State insurance regulators and legislators are increasinglyscrutinizing "price optimization," a practice that some insurersare reportedly using as part of the ratemaking process. There is,however, considerable disagreement as to what price optimizationis, how it might operate in the context of insurance, and what, ifanything, regulators should do about it. Earlier this year, theNational Association of Insurance Commissioners (NAIC) instructedits Casualty Actuarial and Statistical Task Force to draft a whitepaper on price optimization, focusing on the areas ofcontroversy. 

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When it's completed later this year, the paper will include aset of policy recommendations for regulators to consider. However,several states have chosen to act before the NAIC's work isfinished. As this is being written, insurance regulators inMaryland, Ohio, California, Florida, Vermont, Washington, andIndiana have issued bulletins declaring that insurers' use of priceoptimization models to determine rates and premiums constitutes"unfair discrimination" in violation of their states' insurancelaws.

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None of the bulletins define "price optimization" in the sameway, although they generally describe it as the practice of varyingcustomer prices based on factors such as price sensitivity (thatis, the willingness of a policyholder to pay a higher premiumrelative to other policyholders) and propensity to shop (that is,the likelihood that a policyholder, when faced with the prospect ofpremium increase, will shop among other insurers for a lowerpremium). Because such factors are said to be unrelated to the riskof loss, price optimization "can result in two policyholdersreceiving different premium increases even though they have thesame loss history and risk profile," according to the Vermontbulletin. The specter of policyholders with similar risk profilesbeing charged different premiums for the same coverage is a commontheme of price optimization critics.

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In the broader economy, firms have long sought to optimize theirpricing strategies by analyzing the demand for various goods andservices relative to their price. Because prices in most industriesare not subject to regulation, price optimization has raised few,if any, legal or regulatory concerns. But insurance is regulatedwith respect to both the price that insurers can charge for theirproducts and the factors they can use to determine those prices, soit's perhaps understandable that price optimization techniqueswould draw the attention of regulators.

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Most readers will be familiar with the system of insurance rateregulation that prevails in the U.S. Property/casualty insurersfile rates with state insurance regulators that are based onprojected loss costs and expenses, plus a reasonable provision forprofit. Projected loss costs are based on specific risk factorswhose utility in predicting the risk of loss must be verified tothe satisfaction of the regulators. Charging different rates forthe same coverage to individuals with similar risk profiles isconsidered "unfair discrimination" and is thus proscribed.

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Judgment Involved in Ratemaking

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This process, however, has never been mechanistic. Regulatorstypically understand that judgment is part of the ratemakingprocess, primarily due to the uncertainty surrounding theactuarially indicated, cost-based rates and factors. Thus, ratefilings have often involved some deviations from actuariallyindicated costbased rates. Regulators have frequently accepted suchdeviations with the implicit understanding that there is a"reasonable range" around the indicated rates and factors. Notsurprisingly, companies report that deviations are far more likelyto be approved when they fall below the indicated rate or fallbetween the current and indicated rates.  

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Traditionally, the practice of subjectivelyadjusting or supplementing cost-based rates to align with customerconversion (that is, the likelihood that a prospective policyholderwill accept an offer of coverage at a given premium), retention(that is, the likelihood that an existing policyholder will remaina customer if confronted with a premium increase), and similarmarket considerations has been referred to by terms such as"market-based pricing," "rate smoothing," and "ratetempering." 

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One question, then, is whether price optimization truly"represents a departure from traditional cost-based rating," as theOhio bulletin would have it. It's arguable that the perceivednovelty of price optimization lies mainly in its use of formalmodeling techniques, as opposed to managers' subjective judgment,to deviate from cost-based rates based on the market considerationsidentified previously—and that such deviations are not novel atall. 

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A second question is whether an insurer's use of formal models,algorithms or other statistical techniques, including those thatconsider consumer price sensitivity, should cause regulators toalter past practices for reviewing rate filings. Regulators havehistorically required that each factor be correlated with futurecosts such as losses and expenses; that any deviation from theactuarially indicated cost-based rate must be actuarially justifiedas "reasonable"; and that all individuals within a given risk classmust be charged the same rate.

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For example, if an insurer were to use a customer pricing methodthat resulted in different rates or premiums for individualinsureds within the same class, a regulator would rightly considerthe result to be unfairly discriminatory. It should not matterwhether the insurer's pricing method was called "priceoptimization," nor should it matter if the method involves formalmodeling as opposed to subjective judgment. Likewise, the fact thatan insurer may have taken customer price sensitivity into accountwhen developing its rates should be considered immaterial to thequestion of whether the rate filing complies with existinginsurance laws.

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One could argue that explicit regulation regarding priceoptimization is unnecessary, given that most states have languagein their insurance law prohibiting rates that are "inadequate,excessive, and unfairly discriminatory." However, if regulatorsfeel compelled to explicitly regulate price optimization, it isimperative that they precisely define the meaning of the term. Thestates that have issued bulletins banning price optimization havetended to offer superficial definitions based largely on anecdotesabout the presumed effect of price optimization on consumers andassumptions about insurer motives. 

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If nothing else, the NAIC's white paper could help resolve thecontroversy over price optimization by reminding regulators thatactuarial projections are a starting point and that marketconditions, such as demand and competition, have always played arole in property/casualty insurance pricing.  

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Robert Detlefsen, Ph.D., serves as the vice president,Public Policy at the National Association of Mutual InsuranceCompanies.

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