The document discusses the multiple dimensions of pricing sophistication for property and casualty insurance companies. It identifies five key dimensions - data, modeling approach, rating plan design, competitive sensing, and pricing strategy. The document provides a spectrum for each dimension, ranging from low to very high sophistication. It explains where different companies may fall along each spectrum based on their capabilities and resources. The goal is to provide insurers a framework to evaluate their own sophistication and identify areas for improvement.

1. 14 | Emphasis 2009/2
PROPERTY & CASUALTY INSURANCE
MULTIPLE DIMENSIONS OF PRICING SOPHISTICATION
Enhanced pricing sophistication has reshaped the property & casualty insurance
landscape. A company’s sophistication will be determined by where it places itself along a
spectrum of pricing methods with five critical dimensions.
By Charles R. Wolstein and Christopher W. Hurst
Predictive modeling has been instrumental I competitive sensing could conclude that red cars tended to
in driving improvements in pricing sophis- have higher loss costs than white cars, the
I pricing strategy.
tication that have reshaped the competitive company first had to capture data on car
landscape in personal lines over the last color. A current example is advance quote
Disaggregating pricing sophistication into
five to 10 years. Generally, more sophisti- discounts, whereby prospective policy-
its components gives management and
cated raters have grown and profited at holders are eligible for a discount if they
staff from across functions (from statistical/
the expense of less sophisticated raters. solicit a quote far enough in advance of
analytic gurus, to line management, to
Pricing improvements continue to spread their current policy’s expiration date.
strategic planners) a common vocabulary
throughout the industry — from large Obviously, if you don’t collect this infor-
for understanding how to enhance pricing
companies to small, and from personal mation, you can’t incorporate this feature
sophistication, consistent with the compa-
insurance to mainstream and specialty into your rating plan.
ny’s business strategy, organizational
commercial lines.
capabilities and competitive position.
Sophistication along the data dimension
Nevertheless, some insurers have been slow is also a function of what you do with the
Data
to adopt this transformative technology, data you have before applying modeling
The first dimension is data. Arguably, the
creating big differences in pricing sophis- techniques. Companies’ databases are often
predictive modeling breakthrough came as
tication across companies. too aggregated to be useful for modeling,
much from recognizing the power of data
typically because they were designed for
as a source of competitive advantage as
In prior articles we have described predic- univariate analysis. To maximize value
from the application of advanced statistical
tive modeling, competitive market analysis for rating plan design, data need to be
modeling techniques.
and price optimization. Here we provide accessed at nearly the transaction level.
a framework for understanding the key Also, data may require considerable
The data you are able to use are a function
elements of pricing sophistication, using manipulation and restructuring. For exam-
of the volume, type and quality of data that
personal auto insurance in the U.S. as an ple, a number of rating factors should be
you capture. For each customer segment
example. considered not only at the individual
analyzed, there must be sufficient and cred-
driver level but also for households,
ible data from which to draw meaningful
DECONSTRUCTING THE DIMENSIONS offering additional potential price discrim-
correlations with loss experience and
OF PRICING SOPHISTICATION inators. Finally, inserting suitable default
competitive prices. Often, thin-data seg-
Although many people think of pricing values for incomplete data (for recently
ments can be supplemented with external
sophistication as primarily a function of programmed rating variables, for example)
or competitive benchmarks to increase the
rating plan design, it is in fact multidimen- and/or estimating missing values through
reliability of the resulting data set. Further,
sional. To discuss rating sophistication, modeling techniques can further enhance
the data must be systematically captured
we will use the framework in Exhibit 1, the value of the starting database.
and maintained in a structure that can be
on page 16, which displays five dimen-
accessed.
sions along a spectrum of increasing The richer and more reliable the data about
sophistication: policyholders and the vehicles, property
While data credibility is important, the
I data and businesses they want to insure —
type of information available is at least as
whether collected internally or purchased
I modeling approach important, because breadth of data tends
from external sources — the richer and
to enable the creative breakthroughs. To
I rating plan design more reliable the insights that can emerge
take a simple example from the early days
from the analysis.
of predictive modeling, before one insurer

2. Emphasis 2009/2 | 15
Charles R. Wolstein is a Principal of Towers Christopher W. Hurst is a consultant with
Perrin in Washington, D.C. He has expertise in Towers Perrin in St. Louis. He specializes in
both life and property & casualty insurance, ratemaking, rating plan design, competitive
and specializes in distribution strategy and market analysis, and pricing strategy for per-
economics as well as organizational perfor- sonal and commercial lines, as well as reserv-
mance improvement. Mr. Wolstein received an ing for warranty lines of business. Mr. Hurst
M.B.A. with honors from Columbia Business is a graduate of Northwestern University and
School with a dual concentration in finance a Fellow of the Casualty Actuarial Society.
and international business.
Modeling Approach Finally, the more sophisticated modelers At the upper end of the spectrum, compa-
Once a data set has been created, the com- not only use more advanced modeling nies are creating innovative rating variables
pany can apply a variety of statistical techniques to better predict loss costs, by leveraging new sources of external data
techniques to the data to develop a new they also model other important factors beyond credit scores (e.g., census data, GPS
rating plan. As with the other dimensions, such as expenses, conversion/retention technology) and nontraditional internal
available resources (e.g., time, financial, and customer lifetime value. data (e.g., billing history, policyholder
skilled personnel) and the perceived value information collected for other lines of
of advanced approaches in meeting pricing Rating Plan Design business). Such companies may also be
needs dictate where companies end up on The rating plan design refers to the rating increasing the level of dependency (or
the sophistication spectrum. variables and territory structure that deter- “interactions”) between variables to fur-
mine the number of price points included ther improve the risk-based accuracy of
On the low end of the spectrum, compa- in the plan. Rating plan sophistication the proposed premiums.
nies may either rely solely on competitive is a function of the number of variables,
information and agent feedback to update the segmentation of the variables and the Territory structure is an important element
their rating plan, or do simple, univariate interactions among the variables. of rating plan design. At the low end of
analyses. With univariate analysis, indicated the sophistication spectrum for territorial
premium relativities are developed for Many companies have historically associated structure, companies adopt historical ISO
just one variable at a time, without regard price sophistication with this aspect of territory definitions in the U.S. This
to how these variables interact with other their overall pricing scheme, although it is approach is simple, inexpensive and conven-
variables (e.g., age versus gender). Such only one of several important dimensions. ient, especially for companies that don’t
a simple approach can lead to gross have enough data to develop their own
overstatement or understatement of charged On the low end of the sophistication spec- territory definitions. Moderately sophisti-
premiums by segment compared to rates trum are companies that have not yet cated companies develop and file their
developed using multivariate analysis. adopted recent segmentation innovations own territory definitions, typically based
(such as credit scoring and tiering) or even on analysis of internal loss costs at the
In the middle of the spectrum are compa- expanded the number of price points for ZIP-code level.
nies that apply simple generalized linear existing variables (e.g., moving from
modeling techniques with very few variable banded age ranges to individual driver age More sophisticated companies vary terri-
transformations and/or interactions among rating factors). These insurers typically rely tory definitions by coverage or peril — for
variables. Such approaches might include on more traditional rating variables such example, a company might have separate
just an age variable, whereas more as age, gender, marital status and merit personal auto territorial definitions for
advanced approaches could also include rating to determine premiums. Today, rel- liability, collision and comprehensive
age/gender or age/credit score combination atively few insurers fall into this category coverages, and distinct homeowners terri-
variables, among others. More advanced — but many have moved only modestly torial definitions for fire, theft, wind and
approaches might also include different beyond this level, perhaps adding a narrow other coverages. Some also adopt non-
transformations of a single variable using tiering structure or a few new variables to contiguous territorial definitions. Exhibit 2
curve-fitting techniques to transform a their traditional rating plan. Reasons for on page 17 illustrates how noncontiguous
variable, or other statistical techniques such such a limited approach range from limited territories can help achieve the goal of
as clustering, decision trees or neural net- data and resources to lack of management territory design with fewer territories.
works to group like values of the variable. appreciation of the need or value.

3. 16 | Emphasis 2009/2
EXHIBIT 1
Five dimensions of rating sophistication
NONE LOW MEDIUM HIGH VERY HIGH
Data Limited (internal) Internal Low, plus: Medium, plus: High, plus:
Bureau Purchased credit More internal data Components of credit Transformed variables
Externally purchased info score (i.e., combinations of
Geo-demographic, More detailed insured internal/external info)
weather, etc. data
Modeling None Univariate Simple multivariate Complex models with More complex models
Approach significant variable
interactions
Rating Plan Traditional “ISO” type Few tiers Low, plus: Medium, plus: High, plus:
Design Age, gender, marital Country/city/ZIP More tiers Credit (proprietary) Creative new variables
status, etc. variations Multiple new variables Interactions between Cross-LOB variables
Follow historical ISO Independent territories variables Vary expenses by segment
territories (often ZIP-based) Different and complex Different rate for every
territories varying by ZIP, possibly for every
coverage/peril location
Competitive None Quantitative Small sample/profile Rating engine Rating engine
Sensing agent-driven
Pricing Cost-based Cost-based Cost-based Cost-based with Price optimization
Strategy Uniform rate charges Uniform rate charges Limited cross-subsidy competitive/marketing Competitor behavior
by class by class consideration Price elasticity
Possible variations Possible variations by tier (consumer behavior)
across territories to reduce cross-subsidies
It is the combination of territory design on competitor rates. However, quite a few price points for this kind of sampling
and the number of discrete territorial rates invest relatively modest amounts of time, approach to provide a reliable view of
that provides competitive advantage, not effort and resources in this activity (see how they are pricing or how your rates
just the number of territories. If the number “Overcoming the Challenges of CMA,” compare across your book of business.
of discrete territorial rates is limited (i.e., Emphasis 2008/1 for details on alternative
many territories have the same rate), methods). The most sophisticated companies are
having more finely specified territories using comparative raters to run their entire
provides less value. The low end of the spectrum is defined book of business through competitor rating
by qualitative, agent-driven competitive algorithms. This approach provides much
Competitive Sensing insights. Indeed, if you sell through agents, more comprehensive, reliable and specific
As rating plans have become increasingly like it or not, you will hear from them information about how their rates compare
sophisticated and the number of potential about how your prices compare to those to those of competitors.
price points has increased exponentially, of competitors. The problem with this
understanding competitors’ rating approaches type of input is that it tends to be anec- Pricing Strategy
and prices has become much more difficult. dotal and, sometimes, skewed. The next step is to combine data, modeling,
But it has also become more important, rating plan design and competitive sensing
given the consequences of falling behind This deficiency is the same one that hampers into a coherent and compelling pricing
competitors in pricing sophistication and the most common approach to competitive strategy.
rate competitiveness. Pricing needs to sensing — rating a sample of risks using
reflect (or at least recognize) competitor your best interpretation of competitors’ Target competitiveness is one aspect of
rates, as well as insurance risk and cost rating plans. This defines “medium” sophis- pricing strategy, e.g., does the company
considerations. tication along our spectrum. Historically, want to target rates at the midpoint of its
rating a sample basket of risks could competitive peer group or, say, in the top
Very few insurers these days fail to perform provide a reasonable perspective on com- quartile? Another issue is cross-subsidiza-
some type of competitive analysis focusing petitors’ pricing, but no more. Sophisticated tion — how much do we want between
raters simply offer too many different

4. Emphasis 2009/2 | 17
EXHIBIT 2
Indicated North Carolina personal auto territories — bodily injury (illustrative)
Contiguous clusters Noncontiguous clusters
70% When the complexity and costs of further
59% improvements outweigh their practical
60%
Percent of total variance
Pre-Clustering benefits, you have reached the point of
within territories
50%
diminishing returns. But since companies
40% continue to invest in this area, even your
30% latest innovation will likely soon be out of
20% Contiguous
date. Pricing sophistication really is the
10% Noncontiguous proverbial treadmill — you must keep
moving simply to avoid losing ground. The
0%
more resource-constrained you are, the
4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50
harder it is to keep up. Sophisticated and
Number of territories
large competitors understand this dynamic
and are continuing to press their advantage.
new and renewal business, across classes I How should we prioritize our efforts to
ENHANCING PRICING
of business, across territories? (Generally realize the highest and fastest payback?
SOPHISTICATION
speaking, the lower the inadvertent cross-
The case for enhancing pricing sophistica-
subsidies, the further to the right on the How far you need to move along the spec-
tion is clear. A decade ago, companies
sophistication spectrum.) trum is a function of your competitive
that started down this path took a major
circumstances. If you routinely compete
leap of faith, and have benefited from
Another fundamental consideration is the against the large national players that have
their trailblazing. Today, pursuing rating
basis for pricing. On this question, every- been investing heavily in pricing sophisti-
sophistication using predictive modeling
thing left of center on the spectrum can be cation for a long time, you will need to
techniques is “table stakes.”
thought of as traditional cost-based pricing. move further along the spectrum to close the
At the high end of the spectrum, companies competitive gap. If you tend to compete
The questions, then, become tactical: in
are exploring price optimization, whereby more with local and regional competitors
what areas to move forward, how far to
price is a function of loss costs, competi- that have not made such significant invest-
move, how quickly to move. Understanding
tor rates and customer demand elasticity ments in this area, then you need not move
the dimensions of rating sophistication can
— factors that allow for optimum trade- so far, at least for now. Keep in mind that
help you think through these questions
offs between growth and profit (see “Price you will always be at a disadvantage
and establish your own road map, either to
Optimization for Profit and Growth,” compared to every company that is more
retain (or regain) competitive advantage or
Emphasis 2008/4). How this “free market” sophisticated than you in its pricing.
to close the gap with more sophisticated
thinking will fare in the face of the current
competitors.
regulatory environment is a question that Your company’s focus will depend on your
will play out over time. starting point in each dimension and the
For comments or questions, call or e-mail
particular expertise you can leverage. Some
Charles R. Wolstein at 1-703-351-4757,
CHOOSING A PATH dimensions require more effort to address
charles.wolstein@towersperrin.com, or
Our intent is to clarify the dimensions of than others (e.g., addressing significant
Christopher W. Hurst at 1-314-719-5846,
pricing sophistication to assist in answering data deficiencies tends to be a long-term
chris.hurst@towersperrin.com.
some key questions, such as: effort with significant technology/infra-
I How far do we need to go in each dimen- structure implications).
sion to be able to compete effectively?