Price Optimization, 29 October 2009                                                                          Page 1 of 7

Price Optimization, 29 October 2009                                                                   Page 2 of 7

Price Optimization, 29 October 2009                                                                                       ...
Price Optimization, 29 October 2009                                                                                       ...
Price Optimization, 29 October 2009                                                                                       ...
Price Optimization, 29 October 2009                                                                                       ...
Price Optimization, 29 October 2009                                                                                 Page 7...
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Price Optimization for Warranties


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Price Optimization for Warranties

  1. 1. Price Optimization, 29 October 2009 Page 1 of 7 October 29, 2009 ISSN 1550-9214 Editor's Note : This column by Christopher W. Hurst and Jose Moreno Codina of Towers Perrin is the latest in an ongoing series of contributed editorial columns. Readers who are interested in authoring a contributed column in the future can click here to see the Guidelines for Editorial Submissions page. Price Optimization: A Potent Weapon for the Warranty Industry. By Christopher W. Hurst and Jose Moreno Codina, Towers Perrin The hotel industry has long taken advantage of flexible pricing, based on demand, the type of customer, the day of the week and the season. If you make a reservation at a popular resort hotel at the height of the season, you'll certainly pay top dollar. Conversely, many city hotels that rely on business travelers during the week offer cheap weekend rates to attract guests and fill rooms on Saturday nights. This is "price optimization" -- the integration of demand- side pricing (a customer's willingness to pay) into an overall pricing strategy. Traditionally, many in the warranty industry have priced their goods and services based on supply-side factors (production cost plus a margin for profit). However, this cost-plus-profit approach leaves a lot of money on the table in the form of lost revenue from prospective customers. According to AMR Research, between 1% and 5% of value is lost across all industries because companies don't know enough about their customers' willingness to pay or don't have the ability to profit from this knowledge. Pricing can be one of the most potent weapon companies have. When a more sophisticated pricing approach is implemented, operating profit increases significantly, much more than when other factors such as variable cost, volumes or fixed costs are adjusted. In a few industries where the product's value is largely intangible (e.g., cosmetics), prices have always been largely based on demand. However, it is only in recent years, with the development of sophisticated predictive modeling capabilities, that a broader spectrum of industries has started to pay attention to the demand side. Among other obstacles, understanding how customers respond to price changes is fiendishly difficult. And until recently the data crunching and econometric modeling capabilities it demands simply haven't been widely available. But now, demand-side pricing techniques have begun to spread from the industries that originated these practices -- hotels and airlines - - to other industries, such as retail, automotive, telecommunications and financial services. The aim of price optimization is to set prices across an insurer's portfolio in a way that maximizes a predefined measure of customer value over a given time period and aligns pricing with the company's strategic objectives. Effective price optimization allows a warranty provider to increase and decrease premium prices based on a combination of marketplace variables, including (but not limited to) product demand, certain customer characteristics and the competitive landscape. It also takes into account the implications of price differentials, including profitability and lifetime value. Parker Hannifin Case Study An illustrative case is Parker Hannifin Corp., a leading producer of industrial parts used in aerospace, transportation and manufacturing. Throughout most of its history, Parker Hannifin priced the 800,000-plus products it sold using a simple cost-plus pricing model. In 2001, new management concluded that a new pricing strategy was the key to improving margins. Managers observed that, under the current pricing system, efforts to improve a product or reduce production costs did not necessarily result in higher margins. Prices for the improved product had the same margin as the standard product, because reduced production costs were routinely passed on to customers through lower prices. As a result, Parker implemented a new pricing strategy that factored customer demand and levels of competition into the price for each product. The effort was a resounding success: The company's return on invested capital went from 7% in 2002 to 21% in 2006! 10/30/2009
  2. 2. Price Optimization, 29 October 2009 Page 2 of 7 Three Building Blocks of Price Optimization In essence, price optimization is about getting to know your customers and your market better. As can be seen in Exhibit 1, there are three constituent parts of a comprehensive price optimization program, each of which is a value-adding activity in and of itself: Claim propensity models express how customer attributes are predictive of their inclination to report a claim. These models are used to develop new rating variables or increase the accuracy of existing rating variables. Market situation models express how the company's competitive position and the market's competitive intensity vary by segment or niche within the market. As discussed further below, the relative value and importance of these market situation models within the warranty industry can vary by market and entity. Customer behavior models express how the customer's attributes and the market's situation are predictive of the customer's behavior (e.g., response rate or cancellation rate). Exhibit 1 Price Optimization Balances the Trade-Off between Supply/Cost and Demand/Revenue In this example, we integrate profit (cost) models by customer segment and distribution channel with price elasticity models. The goal is to set prices that optimize the trade-off between the contribution per policy and volume of business expected to meet a given financial objective and business constraints. All three of these modeling techniques are essential building blocks of price optimization (Exhibit 2). Exhibit 2 Three Types of Predictive Models Support Price Optimization 10/30/2009
  3. 3. Price Optimization, 29 October 2009 Page 3 of 7 This Week's Warranty Headlines: Price optimization integrates claim propensity, market situation and customer behavior Assurant Solutions reports increased models to predict the impact of price changes on volume and to identify the best price net operating income and a reduced changes for a given financial objective and constraints. The goal is to provide a company domestic combined ratio. with the tools necessary to reach a particular strategic objective (e.g., volume or profitability) Press Release, October 28, 2009 and to allow for flexibility to adapt to changing business circumstances. Australian regulators cite Auction Alliance/Deals Direct for misleading The power of price optimization is that it allows the company to gather demographic and warranty policies. market data and use them, singly or in combination, to set rates. These data range from Sunday Times, October 28, 2009 variables that help predict prospective losses (e.g., credit score and loan-to-value ratios), to DeNooyer Chevrolet and Redline competitor pricing, to customer likelihood to purchase a warranty at specific times of the day. Motorsports sell high-performance In fact, the list is limited only by the company's needs. cars backed by GM warranties. Albany (NY) Times-Union, October 28, 2009 Claim Propensity Models Brocade offers next-day limited lifetime warranty on select Internet The traditional focus of many companies has been to seek advantage by using available data switches. to better select or reject risks and price them. Sophisticated claim propensity models can Press Release, October 28, 2009 integrate qualitative customer and product attributes with traditional quantitative rating risk RV company EarthRoamer files for factors. The results allow more accurate prediction of both the likelihood that a policyholder Chapter 7 liquidation with 100 may experience a claim in the future and the probability of the claim being above or below warranty claims unpaid. average claim costs for any given class. These models can be used for targeted marketing, Boulder (CO) Daily Camera, October 28, 2009 underwriting segmentation and more accurate pricing. Consumer Reports survey calls Ford "the only Detroit automaker with Companies face several issues in moving to a greater use of more accurate risk assessment world-class reliability." and pricing. First is the challenge of gathering accurate data and scrubbing them so they're Press Release, October 27, 2009 useful. Second is conducting statistical analyses and extracting usable insights from them. Finally, more accurate risk assessment and pricing entails a fundamental shift in a company's Johnson Controls takes a $105 million culture. warranty charge in its residential HVAC business. Press Release, October 27, 2009 Claim propensity models almost always reveal some surprising, nonintuitive results that challenge long-held beliefs, and the company's staff must learn to trust the data that come out Companies claiming to represent of them. By definition, new risk assessment models are not consistent with market practice. BSkyB sell bogus satellite insurance Implementing claim propensity models is expensive, and if the staff ignores the results or the renewals in UK. company doesn't act on them, it will make no sense to incur the costs. Yeovil Express, October 27, 2009 Florida attorney general sues Market Situation Models Hollywood Auto Gallery over allegedly bogus warranties. Press Release, October 26, 2009 Many companies analyze the price competitiveness of their products based on a small sample of representative hypothetical customers by comparing their prices against key competitors. Isuzu Commercial Truck of America While this approach gives the company a general sense of its relative price position, insights offers powertrain warranty on used from such an analysis are limited by the small sample size. Innovative companies have Class 3-5 trucks. Press Release, October 26, 2009 (Word file) significantly expanded the extent of these price comparisons and found new ways to make use of the richer market information they provide. Forklift suppliers say warranties help them sell maintenance contracts to By populating a market situation model with price comparisons for virtually every possible warehouse managers. customer (i.e., every combination of customer attributes) across a broader array of Arabian Supply Chain, October 25, 2009 competitors, companies can identify customer population segments and niches where their Qatar Automobiles Company offers competitive position is weak or strong. More importantly, the large volumes of price lifetime warranties on Mitsubishi comparisons facilitate a more complete analysis of the competitive intensity of particular vehicles. market segments. AME Info, October 25, 2009 10/30/2009
  4. 4. Price Optimization, 29 October 2009 Page 4 of 7 This analysis, in turn, enables the company to make tactical decisions about which segments Wal-Mart to offer TV and PC to attack and which segments to retreat from. Competitive market analysis using market installation and support services situation models is used: through NEW Customer Service Cos. Wall Street Journal, October 23, 2009 to help identify segments where the company's prices are low or high relative to the Hyundai's ten-year powertrain market; warranty offer in 1999 was a marketing coup in the U.S. to understand the competitive intensity in each segment and support strategic Marketplace, October 23, 2009 decisions regarding product deployment in different competitive segments; and UK company called e-motive launches line of electric scooters covered by to understand the potential scope for price changes and what impact such changes two-year warranties. would have on market positioning. Which? October 23, 2009 Intel CEO says it's more expensive to In certain warranty industries (such as the vehicle service contract industry), a warranty keep old PCs running than to buy new product is often sold exclusively through dealerships. In other cases, the product is sold direct to the consumer. For dealer-sold contracts, there may be less value attributed to the actual ones. Computerworld, October 22, 2009 price of a particular contract since many consumers don't obtain multiple price quotes. However, the relative competitiveness of a vendor's warranty product may still help predict Extended warranty sellers for satellite what the customer is willing to pay for the contract. TV equipment told to stop saying they represent Sky. The Mirror (UK), October 22, 2009 In some cases, competitor prices for warranties may not be as easy to obtain as they might be for other industries. Depending on the product, price information may be found through John Deere Power Systems offers internet searches, dealership and general agent assistance, or even competitors' rate filings yacht buyers a 5-year/2,000-hour with state departments of insurance. However, if the information isn't available, a simpler extended warranty at no cost. competitive index can be based on only the terms and coverages of warranties on similar Press Release, October 21, 2009 products offered by selected competitors. For instance, it's likely that the terms for some Service Protection Advisors launches product warranties (e.g., length of coverage, waiting period) and details of what types of month-to-month vehicle service losses are covered by competitors can predict the likelihood of a prospective customer contract program. purchasing your product. Press Release, October 21, 2009 Alliance for Grey Market and Customer Behavior Models Counterfeit Abatement publishes warranty & service abuse study. Developing accurate customer behavior models is the final building block in price Press Release, October 20, 2009 (PDF file) optimization. By developing models of customer responses to marketing campaigns, Lawsuit alleges Gateway should have competitive activity and other pricing or service events, companies can gain a comprehensive known MPC was financially troubled. picture of customers' demand preferences at different price points and understand how they Consumer Affairs, October 20, 2009 will affect new business development. Because this analysis enters new territory for most & Home Warranty companies, it will likely require a shift in mindset on the part of management, followed by careful project planning to be sure the analysis results will be usable. of America to bundle homeowner's insurance & home warranties. Press Release, October 20, 2009 The price elasticity function takes into account different variables that have not been widely analyzed, including the history of price variations, brand strength and awareness, distribution Zildjian doubles warranty on cymbals channel and other significant factors. The result of this modeling produces a scoring to two years. Music Instrument Professional, October 20, 2009 algorithm to predict conversion rates for price relative to price changes and, if applicable, to the competition. AmTrust Financial Services joint venture to acquire GMAC's auto The most effective way to generate a price elasticity of demand curve is to vary prices and insurance business. measure the impact on volume. Insurers can use controlled testing of rates to generate Press Release, October 19, 2009 demand curves. By replicating the rate structure and marketing to one group of customers A.M. Best revises ratings status of through parallel testing of multiple sets of rates, they can measure the impact on volumes as GMAC Insurance Group following prices change. This kind of testing helps measure conversion and retention rates by price. AmTrust announcement. Press Release, October 22, 2009 Where parallel controlled testing is not appropriate, multivariate techniques drawn from Nationwide Home Warranty ordered to historical data can be used to develop models explaining the likelihood of retention as a stop selling service contracts in Florida function of price change and customer characteristics. Models may also include competitors' without a license. prices. Insurance Journal, October 19, 2009 Whittaker Builders files for bankruptcy Bringing It All Together but warranty work to continue. St. Louis Business Journal, October 19, 2009 The final step and culmination of this work is to develop a new pricing structure that Sony offers insight into Bravia quality optimizes profit per customer. In other words, it maximizes profitability subject to a control process. minimum volume of business. A company's preference for market share over short-term Current, October 18, 2009 profitability will shift over time. It may decide to aggressively increase market share when the market is strong in order to benefit from a hardening. Alternatively, when facing capacity Canon replaces Pixma MX300 printer constraints, a company may wish to focus only on its most profitable customers. as a goodwill gesture six months out of warranty. The Consumerist, October 18, 2009 Using price optimization techniques, a company can leverage sophisticated analytical methods to clarify strategic direction in pricing strategy and react quickly and nimbly to new SquareTrade CEO pitches longer patterns in data as they are uncovered. By integrating the three components of price warranties for less money in online optimization -- claim propensity models, market situation models and customer behavior interview. models -- companies can more confidently meet particular profit objectives or change prices Auction Bytes, October 18, 2009 to meet market share targets, while understanding the profit implications of doing so. Towers Perrin estimates the cost of defective Chinese drywall at $15 to Our objective is to move a company closer to the "efficient frontier" that represents $25 billion. maximum profit for each particular volume of business (Exhibit 3). New Orleans Times-Picayune, October 18, 2009 Sky hears complaints accusing Digital Exhibit 3 Satellite Warranty of using misleading 10/30/2009
  5. 5. Price Optimization, 29 October 2009 Page 5 of 7 Efficient Frontier of Portfolio Profitability sales tactics in UK. The Independent, October 17, 2009 Insurers dropping policies after homeowners file Chinese drywall claims. Associated Press, October 15, 2009 Harley-Davidson to discontinue Buell brand, but warranty coverage will continue as normal. Associated Press, October 15, 2009 The pitfalls of extended warranties. Wall Street Journal, October 15, 2009 Fiat India's new Fiat First program includes extended warranty options for Punto and Linea. Wheels Unplugged, October 15, 2009 Tata Motors gives Indigo Manza a two- year/75,000-kilometer warranty. Press Release, October 14, 2009 IDC's PC tracker report puts HP in first place worldwide, Acer in second, and Dell in third. CNET News, October 14, 2009 Why Saturn owners will lose out on warranty repairs. Popular Mechanics, October 14, 2009 Given the complexity of different analyses, price optimization is typically undertaken in Florida regulators order National Home phases by iteratively testing price changes against volumes and profitability. Testing is first Protection Inc. to stop selling home performed across a small part of the portfolio and is then expanded to more markets and lines warranties. of business. The advantage of a phased approach is that it can be used to prove the concept, Insurance Journal, October 14, 2009 and tactics can be adjusted according to results. The outcome of each step can help Aspen Avionics signs agreement for demonstrate impact in order to gain further organizational buy-in, and the information SigmaQuest SigmaSure product quality collected during the first phases can be used to provide input to later phases. management software. Press Release, October 14, 2009 Initially, price testing can be used to make iterative improvements to profitability. In later Warranty Holdings acquires motorcycle stages, we combine multivariate models of costs and price elasticity to simulate the service contract marketer RpmOne Inc. relationship between price change at the customer level and overall profitability. Findings can be used to set prices across the whole portfolio. Press Release, October 13, 2009 Johnson Controls forecasts 12-cent- Developing price-testing capabilities can help your company move to more textured and per-share warranty charge in its accurate representations of your market. But there is hard work involved. For each step to be valuable, you'll need solid data, sophisticated statistical models, competitive intelligence, and residential HVAC business. Press Release, October 13, 2009 courage and conviction. Malta's Consumer Affairs Act gives buyers 2 years from purchase date to A Word About Auto Warranties return faulty products. Times of Malta, October 11, 2009 For many in the auto warranty industry (and perhaps in some specific cases in other warranty Service USA and Kansas Corp. acquire industries), selling primarily through auto dealerships (or other third parties who contribute DVD Blue Beam Repair Inc. to the final charged premium) presents a unique challenge to price optimization because the Press Release, October 11, 2009 insurer or administrator has limited control over the final price (given the mark-up applied at the dealership level). In these cases, it becomes critical for the warranty administrator/insurer Canadian auto dealers say voluntary to establish processes for working directly with the dealerships to design a price optimization right to repair deal should replace approach that adds value for all parties. pending legislation. Press Release, October 9, 2009 In these cases, price optimization models can be designed to maximize profits for the Lenovo opens first retail shop in India; dealership and the administrator/insurer -- or at least achieve a balance between the goals of New Delhi location also hub for each party. And in cases where the dealership shares in the ultimate profitability of their warranty work. dealer-sold vehicle service contracts (through individually owned reinsurance companies), Channel Times, October 9, 2009 the dealership has even greater vested interest in the ultimate profitability of the product. Tradewinds Distributing Company details warranty durations for its Once a company has a picture of customer preferences and is armed with an understanding of Whirlpool branded HVAC units. how various pricing actions will impact purchasing decisions, it can apply that understanding Press Release, October 8, 2009 to other components of the pricing strategy developed earlier in the process. Construction industry dinner attendees get update on defective drywall from Achieving various levels of price optimization is a journey. We recommend that companies China. interested in raising their game start by understanding where they stand relative to their Fort Myers (FL) News-Press, October 8, 2009 competitors, then determine the best way to improve their modeling and analyses. What Denny Hecker's auto dealerships methodologies, benchmarks or analyses may be missing from your current approach that accused of pocketing customers' could help you achieve greater profitability? With this knowledge, you can decide how to move forward. extended warranty premiums. St. Paul (MN) Pioneer Press, October 8, 2009 NHTSA investigates reports of Toyota Tundra frame corrosion that may cause brake failure. 10/30/2009
  6. 6. Price Optimization, 29 October 2009 Page 6 of 7 Detroit Free Press, October 8, 2009 About the Author: GadgetGuard releases iPhone app that sells its user an extended warranty for Christopher W. Hurst is a consultant with Towers $3-to-$5/month. Perrin and is located in the firm's St. Louis office. He Press Release, October 7, 2009 specializes in reserving and pricing for warranty, GAP Admiring US Fidelis employee was the and other F&I products for various entities writer of company owner Darain (manufacturers, third party administrators, insurers, Atkinson’s Online Blog. and reinsurers) and types of products (vehicles, homes, St. Louis Post-Dispatch, October 7, 2009 heaters, and air conditioners). SEAT says the number of warranty claims on its Ibiza model have tumbled Mr. Hurst’s warranty experience includes a range of by 38%. services for clients, including performing liability Press Release, October 7, 2009 valuations of warranty obligors; forecasting unpaid liabilities (both a point estimate and a range of Federal report blames the collapse of a possible outcomes), unearned premiums and indicated Dallas Cowboys practice facility on rates; conducting funding studies for catastrophic stop- design failures. loss reinsurance protection for vehicle service contract Dallas Morning News, October 7, 2009 providers; developing estimated losses (and the Assurant Solutions introduces a new resulting necessary funding) for new products; monthly protection program for completing year-end reserve reviews (including a Statement of Actuarial Opinion) for netbook personal computers. warranty and other long-duration contract insurers; and providing expert witness support. Mr. Press Release, October 6, 2009 Hurst is a graduate of Northwestern University, a Fellow of the Casualty Actuarial Society, Warrantech Consumer Product and a Member of the American Academy of Actuaries. Services to administer service contracts for Appliance Direct. For comments or questions about this article, please feel free to call or e-mail Mr. Hurst at +1 Press Release, October 6, 2009 (314) 719-5846 or Warranty Direct UK finds Honda Jazz most reliable, Seat Ibiza least reliable supermini car. Press Release, October 5, 2009 (Word file) Greg Gadbois joins Assurant Solutions as ESC Business Development Director. Press Release, October 5, 2009 Israeli Peugeot and Citroën distributor drops coolant replacement requirement in warranties. Ha'aretz, October 5, 2009 More Warranty Headlines Sign up for a free subscription to Warranty Week: subscribe change of address unsubscribe 10/30/2009
  7. 7. Price Optimization, 29 October 2009 Page 7 of 7 Free subscription to Warranty Week: Click here for the plain text or the HTML email edition. Copyright © 2009 Warranty Week, All Rights Reserved 10/30/2009