In Part 1 of this article series, I described cost-based pricing used by actuaries, which includes business judgment—introducing differences between the technical price indication for a book of business and final “street prices” filed with regulators.

Executive Summary

Opinion: Allstate's rating process made price optimization the biggest controversy in P/C insurance. But it might not be what it seems, according to James Lynch, chief actuary of the Insurance Information Institute. In this three-part series of articles, Lynch explains what he calls the ultimate irony—that "the Allstate plan that kicked off the brouhaha might not even be price optimization." Here, in Part 2, he explains classification plans that introduce individual surcharges and discounts to overall pricing indications for different groups of customers and how Allstate introduced an enhancement to this step—designed to solve "the reversal problem." Lynch was asked by Allstate officials to review and write about the plan, but he independently chose Carrier Management to publish his article. The article is based on his review of a report by another actuary, information from Allstate and knowledge he has gained from his study of price optimization over a two-year period. Part 2 of a three-part article series.

But pricing actuaries do much more than estimate how much rates should change on an entire book of business. They must estimate the various discounts and surcharges that different groups of customers must pay.

A company might charge $300 on average for collision coverage in a state. But hardly anyone would pay exactly that amount. Male drivers would pay more in most states. Middle-aged drivers would usually enjoy a discount.

All of those adjustments that take the $300 average and turn it into the, say, $278 that you would pay are called rating variables. The system that blends all the variables together—up for male drivers, down for the middle aged, down for those with excellent credit, up for those with a DUI conviction—is known as a classification plan, or class plan for short.

The first auto class plans go back at least six decades, according to a presentation actuary Jeff Kucera made at the Midwest Actuarial Forum in April. The first plans had a handful of variables, maybe a half-dozen.

Actuaries over time have found more and more variables that credibly predict how likely a customer is to file a claim. Today there are hundreds. Married people file claims less frequently than single people. Middle-aged people file less often than young people. Homeowners file less often than renters. (Not all insurers use every variable, and some variables are prohibited in some states.)

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