Nearly one-third of the U.S. states have now issued directives on the use of price optimization to determine insurance rates and, to date, most states have taken a skeptical view of the practice. Meanwhile, at the national level, a task force of the National Association of Insurance Commissioners (NAIC) has nearly completed its work on a white paper on price optimization that includes specific recommendations for regulators.
State Insurance Bulletins
At the individual state level, Delaware, the District of Columbia, Maine, Montana, Pennsylvania, Rhode Island, Vermont, Virginia, and Washington have all recently joined the list of regulators opposing price optimization.
The bulletins issued by Delaware, Rhode Island, and Maine generally follow the model bulletin appended to the NAIC Casualty Actuarial and Statistical (C) Task Force White Paper (discussed in more detail below). These bulletins expressly state that they do not prohibit “capping or transitional pricing if applied on a group basis” or “the use of sophisticated data analysis to develop finely tuned methodologies with a multiplicity of possible rating cells.”
Most recently, on October 1, 2015, the Delaware Department of Insurance issued Bulletin 78, which reminds insurers of the state’s ratemaking laws. The Bulletin concludes, “To the extent that price optimization involves gathering and analyzing data related to numerous characteristics specific to a particular policyholder and unrelated to risk of loss or expense, insurers may not use price optimization to rate policies in Delaware.” The Bulletin directs insurers to submit compliant filings no later than December 15, 2015, with proposed effective dates no later than April 1, 2016, for new business and July 1, 2016, for renewal business.
The Rhode Island Department of Business Regulation issued Bulletin 2015-8 on September 18, 2015. The Bulletin notes that price optimization may involve “the judgmental use of factors not specifically related to a policyholder’s risk profile to help determine or adjust his or her insurance premium.” It states that the use of these non-risk-related factors is unfairly discriminatory under the state’s rating laws and directly conflicts with the statutory principles underlying the state’s property and casualty marketplace. The Bulletin directs insurers to submit revised filings removing factors based on price optimization within 60 days.
In Maine, the Superintendent of Insurance issued Bulletin 405 on August 24, 2015 to address “ratemaking methodologies [that] make use of data analysis techniques that have been developed to test the willingness of individual customers to pay higher rates for coverage than other customers with similar underwriting characteristics.” The Bulletin takes the position that using elasticity of demand may violate Maine’s rating law. Insurers using price optimization must submit revised filings removing those factors within 60 days of the date of the Bulletin, and insurers with pending rate filings must disclose use of non-risk-related factors.
Montana, the District of Columbia, and Vermont have all joined the anti-price optimization bandwagon, directing insurers to stop using price optimization and to update their rate filings.
The Montana Commissioner of Securities and Insurance issued an Advisory Memorandum regarding price optimization on September 18, 2015. The Memorandum defines price optimization as “the practice of varying rates based upon factors not related to risk of loss, or based upon otherwise risk-related factors applied for a purpose other than to determine risk of loss.” It outlines the state rating laws and potential techniques by which price optimization could be used. It states that the Commissioner will deny any rating plan submitted in the future that employs price optimization and requires insurers currently using price optimization to notify the Commissioner of that fact, and file an updated rating plan that does not use price optimization, by February 1, 2016.
On August 25, 2015, the District of Columbia’s Department of Insurance, Securities and Banking banned the use of price optimization through Bulletin 15-IB-06-8/15. The Bulletin defines price optimization as “an insurer’s practice of charging the maximum premium that it expects an individual or class of individuals to bear, based upon factors that are neither risk of loss related nor estimated expense related,” and it focuses on willingness to pay. The Bulletin concludes that activities falling under the rubric of “price optimization” violate the insurance laws and are unfairly discriminatory. It therefore bans the inclusion of price optimization in all future rate filings and requires companies using price optimization to submit a compliant filing by November 30, 2015, with proposed effective dates no later than March 31, 2016.
Vermont also joined the list of states issuing guidance on price optimization on June 24, 2015. Insurance Bulletin 186 notes that the practice of price optimization may involve “the judgmental use of factors not specifically related to a policyholder’s risk profile to help determine or adjust his or her insurance premium.” The Department of Financial Regulation, Division of Insurance reminds insurers that under the state’s statutory requirements, judgmental adjustments to a rate cannot be based on non-risk-related factors like “price elasticity of demand”; base rates and rating classes must be based on factors specifically related to an insurer’s “expected losses and expenses.” The Bulletin requires insurers to disclose the use of any non-risk-related factors to help determine an insured’s final premium both going forward and for any pending rate filings.
Pennsylvania, Washington, and Virginia have issued guidance indicating that certain uses of price optimization would likely violate state laws and therefore will not be approved in the state, but did not require any specific changes to current rate filings.
The Pennsylvania Insurance Department filed a short notice on price optimization on August 21, 2015. In Notice 2015-06, the Department acknowledges the question of whether price optimization techniques may be used by insurance companies and declares, “[t]he answer is no.” The Department then “remind[s]” insurers that it has a long-standing prohibition against the use of price optimization techniques in property and casualty rates. It notes that customers with the same risk classification profiles should be charged the same premium and concludes that “[r]ates that fail to reflect differences in expected losses and expenses with reasonable accuracy are unfairly discriminatory under Commonwealth law and will not be approved by the Department.”
The State of Washington provides a general definition of price optimization as “an insurer’s use of sophisticated statistical analysis, often using non-insurance data, to predict a policyholder’s likelihood of renewing a policy” in Technical Assistance Advisory 2015-01, issued on July 9, 2015. The Advisory notes that if the use of price optimization “results in premiums, rates, or rating factors unrelated to cost and risk,” a filing would be considered unfairly discriminatory under state rating laws and would not be approved.
Virginia’s Property & Casualty Filing Guidelines Handbook, updated in June 2015, contains a short section about price optimization. It concludes that price optimization, defined as “[s]etting rates or modifying filed rates based on characteristics unrelated to expected losses or expenses,” violates state law and is not permitted in Virginia.
NAIC White Paper
At the national level, the NAIC Casualty Actuarial and Statistical (C) Task Force has nearly completed its work on a white paper on price optimization practices in ratemaking for personal lines property and casualty insurance. The White Paper provides background on what price optimization is and how it compares to traditional ratemaking, identifies potential benefits and drawbacks to the use of price optimization, and makes recommendations to regulators with respect to price optimization. Since the NAIC Summer Meeting, the Task Force has issued two revised drafts of the White Paper and considered comments from regulators and interested parties.
The current draft of the White Paper includes the following recommendations to regulators:
Regulators should address price optimization through state laws prohibiting rates that are excessive, inadequate or unfairly discriminatory.
Rating plans should be derived from sound actuarial analysis and be cost-based.1 Proposed rates developed from an actuarial analysis must comply with state laws and should be consistent with the actuarial principles derived from a professional actuarial body, and the actuarial standards of practice established by the Actuarial Standards Board.
Two insurance customers having the same risk profile should be charged the same premium for the same coverage. Some temporary deviations in premiums might exist between new and renewal customers with the same risk profile because of capping or premium transition rules.
Not all rates and rating plans that are accepted or approved will strictly adhere to actuarial indications, which are only an estimate of the cost to transfer risk—some insurer judgment will inevitably enter the ratemaking process. States should allow flexibility reflecting insurance loss and expense costs in the selection of rating factors. In addition:
The selection of a proposed rate between the currently approved rate and the actuarially indicated rate should be allowed if based on reasonable considerations adhering to state law and consistent with actuarial principles reflecting insurance loss and expense costs.
A selected rate outside the range defined by the current and indicated rate may be acceptable provided it is disclosed and complies with state law and is shown to be consistent with actuarial ratemaking principles.
Capping and transitional rules can be in the public’s best interest but regulators should consider the extent, if any, to which they will allow capping and transitional rating. Consideration should be given to the length of time over which premium changes will be limited before they reach the approved rate level, the size and reasonableness of capping’s upper and lower bounds, and the extent to which capping of one rate might impact rates charged to others.
Insurance rating practices that adjust premiums at the individual or policy level, whether included or not included in the insurer’s rating plan, should not be allowed when the practice cannot be shown to be cost-based. These prohibited practices may include:
Price elasticity of demand;
Propensity to shop for insurance;
Propensity to ask questions; and
Rating plans in which insureds are grouped into homogeneous rating classes should not be so granular that rating class segments have little actuarial or statistical reliability. Finely tuned rating plans with a multiplicity of possible rating outcomes is not, in and of itself, a violation of rating laws as long as the rating classes and rating factors are cost-based.
The White Paper also proposes that state regulators take the following actions:
Regulators should consider issuing a bulletin to address insurers’ use of methods that may result in non-cost-based rates. A potential state bulletin is included as Appendix B to the White Paper. As noted above, some states have already issued bulletins that follow this model.
Regulators should consider enhancing requirements for personal lines rate filings to improve disclosure and transparency on rates, rate indications, and rate selections. A list of potential rate filing requirements is included as Appendix C to the White Paper.
Regulators should consider using a standardized filing form to identify the use of price optimization in selecting rates or rate factors. A potential Ratemaking Disclosure Form is included as Appendix D to the White Paper.
Regulators should analyze models used by insurers in ratemaking to ensure the models adhere to state law and actuarial principles. A list of possible questions for regulators to ask is included as Appendix E to the White Paper.
The Task Force will next meet on October 27, which is expected to be its last meeting before the NAIC’s Fall National Meeting in Washington, DC. It is expected that the White Paper will be submitted to the Property and Casualty Insurance (C) Committee for adoption at the Fall National Meeting.
Given the increasing number of regulators taking stances against price optimization and the NAIC’s focus on this issue, insurers may wish to review their ratemaking practices, particularly in the many states that have issued bulletins. Sutherland will continue to report on activity at the NAIC and in the individual insurance departments.
1 The White Paper defines a “cost-based” rate as one developed from and consistent with the expected claims, claim handling expense, underwriting expenses, policy acquisition expense, a reasonable profit, investment income and other risk transfer costs.