cost-based methods
○ ENHANCE disclosure requirements for rate fillings
○ ENSURE compliance with state laws and actuarial principles by analyzing insurer’s rating models