Price Optimization

I'm very late in getting this up, but I wanted to draw some attention to an interesting letter sent by J. Robert Hunter to the Insurance Commissioner of, well, everywhere. The letter makes the case that the well known and pervasive practice of Price Optimization (PO) is contrary to the CAS's established Principles of Ratemaking.

Whether or not PO can be justified under the current Principles has been a matter of debate within the Society for some time, as Mr. Hunter somewhat superciliously documents. Not being an insurance company actuary, I'm only peripherally familiar with the practice, but I do find the overall debate interesting and important from a philosophical perspective. Much in the way that math-averse folks excuse their ignorance by attacking the usefulness of basic algebra or calculus, actuaries and other mathy types tend to dismiss or downplay the importance of non-formal languages and the corresponding ambiguity of meaning. And yet here we see a perfect illustration of why semantics underlie everything we do.

What is a cost? How are costs equitably shared? How is equity balanced against financial and actuarial soundness? What is the difference between ratemaking and setting a final price? These types of fundamental questions are not covered on the actuarial exams, which is why it's no surprise that every actuary answers them slightly differently.

Frankly, actuaries violate the Principles of Ratemaking left and right. We have to by law. Highly effective rating variables like credit score, sex, and race are frequently illegal or not used for public relations reasons. But more importantly, the Principles of Ratemaking are not really used as principles in the fullest sense of the word. Principles are guides to action; the Ratemaking Principles are instead treated as constraints. Put it this way: no one consults the Principles to figure out what should be done; you only look to see if what you already want to do is forbidden.

The real principle at work is, as always, Step 3: Profit.

This is why I have the opposite reaction as Mr. Hunter to the proposed wording change to the Principles, at least in theory. The pricing actuary's role, to me, is mainly to be a check on the tendency of competitive markets to drive prices down. In the short run (the only kind of run consumer groups ever seem to worry about), the actuary is not the customer's friend. The actuary's job is to keep prices high enough for solvency. Everyone else's job is to do whatever drives profits.

When we find ourselves moving away from our stated principles, it's time to ask ourselves whether those principles are still serving their purpose. Have our goals changed? Has the environment? Or maybe, as a heavily regulated industry, we can't afford to ask these questions, lest consumer groups get upset.

Not to snark too much, but I'd also like to note the amusing reference in 2013 to Towers Perrin, a firm I previously worked for but which has not existed since 2009, when it merged with Watson Wyatt to form Towers Watson. In fairness, the citation was from a paper published in 2007, and I'm not entirely sure how the etiquette is supposed to work in these cases (although I'm quite sure that, from an IP perspective, it's Towers Watson's description now.)

I'd appreciate any insight from ratemaking actuaries. How is PO used in practice? Do you feel the Principles are appropriate guides to action?