May 18, 2004CAS Spring Meeting1 Demand Based Pricing: A Company Perspective CAS Spring Meeting May 18, 2004 Floyd M. Yager, FCAS, MAAA Allstate Insurance Company

May 18, 2004CAS Spring Meeting2 Disclaimer The views expressed in this presentation are consistent with, but do not necessarily represent the position of, Allstate Insurance Company. The views expressed herein are subject to the understanding that all applicable state and federal law must be adhered to at all times. The views expressed in this presentation are consistent with, but do not necessarily represent the position of, Allstate Insurance Company. The views expressed herein are subject to the understanding that all applicable state and federal law must be adhered to at all times.

May 18, 2004CAS Spring Meeting3 Issues to Cover Historically, actuaries have focused more on the supply curve than the demand curve Historically, actuaries have focused more on the supply curve than the demand curve Focus on rates and ratemaking regulation Focus on rates and ratemaking regulation Maintaining actuarial objectivity while helping our company optimize results Maintaining actuarial objectivity while helping our company optimize results Working with Product Managers and using indicated rates in marketing decisions around price Working with Product Managers and using indicated rates in marketing decisions around price Difficulty in modeling elasticity and using the results Difficulty in modeling elasticity and using the results

May 18, 2004CAS Spring Meeting4 Background Pricing based on demand is not a new concept in many industries. Pricing based on demand is not a new concept in many industries. With many products this is the way prices are set: With many products this is the way prices are set: Airlines Airlines Hotel Rooms Hotel Rooms Package Goods Package Goods Many products priced so that supply and demand align Many products priced so that supply and demand align Adjust prices to “move” inventory Adjust prices to “move” inventory Charge people what they are willing to pay Charge people what they are willing to pay

May 18, 2004CAS Spring Meeting5 Historical Study Ratemaking Practice has focused on understanding costs Ratemaking Practice has focused on understanding costs Modeling loss costs for overall rates and for segments in classification ratemaking is a primary function of actuaries Modeling loss costs for overall rates and for segments in classification ratemaking is a primary function of actuaries Statement of Principles Regarding Property and Casualty Ratemaking says, in the Definition section: Statement of Principles Regarding Property and Casualty Ratemaking says, in the Definition section: “… This statement is limited to principles applicable to the estimation of these costs. Such costs include claims, claim settlement expenses, operational and administrative expenses, and the cost of capital…”

May 18, 2004CAS Spring Meeting6 Historical Study For overall rates, Loss Ratio and Pure Premium Methods focus on estimation of loss costs in future period For overall rates, Loss Ratio and Pure Premium Methods focus on estimation of loss costs in future period Profit provisions have tended to be an academic exercise and regulated like utilities rather than be determined in the competitive market Profit provisions have tended to be an academic exercise and regulated like utilities rather than be determined in the competitive market General classification ratemaking concentrates on differences in loss relativities among classes General classification ratemaking concentrates on differences in loss relativities among classes Neither method gives consideration to changes in the overall volume or mix of business as a result of any change to the rates Neither method gives consideration to changes in the overall volume or mix of business as a result of any change to the rates

May 18, 2004CAS Spring Meeting7 Historical Study There has been some recognition of the role of elasticity in ratemaking, here are two examples: There has been some recognition of the role of elasticity in ratemaking, here are two examples: “Ratemaking for Maximum Profitability,” Lee M. Bowron, and Donald E. Manis, CAS Forum Winter 2001 Includes ideas for selecting an overall rate change given elasticity of a book and the overall objective of the company. “Personal Automobile Premiums: An Asset Share Pricing Approach for Property-Casualty Insurance,” Sholom Feldblum, PCAS LXXXIII, 1996 Persistency as a factor in pricing for a return over time. Neither paper discusses how to get good elasticity measures. Neither paper discusses how to get good elasticity measures.

May 18, 2004CAS Spring Meeting8 Focus on Rates Due to the focus on understanding of loss costs and expenses actuaries have been counted on for the production of rates Due to the focus on understanding of loss costs and expenses actuaries have been counted on for the production of rates Focus has been to meet regulatory requirements and actuarial standards Focus has been to meet regulatory requirements and actuarial standards Rates should be reasonable and not excessive, inadequate, or unfairly discriminatory Rates should be reasonable and not excessive, inadequate, or unfairly discriminatory If rates are an actuarially sound estimate of the expected value of future costs associated with an individual risk transfer they can meet this standard If rates are an actuarially sound estimate of the expected value of future costs associated with an individual risk transfer they can meet this standard

May 18, 2004CAS Spring Meeting9 Maintaining Objectivity In many companies, actuaries have provided the “voice of reason” In many companies, actuaries have provided the “voice of reason” Role has been to keep the rates appropriate when sales and others pushed for growth at “all costs” Role has been to keep the rates appropriate when sales and others pushed for growth at “all costs” Bottom line responsibility: it has been paramount for actuaries to avoid insolvencies Bottom line responsibility: it has been paramount for actuaries to avoid insolvencies Now we are being asked to maintain appropriate rates while working with Product Managers to grow the business Now we are being asked to maintain appropriate rates while working with Product Managers to grow the business

May 18, 2004CAS Spring Meeting10 Product Management Product managers are charged with the growth and profit for a market (line of business, state, or combination) Product managers are charged with the growth and profit for a market (line of business, state, or combination) Many live the 4 P’s of Marketing (Product, Price, Place, Promotion) Many live the 4 P’s of Marketing (Product, Price, Place, Promotion) Actuaries can clearly help understand what the range of the “right” price for the product may be Actuaries can clearly help understand what the range of the “right” price for the product may be The actuarial rate, as developed by analysis of the costs, needs to be reconciled with the economic price (what a consumer is willing to pay in a competitive market) The actuarial rate, as developed by analysis of the costs, needs to be reconciled with the economic price (what a consumer is willing to pay in a competitive market)

May 18, 2004CAS Spring Meeting11 Product Management Actuaries are positioned to help our companies by bringing analytical skills to more problems Actuaries are positioned to help our companies by bringing analytical skills to more problems Unique understanding of insurance data, regulatory environments, and modeling techniques Unique understanding of insurance data, regulatory environments, and modeling techniques Actuaries can bring perspective around the 3 C’s of Marketing (Cost, Customer, Competition) Actuaries can bring perspective around the 3 C’s of Marketing (Cost, Customer, Competition) How do we use our skills to work with Product Managers to provide input to final pricing decisions? How do we use our skills to work with Product Managers to provide input to final pricing decisions?

May 18, 2004CAS Spring Meeting12 Product Management In the Conclusion of Statement of Principles Regarding Property and Casualty Ratemaking we find: In the Conclusion of Statement of Principles Regarding Property and Casualty Ratemaking we find: “Other business considerations are also a part of ratemaking. By interacting with professionals from various fields including underwriting, marketing, law, claims, and finance, the actuary has a key role in the ratemaking process.” We need to find ways to bring our analytical skills to the problems our companies may face, growing market share while maintaining appropriate returns over time We need to find ways to bring our analytical skills to the problems our companies may face, growing market share while maintaining appropriate returns over time One way may be improving our understanding of demand for the insurance product and communicating how changes to rates may affect the company’s ability to attract and retain business One way may be improving our understanding of demand for the insurance product and communicating how changes to rates may affect the company’s ability to attract and retain business

May 18, 2004CAS Spring Meeting13 Elasticity Price elasticity probably varies significantly by state and line of business Price elasticity probably varies significantly by state and line of business Worker’s Comp in a state with mandated rates likely to be more inelastic than the market for Catastrophe Reinsurance Worker’s Comp in a state with mandated rates likely to be more inelastic than the market for Catastrophe Reinsurance Segments of business likely have differences in elasticity Segments of business likely have differences in elasticity Within a book of business you can see the effect of varying renewal elasticities in the fact that different segments show different retention after a rate change Within a book of business you can see the effect of varying renewal elasticities in the fact that different segments show different retention after a rate change New versus renewal New versus renewal

May 18, 2004CAS Spring Meeting14 Elasticity Modeling elasticity is not easy Modeling elasticity is not easy Data to understand how past actions have affected new and renewal business may not be readily available Data to understand how past actions have affected new and renewal business may not be readily available Difficult to keep up to date on competitor changes Difficult to keep up to date on competitor changes Difficult to isolate even the rate decisions within your own company Difficult to isolate even the rate decisions within your own company Administrative changes happen at the same time Administrative changes happen at the same time Changes in advertising and awareness of company Changes in advertising and awareness of company Other Other

May 18, 2004CAS Spring Meeting15 Elasticity Need to balance the indicated and supportable rate through proven actuarial techniques with decision on price Need to balance the indicated and supportable rate through proven actuarial techniques with decision on price Price which “optimizes” your company objectives probably does not equal your indicated rate Price which “optimizes” your company objectives probably does not equal your indicated rate An “optimal” rate is above the indication is not necessarily excessive. An “optimal” rate is above the indication is not necessarily excessive. An “optimal” rate is below the indication is not necessarily inadequate. An “optimal” rate is below the indication is not necessarily inadequate.

May 18, 2004CAS Spring Meeting16 Elasticity Elasticity and its use in the pricing process seems to be an area ripe for study by actuaries Elasticity and its use in the pricing process seems to be an area ripe for study by actuaries An understanding of the behavior of consumers as we adjust rates and work on behalf of our companies is necessary to help guide better business decisions An understanding of the behavior of consumers as we adjust rates and work on behalf of our companies is necessary to help guide better business decisions