Measuring Customer Value Price Customer optimization value - - PDF document

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Measuring Customer Value: A Different Perspective on Price Optimization

October 3 – 4, 2011 CAS I F S i CAS In Focus Seminar Roosevelt C. Mosley, Jr., FCAS, MAAA Pinnacle Actuarial Resources, Inc.

Experience the Pinnacle Difference!

Measuring Customer Value

Price

• ptimization

Customer value

Interest and use is growing Definition can be challenging Narrows the lens to the exclusion of valuable inputs Components (profitability, customer response) Competition Elasticity of demand Applications beyond pricing are limited Applications Practical considerations

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What is Price Optimization?

Integration of demand side pricing into an Google Definitions

• verall pricing strategy

Offering each customer the right price to achieve pricing and profit goals The process of setting prices to maximize a d fi d f l pre-defined measure of customer value subject to a company’s strategic and business

• bjectives

Definition

Optimize Optimize

• 1. to make as effective, perfect, or useful as

possible

• 2. to make the best of

Optimization: a mathematical technique for finding a Optimization: a mathematical technique for finding a

maximum or minimum value of a function of several variables subject to a set of constraints, as linear programming or systems analysis

Source: www.dictionary.com

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Expanded Definition

XXXX optimization: mathematical technique for finding the best XXXX (most effective, perfect, most useful maximum minimum) subject to a set of useful, maximum, minimum) subject to a set of constraints XXXX =

Price Marketing strategy

Cl i ttl t

Claim settlement process Claim fraud identification Underwriting process Price change

Expected Profit Curve

Optimal Profit Actually profit that is optimized subject to price Expected Profit subject to price and other constraints. Price

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Constraints

Profitability: corporate goals Growth

Success of marketing efforts New business hit ratios

Loyalty: retention ratios Competitive: competitor price AND operational considerations Future: lifetime value implications A i l i i d f i l Actuarial: not excessive, not inadequate, not unfairly discriminatory Regulatory: must operate within parameters of the law

Limits of Price Optimization

Focus is necessarily on price What am I really optimizing? What am I really optimizing? Practical implications of price optimization are unclear Application to other areas of a company is a challenge challenge What happens when the optimal price is significantly different than the price I can charge?

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Expanding the Focus

C stomer

Pricing

Cross Sell

Marketing Quote

Underwriting

Sale

Ongoing Servicing

Customer Service

Retention Claims

Re-underwriting

Scenarios

• 1. Price Change Only
• 2. Price, New Business and Renewal

Changes

• 3. Complete System Changes

Defining Customer Value

Instead of focusing solely on price, expand the lens to including pricing as expand the lens to including pricing as well as broader company considerations

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What is a Valuable Customer?

Low claim frequency risks Niche customer Customer segment where rates are adequate Customer segment a company is / is not successful writing Measures: historical or short term, aggregate Issues With Current Customer Value Definitions Can be subjective Short term view Short term view

Ignores longer term potential value Complicates long term changes

Can hinder implementation of more advanced insurance techniques

Pricing advances Optimization

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Customer Value Definition

P (1 C ) R P (1 C ) R P (1 C )

Expected Value of Existing Business

EVEB = P1 x (1 – C1)

• (1 + r)

R1 x P2 x (1 – C2)

• (1 + r)2

+

R2 x P3 x (1 – C3)

• (1 + r)3

Pi = profit at time i = Premium – E(Loss) - Expense Ci = Probability of cancellation during period i + Ri = Probability of renewal at the end of period i r = discount rate

Potential Customer Value Definition

Value of Quoted Business: VQB = VEB x P(Co) Q Q ( ) VTB = P(Q)x VQB

• (1 + r)tl

Value of Targeted Business

P(Co) = probability of converting quoted business

(1 + r)tl

P(Q) = probability of targeted business receiving a quote tl = time lag between being targeted and receiving a quote

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Elements of Insurance Customer Value

Elements of Insurance Customer Value

Expected profit Customer Response (Likelihood of Retention/Conversion/Marketing Success) Influence of Competition Influence of Price Changes

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Expected Profit

Premium set by the company

E(Profit) = Premium – E(Cost)

Premium - set by the company E(Cost)

For setting premiums

Modeled loss costs by techniques accepted by industry and regulators Variables used limited by regulatory/public acceptance, operational

considerations

For purposes of determining E(Profit) For purposes of determining E(Profit)

More advanced techniques can be used List of potential variables is “unlimited”

Modeling Expected Cost – Expanded Considerations

Use All Available Information

Use Additional/Advanced Techniques

Rating Underwriting Marketing Agency Billing External (demographic, etc.) Endorsement activity

Decision trees Neural networks Clustering Principal components Association analysis

Endorsement activity Payment history Portfolio information

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Examples of Additional Significant Cost Variables –Auto Analysis Presence of additional lines (home, commercial, health) Additional line loss experience Scheduled property Amount of insurance Age of home Prior property claims Prior property claims Home occupancy type Umbrella indicator

Auto Indicated Claim Frequency

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Comprehensive Severity Model Comparisons

Linearity creates issues at the extremes

Expenses

Some are difficult to vary by risk

Subtract fixed dollar amount – can change relative Subtract fixed dollar amount can change relative

profitability but maintains order

Subtract fixed percentage of premium or expected

loss – maintains relative probability

Expenses that could vary by risk

G l l i

General claim expenses Marketing expenses Customer service expenses

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Difference Between “Full Model” and “Rating Plan Model”

18.9% 15.3%

Distribution of Expected Profit

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Customer Response Process

Marketing Effort Quote Sale Renewal Quote Renewal

Customer Response Models

Quoting Analysis

A l i f h lik lih d f i i d b i i i f

Conversion Analysis

Analysis of the likelihood of a insured that has received a quote purchasing insurance from you Analysis of the likelihood of a prospective insured obtaining an insurance quote from you

Retention Analysis

Analysis of the likelihood of a current insured renewing with you

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Quoting Analysis

Analyze characteristics of shoppers and quoters Characteristics

l i f i

Internal company information External demographic information

Credit profiles Marketing profiles

Identify insureds to target Can be done at different levels (individual target, geographic area, risk segment target)

One Way Summary – Means of Entry

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Quoting Analysis Example – Vehicle Year

Response Percentage

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Retention/Conversion Characteristics

Traditional Rating Factors

Class Territory Limit

Agent/Distribution Channel Issues

Satisfaction with

Agent/Service

Limit Insurance Score Claims history Violation history

Account Characteristics

Number of Years Insured Number of Policies Account Size

Agent/Service

Distance to Agent Independent vs. Captive vs.

Direct

Market Conditions

Competitive Position Inflation

U/W Cycle

Renewal Pricing Change /

New Business Price Difference

U/W Cycle Brand Value (company &

competitors)

Conversion Analysis Example

Example

1.000 1.000 1.408 1.431 1.483 1.766

0.800 1.000 1.200 1.400 1.600 1.800 2.000

Relativit

0.000 0.200 0.400 0.600 <missing> 1 2 4 6

EDUCATION

Relative Likelihood

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Retention Analysis Influences on Customer Value

Price changes

Impacts expected profit

p p p

Also impacts expected customer conversion and retention Interaction of these elements can produces unanticipated

changes in customer value

Competitive position

Influences ability to write/retain risks Ultimately impacts premiums charged Depends on more than just price Changes over time and varies by type of risk

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Insurance Demand

Insurance Demand Curve 0.70 0.80 0.90 1.00

Retention by Age

0.00 0.10 0.20 0.30 0.40 0.50 0.60 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 Percent Change P(Renewal)

Retention by Age

0.6 0.8 1 1.2 tion Likelihood 0.2 0.4 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 Rate Change Band Retent LT 26 26-49 50-64 65+

Competitive Influence on Price Impacts

Segmented Market Share Life Cycle Analysis Competitive Quotes Market Position

• Based on market realities

Batch Quote Analysis

• Still retains analysis of price
• Also includes market reality of what is being written/retained
• Allows insurer to then investigate cause of competitive issues

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Measure of Influence of Competition

Competitive Index

0.88 0.88 0.77 0.66

4 5 6 7

1.03 1.02 0.90

1 2 3

Analysis of Batch Competitive Quotes

Due to competitive analysis difficulties, batch quoting is not an exact science Assumptions

Because of insurance scoring and other proprietary

elements, absolute rate level is difficult to determine

More likely to get relative rates between risks correct

Use batch quotes to determine “effective” competitor relativities – what is the estimated rate p difference between your rate and rate of other companies for risk characteristics Use batch quotes to get a range of competitor prices

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Credit Scores Conversion

Example

0 80 1.00 1.20 1.40 1.60 1.80 2.00 Relativity 0.00 0.20 0.40 0.60 0.80 Insurance Score R

Detailed Market Share Segments

1. Detailed vehicle/property market penetration by:

• Geography (ZIP, census block)

V hi l h t i ti ( d l k / d l hi l

• Vehicle characteristics (model year, make/model, vehicle

segment)

• Home characteristics (year built, AOI, construction)
• Driver characteristics (age, marital status, gender, occupation)

2. Penetration levels based on demographic characteristics 3 Penetration levels by company risk characteristics 3. Penetration levels by company risk characteristics 4. Models of projected market penetration based on historical penetration data

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Penetration by Model Year

ABC Insurance Company

3.50% 4.00% 80.0% 90.0% 100.0% 1.00% 1.50% 2.00% 2.50% 3.00% Market Penetration 20 0% 30.0% 40.0% 50.0% 60.0% 70.0% Incurred Loss Ratio 0.00% 0.50% 1 9 7 3 & O L D E R 1 9 7 4 1 9 7 5 1 9 7 6 1 9 7 7 1 9 7 8 1 9 7 9 1 9 8 1 9 8 1 1 9 8 2 1 9 8 3 1 9 8 4 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 2 1 2 2 2 3 2 4 Vehicle Year 0.0% 10.0% 20.0% Market Penetration Incurred Loss Ratio

Putting It All Together

P (1 C ) R P (1 C ) R P (1 C )

Value of Existing Business

VEB = P1 x (1 – C1)

• (1 + r)

R1 x P2 x (1 – C2)

• (1 + r)2

+

R2 x P3 x (1 – C3)

• (1 + r)3

Pi = profit at time i = Premium – E(Loss) - Expense Ci = Probability of cancellation during period i + Ri = Probability of renewal at the end of period i r = discount rate

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Modeling Expected Cost - Considerations

Modeling multiple years

Life changes (household demographics) Life changes (household demographics) Aging of insureds Vehicle changes Uncertainty and time value of money

Current Customer Value

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Customer Value at t = 3 Applications of Customer Value

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Customer Value Formulas

EVEB = P1 x (1 – C1)

• R1 x P2 x (1 – C2)
• +

R2 x P3 x (1 – C3)

• +

Expected Value of Existing Business

EVEB (1 + r) (1 + r)2 (1 + r)3

+

Value of Quoted Business: VQB = VEB x P(Co) Value of Targeted Business VTB = P(Q)x VQB

• (1 + r)tl

Driving Customer Value

Premiums: actuarial Cl i t l i d iti Claim cost: claims, underwriting Cancelation rate: actuarial, customer service, agency, claims Renewal rate: actuarial, customer service, agency, claims Conversion rate: actuarial, customer service, agency, IT Response rate: marketing

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Application of Customer Value Measures

Underwriting

Historically focused efforts on “bad” risks: high frequency, prior

violations and accidents

Use customer value to Improve underwriting workflow, shift focus to

less profitable risks

Actuarial

Price optimization focused on solely changing price to improve

profitability

Customer value considers price as part of bigger picture to help drive

customer value

Marketing

Historical focus on hit ratio, how many customers are responding Use customer value to develop target market profile How do I better attract low response segments

Product management – how do all elements interact, common theme

that flows through the entire program

Practical Considerations

Data/Modeling Regulatory Regulatory Corporate Culture

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Data/Modeling Considerations

Pricing Changes Account vs. Line/Subline Modeling Account vs. Line/Subline Modeling New Business – premium & quote information Competitive information Quoting analysis

Regulatory Considerations

Pricing approach

E(Loss) + Expense Load vs.

( ) p

Premium that optimizes profit

Market conduct

When you determine more profitable business,

what do you do with it?

Underwriting? Marketing? Pricing?

Actuarial standards and codes

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Corporate Culture

Focus is generally on the short term

Business value focuses on the longer term Business value focuses on the longer term Must carefully balance

Culture in many companies is that volume must be preserved at all costs

Business value introduces profitability at the

individual insured level

Finds the optimal point that maximizes profit

based on the combination of price and volume