Price optimization is a hot topic in the insurance world rightnow.

Insurers, customers, state insurance commissioners, big dataexperts, consumer advocacy groups and industry thought leaders areall weighing in on how the practice will affect insurance.

In fact, nearly one in five insurance practitioners predictedprice optimization would be the most impactful industry trend of2016, according to a survey by The Institutes. That’s unlikely tochange for 2017.

And even though it seems like everyone's talking about priceoptimization, there are still a lot of uncertainties. You'd beforgiven if you couldn't say exactly what price optimization is orhow it fits into policy pricing. In this post, we'll dig a littledeeper into three big questions in the price optimizationdebate.

Related: 23 trends, challenges and opportunities in personallines insurance

What is it?

The uncertainty around price optimization starts with defining whatexactly it is — there is no generally accepted definition. In a2015 white paper, the NAIC Casualty Actuarial and Statistical Task Forcedefines price optimization as "the process of maximizing orminimizing a business metric [such as 'marketing goals,profitability and policyholder retention'] using sophisticatedtools and models to quantify business considerations."

Essentially, price optimization boils down to the use of factorsnot directly related to risk in establishing rates and premiums.The Insurance Information Institute offers a classicexample of basic price optimization: the cost of auto insurancefor young drivers. Young drivers typically pay a lot for carinsurance, but insurers usually limit their rates in order to keeptheir parents as customers. Insurers subsidize costs not based onrisk but in the interest of retaining customers — that's priceoptimization. I.I.I. points out that some insurers have been usingthis kind of price optimization for a long time, and regulatorshave never objected to it.

(Photo: iStock)

Here's another example that gets at some of the morecontroversial aspects of price optimization:

Two customers with the exact same risk profiles have policiesthat are up for renewal. Customer A has been with the insurer for10 years and has never questioned or complained about the price shepays. Customer B has been with the insurer for five years and hasthreatened to switch to a competitor several times. Insurers mayuse price optimization strategies to generate different rates foreach customer even though they have the same risk profile.

This form of price optimization is based on the economicprinciple known as elasticity of demand — in this context, how muchthe price can go up before a consumer refuses to pay. In the era ofbig data, insurers can buy access to exponentially larger amountsof customer data, from their credit histories or cable providers towhen they last upgraded their cell phones. The controversy stemsfrom entering this information into complex algorithms to determinehow much of a premium increase a customer will accept beforedeciding to look elsewhere.

Who’s doing it?

Although airlines and hotels build their business around priceoptimization, the practice is far less widely accepted within theinsurance industry, and the vague definition makes it difficult todetermine how many insurers currently engage in it. In 2013, priceoptimization software company Earnix released a report claiming 26 percent of North Americaninsurers use price optimization. In that same year, however,Willis Towers Watson, which also sells priceoptimization software, found that only 12 percent of insurers use priceoptimization in personal lines and that no commercial linesrespondents use the practice.

(Photo: iStock)

Is it legal?

As of May 2016, notices that limit or ban price optimization in theinsurance sector have been issued by Washington, D.C. and 18states: Alaska, California, Colorado, Connecticut, Delaware,Florida, Indiana, Maine, Maryland, Minnesota, Missouri, Montana,Ohio, Pennsylvania, Rhode Island, Vermont, Virginia andWashington.

Two notable lawsuits challenging insurers' use of priceoptimization are making their way through the California and NorthDakota court systems, but one law firm says that so far, these cases"raise more questions than they answer." For now, the legality ofprice optimization is still very up in the air and depends onspecific state regulations and the exact actions an insurer takesunder the umbrella of price optimization.

Related: Emerging risks in auto technology

Legal issues aside, price optimization as it applies toinsurance hasn't had the best reputation of late. Last year, NPRpublished an article on price optimization titled "Being A Loyal Auto Insurance Customer Can CostYou." Consumer Reports published articles on price optimization in car insurancerates and even has a petition with the tagline "price me by how Idrive, not by who you think I am!"

But price optimization advocates argue that the practice doesn'tautomatically mean higher prices for customers. In some cases,price optimization may result in lower costs, such as when aninsurer wants to attract more customers from a specific demographicor when its competitors are offering lower prices. Many insurersclaim that new forms of price optimization are part of a naturalprogression of pricing structures driven by big data analytics.

NAIC's white paper ultimately recommends that "two insurancecustomers having the same risk profile should be charged the samepremium for the same coverage." Nonetheless, it's clear thatthere's still a lot of debate around price optimization as theindustry and regulators work to figure out exactly how to define it— and whether it belongs in the insurance world.

What do you think?

Related: 4 tips for the successfulunderwriter

Susan Kearney, CPCU, ARM, AU, AAI, is a seniordirector of knowledge resources at TheInstitutes. Opinions expressed in thisarticle are the author's own.