Property & Casualty Insurance

Price Optimization
For New Business Profit and Growth
By Angel Marin and Thomas Bayley

Non-life companies want to maximize profits from new business.

Price optimization can make the difference.

“ Incorporation of a Introduction Incorporation of a customer behavior model in the

customer behavior model pricing system for new business is fundamental to
To write more new business, property & casualty premium optimization. The improvements made in
in the pricing system companies need to define the type of customer collecting customer and competitor information,
for new business is they want to attract and then understand how price- combined with the increase in computing capacity,
fundamental to premium sensitive these customers are to their products. By can help insurers to move from pricing exclusively
effectively analyzing price sensitivity and expected according to risk attributes toward an integrated
optimization.”
sales volumes at varying profit levels, companies pricing approach. Such an approach incorporates
can increase new business conversion rates — competitors’ premiums and customer behavior along
given target levels of profitability — to arrive at an with risk attributes in the pricing of new business.
optimal new business pricing strategy. Combining these elements should help companies
Insurance companies have made significant find the most profitable balance between the
advances in more granular risk-based pricing extremes of low-volume/high-profit sales and low-
through the use of predictive modeling techniques. profit/high-volume sales.
As a result, the spread of new business loss ratios
compared with those for renewal business (known Why Optimize Prices for New Business?
as the new business penalty) has been reduced. It is easy to write more new business by simply
Predictive modeling has driven this improvement, reducing the overall level of premiums. Similarly,
and companies can now turn their attention to how a company can increase the per-policy profitability
to increase overall new business profitability. of new business by increasing premiums for a
The process needed to conduct this analysis, called given risk profile. However, neither of these pricing
price optimization, was described in a previous strategies will work in a real insurance market.
article (“Price Optimization for Innovative Insurers,” Balancing growth and profitability is the key to long-
Emphasis 2008/1). We also described how price term success.
optimization could be used to improve the retention By using price optimization techniques to analyze
and profitability of an in-force portfolio (“Price Optimiza- information about competitors’ price levels and
tion for Profit and Growth,” Emphasis 2008/4). In customer behavior related to price levels, companies
this article, we show how price optimization methods can find the proper balance between these factors.
have also been successfully applied by property & An optimized pricing system can also help:
casualty companies to improve new business
conversion rates and achieve the desired overall • Determine the optimal price within the range of
profitability for the portfolio — while working within possible prices for every insured
management and regulatory constraints. • Adapt the premium based on market
competitiveness to attract certain profitable
segments of business
• Attract new customers with strong loyalty and
increase the potential for cross-selling

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Development of the pricing system should consider Claims Discount in the U.K. or Bonus-Malus in
not only the risk but also the variation of other Continental Europe.
acquisition costs, customers’ sensitivity to product • Model refinement. These models are usually
price (elasticity), and the likelihood of their buying refined by incorporating the probability that the
other products (cross-selling) or staying longer with policyholder remains with the company over time,
the company. and may also take into account extra profit arising
from cross-selling and referrals (both of which can
To address these issues, companies need to start
be modeled probabilistically).
by defining a “benefit function” that incorporates
• Benefit function. In particular, this can be
the primary elements of product profitability over
modeled using time horizons chosen according to Angel Marin
the required time horizon. The goal of the price
the financial goals of the company. It can be built Specializes in pricing
optimization process is to find the premium level and reserve review
for a short-term time horizon, such as one year, or
that will maximize this benefit function. Figure 1 support for P&C insurers.
for a longer time period of three to five years. Towers Watson, Madrid
shows a typical breakdown of this function.
• Pure premium model. This can be carried out by
To arrive at a benefit function model, the following modeling frequency and severity separately, or
items will need to be included: can be done directly through the modeling of loss
costs, adjusted for inflation and loss development.
• Conversion rate model. This model estimates the
• Expenses. All expenses must be considered,
probability of writing a new policy considering the
including those for acquisition, administration and
relevant variables related to the customer and
claim handling (perhaps varying by client profile).
market competitiveness.
Expenses can be modeled both at the portfolio
• Proposed premium to be offered to the
and per-policy levels.
potential insured. This is what the optimization
process essentially solves for. This proposed Thomas Bayley
premium is calculated by taking into account the Specializes in reserve
review and pricing
appropriate probability of discounts such as No support for P&C
companies.
Towers Watson,
Philadelphia
Figure 1. Structure of a benefit function for new business price optimization

Maximize Benefit Function...

General
Benefit Conversion Proposed Pure and Loss
function = rate x( premium – premium – acquisition – adjustment )
expenses expenses

Emphasis 2010/1 | 19
 Some of the most important variables used in To ensure that the model represents current market
modeling these components are the classification of reality, the internal and external data must be
agents, driver age, claim history, geographical area continually tested and upgraded. A model based
or territory, Bonus-Malus system (or equivalent claim on market information even just a year old may not
discount/surcharge system), and the difference accurately reflect current market competitiveness,
between the offered and the market premium. and its use can lead to unprofitable pricing
decisions.
Building a Price Optimization Model Competitive market analysis (CMA) enables insurers
for New Business to obtain premium rates for as many risks and
Elasticity of demand is a key ingredient in this competitors as possible (see “Competitive Market
process. Each company has its own elasticity-of- Analysis in Personal Lines,” Emphasis 2007/2).
demand curve (formed by its potential client profiles, CMA incorporates the insight and knowledge of
each with its own behavior). The curve is based on general market behavior (market direction, key
an analysis of the relationship between changes in competition), knowledge of price levels by rating
the incremental quantities of policies converted from factors, intensity of the competition by segment
initial quotations and the price increase or decrease (measure of price dispersion) and a comparison
proposed by the company. of the company’s prices against market prices by
segment.

“The classic approach, which

Figure 2. Comparison of discount profitability and conversion rate
in a European auto market
calculates premiums based solely
Difference in premium offered by the company vs. market premium
on loss costs, is not enough to
35%
Discount probability
70%
optimize a company’s growth
30% 60%
and profits from new business.”
Discount probability

25% 50%
Conversion rate

20% 40%
Conversion rate
Figure 2 shows a real example from a European
15% 30% auto insurance market that gives policyholders rate
discounts for various reasons. The price elasticity
10% 20%
model needs to take this discounting into account.
5% 10% The figure shows two direct relationships: first,
between the conversion rate and the difference
0% 0%
between the premium offered by the company and
Below the market Above the market
the market premium for the relevant segment,
and second, between the probability of applying
Figure 3. The optimization model discounts to a new policy and the company/market
premium differential. It is clear that:
· Pure premiums Individual premiums, optimized • The lower the premium offered by the company in
· Financial objectives in accord with the demand
· Conversion rate model Optimization function and financial goals
comparison with the market premium, the higher
· Cross-selling effects of the company the conversion rate and vice versa.
· Competitors’ rates
• The lower the premium offered by the company in
Input Statistical tools Output comparison with the market premium, the lower
the probability of the client being given a discount.
• The higher the premium offered by the company in
comparison with the market premium, the higher
the probability of the client being given a discount.

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Along with the price elasticity information, other target. The process may need to incorporate “ Balancing growth and
data are needed to build the model, including pure constraints to satisfy any management or regulatory profitability is the key to
premiums by class of business, financial goals of restrictions, which will lead to an adjusted and
long-term success.”
the insurer, cross-selling information and competitor definitive combination of prices and client profiles.
prices by class.
Results Obtained From the Price
Figure 3 shows the inputs necessary for the new
Optimization Model
business optimization model and the outputs that
would be generated. The new business optimization process produces
an efficient frontier where, for each conversion rate,
Figure 4 is a schematic of the optimization process
there is a combination of policies and prices that
for new business. At the start, the company needs
produces different profitability levels. However, only
to determine the constraint and the target. It is
one combination of policies and prices will give the
possible to define the total new business revenue
maximum profitability for a given overall conversion
and maximize profitability given that revenue or
rate. The graph of the maximum profitability for each
(more commonly) to define the overall new business
overall conversion rate forms an efficient frontier.
profitability and maximize new business revenue
There are other suboptimal combinations for the
given that profitability target. The choice between
same conversion rate level, but the profitability will
these two approaches is a key management input.
be lower.
The new business optimization process calls for an
A company might also want to maximize the
appropriate software tool that can jointly analyze all
revenue of new business, maintaining a given level
the elasticity-of-demand functions for all potential
of profitability. In that case, management would
clients’ profiles. With this analysis, the company
determine the overall profitability (in whatever form
can determine probabilistically the best combination
this is defined) to be achieved by the new business,
of conversion rates and types of client, and then
and the optimization process would produce the
produce the desired maximum (the number of new
combination of client profiles and individual prices
business conversions) given an overall profitability
to achieve it (i.e., maximum number of new policies
or highest possible conversion rate), allowing for any
restrictions.

Figure 4. New business optimization process

Conversion rate model

To estimate the probability
that the insured X accepts
a policy at a price P
considering market price Q

New Total benefit

business Simulation function
Profitability function
To estimate the profitability
if the insured X accepts the
price P:
+ Premium P
- Expected pure premium
Applied - Internal expenses
- Acquisition expenses
Goal seek
premiums

Initial target:
Profitability Optimization

Emphasis 2010/1 | 21
 Figure 5 shows an example of an efficient frontier “By adopting price optimiza-
for new business conversion.
tion early, pioneering com-
• The current Company strategy (red dot) is clearly
suboptimal. panies will capture more of
• The green dot represents Strategy 1, where the
company improves profitability while maintaining
the new business that they
the same conversion rate. desire at profitable rates.”
• The orange dot represents Strategy 2, where
the company improves profitability at a reduced
conversion rate.
Implementing Optimized
• The blue dot represents Strategy 3, where the
New Business Rates
company increases conversion rates while
maintaining the same profitability level. The optimal price for new business will be the one
that satisfies the company’s strategic objectives
while maximizing profitability, subject to management
and regulatory constraints. Optimized rates can be
Figure 5. Efficient frontier for new business conversion implemented in two different ways:
28.75 • As an algorithm that calculates the optimized
price per individual customer based on his/her
28.60
Increase conversion rate/keep expected profit particular rating attributes, which can be built into
28.45 the rating structure and operate in real time
Conversion rate

Keep conversion rate/ • As a set of optimized premium rates that would fit
28.30 improve expected profit
into a tabular rating structure
28.15 Company strategy
Advantages of Adopting Price
28.00
Reduce conversion rate/
Optimization of New Business
27.85 improve expected profit
The classic approach, which calculates premiums
27.70 based solely on loss costs, is not enough to
0.00% 3.40% 9.18% 12.09% optimize a company’s growth and profits from new
Expected Profit business. The combined analysis of the different
Strategy 1 Strategy 2 Strategy 3 Company strategy Efficient frontier indicators that affect profitability allows insurers to
reach their financial objectives while maintaining a
competitive market position — thereby maintaining
flexibility in the face of cyclical changes.
Figure 6. Financial indicators for efficient frontier strategies
The statistical techniques and models needed for
Written this analysis are available but are not yet widely
Conversion Average Expected Number premiums
Scenarios rate premium profit of policies (thousands) used, although they are rapidly gaining adherents
in different markets. By adopting price optimization
Company strategy 28.2% 334 0.0% 146,208 48,779
early, pioneering companies will capture more of the
Strategy 1 28.2% 337 3.4% 146,208 49,201 new business that they desire at profitable rates —
and gain significant competitive advantage.
Strategy 2 28.0% 343 9.2% 144,925 49,767
For comments or questions, call or e-mail
Strategy 3 28.5% 332 0.0% 146,932 48,833
Angel Marin at +34 1 590 3009,
angel.marin@towerswatson.com; or
Thomas Bayley at +1 215 246 7376,
thomas.bayley@towerswatson.com.

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