Price Optimization: A Potent Weapon for Warranty Industry

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!

http://www.warrantyweek.com/archive/ww20091029.html 10/30/2009


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



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.
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



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
HomeInsurance.com & 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.
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.
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



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.

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.
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.
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.

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.



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 chris.hurst@towersperrin.com.
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.


Israeli Peugeot and Citroën distributor
drops coolant replacement
requirement in warranties.
Ha'aretz, October 5, 2009

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