Introduction

In this article the basics of insurance pricing will be explained: Why pricing is so important, what happens if the pricing strategy is out of line, and how insurance companies set their premiums using statistical modelling. In the final section a very simple case study using real insurance data is presented to put some flesh on the bones of the ideas in the introduction.

Why pricing matters

The insurance industry is an industry concerned with hedging against the risk of uncertain financial loss, and the business of insurance companies is therefore largely a risk management endeavor. The insured trades future risk with an insurer for a fixed premium through a contract, known as the insurance policy, and if the policy holder is subject to a loss they can submit a claim to the insurer, if permitted by the policy. The premium is set by the insurer in advance of any claims, and hence it is vital for the company to predict the risks of their customers in order to set a profitable premium. With this in mind, it is not surprising that predictive modelling is extensively used in insurance companies; both in assessing customers and setting premiums.

As an example to highlight the importance of having a well thought-out pricing strategy, assume two insurance companies, A and B, exist and A has a low premium relative to the risk of loss, while B has an adequate premium in relation to the risk. In this scenario, a high risk customers would opt for A since their premium is relatively low compared to B, thus A would attract high risk customers and in effect see their margins being eaten up. On the contrary, if A’s premiums are too high they would not attract any profitable customers and still lose money. In the light of this simple example, we see why a competitive pricing strategy is paramount.

Moreover, according to the Accenture Financial Services’ 2017 Global Distribution & Marketing Consumer Survey, a study of 32,715 insurance customers across 18 markets, the price was found to be the number one driver of customer loyalty, with 52% of auto insurance customers choosing it as their top lever.

How do insurance companies set premiums?

As explained above, the premium is set in relation to the risk of the customer, to ensure that the loss of the customer is covered. However, this does not account for all of the final price. Like any other business, an insurance company has their own costs and operate to make a profit. Therefore, the premium is set to not only cover the loss of the customer, but also to cover costs and keep a decent margin.

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