The Impact of Price Changes on Costs

The traditional role of the pricing actuary is to estimate an insurer's expected future costs for an upcoming policy year. Those cost estimates are then used to recommend the product's price. However, traditional actuarial techniques for estimating future costs do not reflect changes in customer behavior based on changes in the product's price. Effectively, the techniques assume customer behavior and product price are independent. This paper will show that the pricing actuary has the process backwards. Instead of using expected costs to set price, the actuary would be better served by estimating future costs based on a selected price, and determining which future price/future costs combination is most attractive to the insurer. The rational behind this paper is that customer behavior is dependent on price. As such, price changes will have an impact on the insurer's retention of current customers, the insurer's attractiveness to new customers and the quality of those customers (from a loss cost perspective). Moreover, an insurer's expenses are not entirely variable with premium. The ability to attract and retain customers has an impact on the insurer's expenses and expense ratio. This paper will present a model of an insurer in which a rate decision is to be made. The rate decision will be viewed from the traditional approach and from an approach developed in this paper.