Dynamic pricing is not just about profitability | Insurance | Deloitte

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Dynamic pricing is not just about profitability

Dutch Insurance Outlook 2017

In the years to come, dynamic pricing in the insurance sector will become business as usual for many insurers. As private and SME insurance propositions are highly commoditised, price has become one of the decisive factors for most customers. But profitable pricing is only possible when insurers have insight into the risk, profitability, and the expected behaviour of their customers. In this article we discuss the most important aspects and considerations with regard to dynamic pricing.

Technology has changed the insurance market

For years, incumbents have had a rather traditional and inside-out pricing model: pricing started with the calculation of the risk premium by actuaries based on internal data resources. Then several costs and expected profit percentages were added to that premium. The price customers had to pay for their insurance was cost price plus a loading (based on the total client portfolio) with perhaps several commercial discounts. Traditional risk models were mostly based on historic data and commercial models that did not take actual and individual customer behaviour into account.

Technology has sparked an explosion in the availability and processing of data. Data which enables potential customers to compare the price of insurance products. Data which makes it possible for insurers to measure the true individual risk of their customers more accurately, and predict their behaviour after they receive a particular policy offer. Conversely, technology has also had an effect on policy holder behaviour. The speed of transactions has increased and customers expect to be able to receive a quote and start (and stop) their insurance policy instantly, at any time—not wanting to wait for a lengthy pricing process and underwriting procedure. Technology has changed the marketplace, not only for consumer insurance, but also for SME insurance clients, who are acting more and more like private clients. To compete in this fast-changing market, insurers are looking for technologies that allow them to adjust their products and prices rapidly and to monitor the profitability of their portfolio in real-time.

Dutch Insurance Outlook 2017

New winds of opportunity

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Dynamic pricing offers ample opportunities

Dynamic pricing brings together the expected customer value and expected customer behaviour, the overall market for the customer and the strategy of the insurer. Its aim is not to maximise short-term profits. Instead, dynamic pricing provides tools for optimising the portfolio by making it balanced and sustainable, and for identifying opportunities for both profitability and growth.

Customer value projections require predictive models to accurately forecast the true risk, the policyholder’s propensity to hold or buy (churn and conversion), and the actual behaviour of the policyholder: claim frequency, customer service requirements, channel usage, and other products owned. Where the true risk provides information on the expected cost price of the customer over time, behavioural models identify whether a client is willing to hold or buy given the offered premium and market environment. When insurers have insight into the actual customer value, they can start to improve the value of their client portfolio, set a higher price for segments that are loss-giving, and offer discounts to profitable clients who are likely to consider a switch.

The premium based on a client’s behaviour should be challenged by margins. Dynamic pricing needs both an inside-out and an outside-in approach. In considering the inside-out, internal margins and strategic objectives play a significant role. For outside-in, the price the insurer is willing to offer is affected when competing insurers offer a significantly higher or lower price. External prices also influence the discount an insurer is willing to offer their customer to prevent him from switching to, or buying from, the competition if this is valuable on a portfolio level and in line with the strategic objectives.

The availability of new data and technology enables insurers to gain new insights into all the components of their business. The reserve setting, risk management, performance management, product management, marketing, sales, and underwriting can all benefit from new technologies and data. Dynamic pricing is one of the available tools which can help insurers to respond to competition in the market and create their optimal portfolio. Dynamic pricing allows insurers to adjust individual pricing swiftly, in line with changing customer behaviour or market circumstances. For existing clients, automatically-adjusting prices can reduce churn and relocate solidarities between clients to optimise the portfolio, improve margins and long-term value. For new clients it can help acquire attractive new customers and identify cross-sell and upsell opportunities. This helps the insurer to outline a profitable growth path.

What about ethics?

At first glance, dynamic pricing could be regarded as a powerful tool with the sole purpose of increasing profits. Adversaries of dynamic pricing argue it can drive unethical behaviour by insurance companies. Why would one customer agree to pay a different price for his individual insurance than another? Well, different pricing mechanisms operate in different markets: When we dine in a restaurant we expect to pay the same price as anyone else ordering the same courses, but if we book a plane ticket we accept that ticket prices change with the hour.

While a private insurance contract is regarded as highly commoditised from the customer’s point of view, from an insurer’s point of view two insurance contracts can be highly differentiated. A thatched roof is more likely to catch fire than a roof covered with tiles. Similarly, driving skills can vary widely between individuals. Should two different risks require the same premium? Insurance is about pooling costs for adverse events, but to which extent is an insured customer willing to subsidise riskier profiles? Our society is moving towards a future where the individual is becoming more important. It questions the solidarities rooted in our pension system, our health benefit system and our social securities, increasingly preferring a more individual solution. The key challenge in dynamic pricing is to weigh the importance of solidarity in the insurance portfolio versus tailoring a quote to the individual’s risk characteristics. Dynamic pricing forces the insurer to accurately determine the impact of specific characteristics on behaviour, and to subsequently choose which characteristics to use to differentiate between quoted premiums, while creating a balanced and stable portfolio with profitable and satisfied clients.

Setting the right infrastructure

Dynamic pricing requires a solid infrastructure. The infrastructure must allow for connecting and analysing the different types and amounts of data. Many of the required data elements are available at an insurance organisation. Unfortunately, they are often hidden away, scattered over systems which are often outdated or inaccessible: the policy administration, marketing databases or some system that is only available at the customer contact centre. Connecting the various sources of data can provide a wealth of insights and strengthen the predictive modelling required to conduct dynamic pricing. Predictive models need to be continuously tested, updated and improved—calculating customer value is an ongoing process.

Although legacy systems will require modernisation to be able to facilitate dynamic pricing, it is not always necessary to completely replace them. There are several existing IT solutions that can collect data from legacy systems and connect them to other available data, such as website usage data, or online customer clicking behaviour. Moreover, traditional insurers are already working on data management improvements, driven by regulatory requirements. They should review their strategic focus and decide to what extent they should invest in data requirements and processes for dynamic pricing. In that sense, incumbents in the insurance industry have a data advantage over new entrants in the insurance market, as they are better able to accurately define a policy holder’s true risk.

Some incumbents already integrate legacy systems with digital marketing. For example, each individual customer’s website can be automatically adapted to his or her profile. Some insurers are expanding beyond cars for example, and are moving into term life and health insurance. Dynamic pricing is also being integrated on different channels, such as those of brokers or in affinity distribution. New entrants, on the other hand, are not hampered by the legacy challenges and accompanying investments. They are often technology-driven and are continuously building up their own data history.

Internal cooperation is key

It is extremely important that the product management, marketing, sales, underwriting, and actuarial departments work closely together when implementing dynamic pricing. After all, the essence of dynamic prices is that they can be quickly adjusted in light of new information and that is not contained to a specific silo in the organisation. Each department has its own role in this cooperation. The actuarial department brings its models to the table; the marketing department calculates which customers are worth investing in and decides on how to reach out to them; the sales department comes up with the commercial offer; the underwriting department sets the rules of acceptance; and product management defines the needs for potential product changes; all under the umbrella of the boards’ strategic directions.

The departments should develop a decision-making model together, that the pricing specialists can use to set the price. These specialists should have a mandate to act immediately on a competitive observation or on a customer response. 

Start experimenting now

Implementing dynamic pricing is about using individual customer parameters to set the right price, given the market. This way, the client portfolio can be optimised and strategically selected segments can achieve profitable growth. It is not about squeezing every cent out of the individual customer. Insurance thrives on the pooling of homogeneous risks, and dynamic pricing as a tool helps insurers to determine the risk-sharing pools and re-establish the right balance in the portfolio.

Using both an inside-out and an outside-in view, creating a supportive infrastructure, having the right predictive models, and good internal cooperation are ingredients for the successful implementation of dynamic pricing. As always, the ethical aspects, regulations, and strategic direction should be taken into consideration before applying dynamic pricing.

Incumbent innovators have the insurance experience and large amounts of data, but face the challenge of dealing with legacy systems. On the other hand, new entrants have flexible data systems, but lack internal data. Both have the same goal: to gain more insight into the prospective client’s behaviour than the competitor, which enables the insurer to make better-founded decisions on the product and pricing strategy.

More information?

For more information about dynamic pricing in the insurance industry, please contact Mark de Koo via mdekoo@deloitte.nl / +31882887538.

Dutch Insurance Outlook 2017

New winds of opportunity

Request report
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