NAIC.Price

This reading, Price Optimization White Paper, provides background research on price optimization, identifies potential benefits and drawbacks to the use of price optimization, and presents options for state regulatory responses regarding the use of price optimization in ratemaking.

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Study Tips

Since this is a relatively new reading, we don't have a lot of old exam problems to help us determine what the CAS deems important. Unfortunately, that means we'll have to spend more time on this reading, possibly learning things that are of relatively little importance, but we'll use judgment to try to minimize wasted time. As more exam problems on the topic appear, we'll be able to cull the material that needs to be studied. I'd plan for 2 hours on this reading (not including subsequent review time.)

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• differences between traditional ratemaking (including actuarial judgment) and price optimization rating plans
• required disclosures when using price optimization rating plans
• ASOP ratemaking principles with respect to price optimization rating plans (rates can't be excessive, inadequate, or unfairly discriminatory)

reference	part (a)	part (b)	part (c)	part (d)
E (2018.Fall #1)	differences: - price opt. vs traditional	required disclosures: - in price opt. plan	ASOP compliance: - with price opt. rating	ASOP violation: - by price opt. rating
E (2018.Spring #1)	differences: - price opt. vs traditional	unfairly discriminatory: - price opt. data	regulator contraints: - in price opt. plan	required disclosures: - in price opt. plan

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In Plain English!

This reading is organized into 8 sections with numbered paragraphs in each section as indicated below. Some paragraphs are important and others are not. If I don't explicitly mention a paragraph, it means I've judged that paragraph as not important for the purposes of the exam. It's a good idea for you to glance through the source reading yourself in case you spot something you think I missed.

Section 1: Scope

The Scope covers paragraphs 1-3.

paragraph 2

• The primary focus of this reading is personal lines ratemaking.

Section 2: Introduction

The Introduction covers paragraphs 4-10.

paragraph 5

• Traditionally, actuarial adjustments to indicated rates were judgmental and applied only on a broad level (territory for example)

paragraph 6

• More recently, price optimization techniques have made possible granular adjustments to indicated rates.

Question: how does price optimization compare to traditional ratemaking techniques

• price optimization is a process that uses

   - big data (data mining of insurance & non-insurance personal information where permitted by law)

   - advanced statistical modeling

• price optimization makes granular adjustments to indicated rates (specific risk classifications, or even individual insureds)

• We'll return to the topic of traditional ratemaking versus price optimization in more detail later. This paragraph was just to give you the general idea.

Section 3: State Rating Law, Actuarial Principles and Definitions

State Rating Law, Actuarial Principles and Definitions covers paragraphs 11-14.

paragraph 14a

Question define price optimization as it is used in this reading

• the process of maximizing or minimizing a business metric
• uses sophisticated tools and models to quantify business considerations

paragraph 14d

Question define cost-based rate

• this is just the traditional actuarially derived rate based on loss costs, LAE, and other expenses

paragraph 14f

Question define price elasticity of demand

• 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 (you can jack the prices but consumers won't shop around)

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Section 4: Price Optimization Background

Price Optimization Background covers paragraphs 15-30.

paragraph 19

Question: define the terms ratebook optimization, individual price optimization, hybrid optimization

• ratebook optimization

   → adjust factors in a cost-based rating structure using a demand model

• individual price optimization

   → build a pricing structure based on both cost and demand

• hybrid optimization

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

• These definitions highlight the critical concepts of traditional or cost-based pricing, and the demand model of price optimization. If there is only 1 thing you remember from this reading, that's the thing! (Price optimization can be based on metrics other than demand but the demand model is one that's very often used so that's my own personal hook for understanding it.)

paragraph 23

Question: define constrained optimization

• setting minimum & maximum limits on a model's output (Ex: current price and cost-based indication)
• note that unconstrained optimization does not impose these limits

paragraphs 25-30

• These paragraphs seem overly detailed and I think they can be summarized as follows:

Question: describe the main differences between traditional ratemaking and price optimization

difference 1:

traditional: applied at class level

price optimized: can be applied to individual policies

difference 2:

traditional: used cost-based pricing

price optimized: incorporates non-cost-based considerations like propensity to shop around (shopping around relates to demand)

difference 3:

traditional: deviations from indicated rates are subjective

price optimized: deviations from indicated rates are based on quantitative models

Question: identify other miscellaneous differences between traditional ratemaking and price optimization

• traditional ratemaking (including a component for actuarial judgment) will assign the same price to identical risks, but price optimization may assign different prices
• traditional ratemaking (including a component for actuarial judgment) is generally accepted by regulators whereas price optimization may not be acceptable (more on this later)

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Section 5: Identify Potential Benefits and Drawbacks of Price Optimization

Identify Potential Benefits and Drawbacks of Price Optimization covers paragraphs 31-38.

Question: identify benefits and drawbacks of price optimization

BENEFITS

paragraph 35

   - doesn't unfairly discriminate (low-income customers are more likely to shop around)

   - provides more accurate pricing (neither inadequate nor excessive)

paragraph 37

   - if optimization is applied on a ratebook level, it is not unfairly discriminatory

   - note that individual optimization may be unfairly discriminatory

DRAWBACKS

paragraph 31

   - regulators don't have the data to independently verify rates based on price optimization

paragraph 32

   - the models (often GLMs) can produce large individual rate swings (can be controlled by using constrainted optimization)

paragraph 34

   - no evidence of improved stability from using price optimization (effect on long-term costs is inconclusive)

paragraph 38

   - concern that ratemaing ASOPs may be violated (if rates are unfairly discriminatory)

Ratemaking ASOP Review Question: identify 3 things that a rate filing cannot be

paragraph 39

   - a rate filing cannot be: inadequate, excessive, unfairly discriminatory

Section 6: Regulatory Responses to Price Optimized Rating Schemes

Regulatory Responses to Price Optimized Rating Schemes covers paragraphs 39-42.

This sections has many bullet points list - a favorite type of exam question - but its impossible to know which ones might be asked. :-(

paragraph 42

Question: identify possible regulatory responses to price optimization rating plans

paragraph 42a

• determine permissibility with respect to state laws

paragraph 42b

• define regulatory constraints (min/max rate swings, methods apply only to rate classes of at least a certain size)

paragraph 42f

• transparency: require full explanation of...

   ==> DAM - Data / Methods / Assumptions

   ==> rate differences between customers with identical risk profiles (if any)

paragraph 42(d) & 42(f)

Question: identify disclosures a regulator may require when price optimization is used in a rate filing

• rate adjustments that are not cost-based
• whether price optimization was used (Ex: demand models)
• 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

==> I found these by using cntrl-f in the source reading to search for the word disclosure.

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Section 7: Recommendations for Regulators

Recommendations for Regulators covers paragraphs 43-49.

paragraphs 45-46

Question: identify recommendations of the Task Force on Price Optimization regarding pricing methodology

• 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 - due to transition rules for example)

paragraph 48

Question: identify rating practices or considerations that the Task Force on Price Optimization believes are unfairly discriminatory

• 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

Section 8: State Considerations

State Considerations covers paragraph 50.

paragraph 50

Question: identify recommendations of the Task Force on Price Optimization regarding state regulatory practices

• issue bulletin addressing use of non-cost-based methods
• enhance disclosure requirements for rate filings
• ensure compliance with state laws and actuarial principles by analyzing insurers' rating models

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Extra Exam Problems

Here's a final quiz with some exam problems that weren't covered by earlier quizzes.

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