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M As99 3 02 PDF
M As99 3 02 PDF
A Comprehensive Product
Development Process
Shane A. Chalke
,,%.,
11. Macro Pricing: A Comprehensive Product Development Process 11
example, calculating product rates and values to expect alter the irrelevance of nonmarginal expenses--the
a present value of profits equal to 5 percent of premium principle remains sound.
involves a cost-plus determination of price. On a more conceptual level, it should be evident that
In a competitive market, a provider cannot choose a the consideration of nonmarginal costs in any decision
particular level of profit with any certainty that such a leads to less-than-optimal decisions. The value of any
profit level will be realized. Profit may be maximized, particular action can be considered only in relation to
but not chosen. For example, when increasing the unit other alternatives. Consideration of nonmarginal costs
profit goal, there comes a point at which total profitabil- in assessing the desirability of a particular action
ity decreases as the unit goal is increased. This happens implies that these nonmarginal costs can be saved by
when the negative effect on production of the increased choosing against this action. However, this is true only
price (caused by the increase in profit goal) outweighs if the costs were indeed marginal. Therefore, consider-
the increase in unit profit. At that point, the unit profit ation of nonmarginal costs exaggerates the cost of a
goal ceases to be correlated with the more fundamental particular action, resulting in an inaccurate assessment
goal of total profitability. of the value of that course of action.
FIGURE 1
Jction Versus
Microchip Production Ven ;u Price
2.00 lO / 10.51 0,90
1.90
1.80 0 ~ ~
1.70 0.30 0.50 0,70 ().90 1.10 1.30 1.50
1.60
' Price
1.50
1.40
1.30
1.20 However,
H e t, with the traditional
tr~ dition~ 1 approach,
approa~ h, the
the.,information
informat
8 1.1o to make this decision would not have been available.
'¢ 1.00
0.90 It might be argued that the company chose the wrong
0.80 profit goal; that is,' the chosen $0.10 per microchip was
0.70
0.60
too small. This argument misses the point. Certainly, if
0.50 the company had chosen a unit profit goal of $0.49, the
0.40
0.30
unit-based, cost-plus algorithm also would have
0.20 resulted in the optimal price of $0.90. However, this
0.10
0.00
would have been the result more of coincidence than
100 300 500 700 900 superior pricing technique, because the information
Number of Microchips (In Millions) necessary to choose the optimal profit goal is not gener-
ated through the traditional analysis.
Substitutingf(P) into the total profit equation yields
500 MN/P °'2 - 75 MMJP 1"2 - 340 MM. E. The Concept of "Open Decision
Points"
Now expected total profitability can be determined at
a variety of possible prices and graphically depicted as The traditional algorithm has a further problem that is
in Figure 2. somewhat less tangible. Because it does not generate the
The price level expected to yield the greatest total information necessary to make optimal decisions, the
profit is $0.90 per microchip, for a total expected profit entire product development process often reaches a
of $85.5 MM. An examination of total profit at the pre- standstill, with no clear direction for continuing the task.
The standstill generally occurs when those responsible
I
4,
Detail &
assumptions and as such are able to show greater
unit profit at a lower price.
Implementation 3. Either side compromises through fatigue.
4. Either side triumphs through use of political power
within the organization.
After determining desired design features and com- The loop inherent in this algorithm is a result of a
petitive goals, the product development actuary con- conflict for which there is no logical methodology for
structs an initial "plan proposal" Both the profitability resolution. These circumstances are referred to within
and the competitive profile of the proposed plan are this paper as "open decision points." As demonstrated
analyzed. in practice, open decision points often lead to seem-
When the plan proposal is complete, the product ingly infinite human capital loops.
designers (actuarial) and the product distributors (mar- To understand the concept of the open decision
keting) meet to discuss the plan proposal and to deter- point, we must examine the decision process itself.
mine whether to proceed with the design or to assemble Decisions involve three broad steps. The first step is
another plan proposal. In general, such a discussion identifying the available alternatives, which we refer to
focuses on the issue of price. The measure of price may as the "decision set?' The second step is evaluating the
differ from meeting to meeting, sometimes involving expected consequences of choosing each element of the
cash values, commissions, death benefits, or some other decision set. In business decision-making, the conse-
measure or combination of measures describing the quences are generally evaluated according to financial
value of the product either to the agent or to the con- effect. These financial consequences may involve both
sumer. tangible and intangible costs. 6 The third step is choos-
At this point problems typically surface. Those ing one of the alternatives.
responsible for production generally desire more value An open decision point occurs when the first two
to the consumer and/or producer (that is, a lower price). steps in the decision-making process are not explicitly
Conversely, the actuary, responsible for expected prod- analyzed. How does this apply to our traditional prod-
uct profitability (according to the unit measure under uct development algorithm? Consider each step in the
consideration), generally desires a higher price. A decision-making process. The first step is identifying
standoff usually develops. The actuary is uncomfortable the available alternatives. Because the purpose of our
H
set illustrated in Figure 4.
This decision set contains four possible actions,
including the conscious decision to take no action at
all. 8 When choosing among these actions, it is only nec-
essary to rank the outcomes in an ordinal fashion. In
other words, the elements of the decision set need only #I #2 #3
be compared with each other. It is not necessary (nor Act,on
desirable) to compare any element of the decision set
with choices not included within the decision set, Should the elimination of overhead from the analysis
because actions not contained within the decision set cause doubts about the relevance o f the answer, we can
are not available as possible choices. It is unreasonable compare the decision that results when the analysis uti-
lizes overhead expenses.
=_
~_ 2o
VI. Levels of Decision-Making
Within an Insurance Company
10
7.406 - - -
To address the issue of "covering the overhead," we
0.32 must first define what covering the overhead means.
0 When a person speaks of covering overhead, generally
0,00 0.20 0.40 0.60 0.80 1.00
the reference is to the profitability of the company in
Price
total. In other words, a company is said to cover over-
head in a particular year if the profits for the company
A problem has been introduced with the inclusion of as a whole for the year are positive. ~°Therefore, "cover-
overhead in the analysis. Recall that the assumed cost ing the overhead" is correlated to the overall health or
of goods sold comprised a $0.15 marginal cost added to viability of the company.
a $0.26 unit allocation of overhead. The allocation of More specifically, among product development actu-
overhead on a per-unit basis implies that this "unit" of aries, "covering the overhead" generally refers to the
overhead can in fact be saved by not selling a unit of condition in which the anticipated marginal unit profit
production. of a product over time exceeds some allocation of over-
This assumption is clearly at odds with reality. An head to this unit of business. This test of covering the
additional unit of business does not cause an additional overhead is usually done by considering the allocated
$0.26 of overhead to be spent. Conversely, reducing piece of overhead as an expense of issuing one unit of
production by one unit does not save $0.26 of overhead. the product.
By allocating overhead we have lost information about Considered logically, this procedure can be analyzed
the true profitability of an additional unit of production. as a particular statement of profit goal used within a
The analysis exaggerates the cost of selling microchips cost-plus-pricing algorithm. Here the goal is simply the
and leads the decision-maker to inappropriate actions. amount of artificially allocated overhead. Using such a
At this point several conclusions can be drawn about profit goal introduces into the analysis all the attendant
the use of overhead expenses in decision-making analysis: problems discussed in previous sections. In addition,
1. Overhead expenses are irrelevant to the analysis of the use of such a goal does not mean that the overhead
various choices within a particular decision set. The will necessarily be covered. The simple statement of a
inclusion or deletion of overhead expenses does not profit goal does not mean that such a goal is attainable.
affect the ordinal ranking of the actions. As discussed earlier, the use of a profit goal with a
2. The allocation of overhead expenses in decision cost-plus, unit-based pricing algorithm does not ensure
analysis is misleading, potentially dangerous, and that such a profit goal will be realized.
necessarily artificial. It exaggerates the true eco- How can we be sure that all company expenses are
nomic cost of any particular action. met (covering the overhead)? In short, we cannot be
3. The use of overhead expenses undermines the deter- sure. The most that can be accomplished through the
mination of the value of any particular action to the pricing process is to attempt to cover as much expense
decision-maker. Expected profitability calculated as possible--in other words, to maximize expected mar-
using overhead expenses does not correlate well with ginal profit. However, we can explore the relationship
the desirability of the action in question.
Figure 9
Decision Levels
~ Product#1
Product #3
1
Line of #1 I~
Business V
~ Product#1
Continue •~ Project#2 Product #2
Company
Product#3
Line of #2
Business
Liquidate
Company
Figure 10
Life Product Demand Surface
Premium Production
~.OXta
A. Updating an Existing Product Form uct would be assumed to be marketed unchanged over
the period of the model office. With the results of such
In general, products are revised or updated with the analysis, the existing product can be added to the price-
hope of presenting a more competitive profile, that is, a production graph.
more aggressive price. The procedure begins by analyz- Note that each row on the price-production graph
ing a range of prices with which to replace the existing represents one choice within our decision set. The row
price. Even though the initial goal of the analysis may for the existing product represents the choice of refrain-
be to investigate a more competitive profile, a range of ing from any product modification (that is, no action).
prices both more and less competitive than that cur- The decision process now begins with an evaluation
rently marketed should be examined. of the latter choice, that of no action. This evaluation is
Each of the prices analyzed represents a particular done be estimating the future sales volume of the exist-
replacement product with a different competitive pro- ing product. In general, this estimate is based upon pre-
file. A model office is developed for each replacement vious sales figures. When an estimate is arrived at, the
product. Business is assumed to be sold over the expected value of continuing with the existing plan can
replacement product's expected life (perhaps two to be read directly from the graph as the vertical compo-
three years). The model office is developed for a range nent of the existing product curve. This figure repre-
of possible annual production levels. For each of the sents the expected financial consequence of one of the
analyzed products, at each of the possible production choices within the decision set, that of no action.
levels, the expected present value of future profits is With an assessment of the marginal profit of continu-
calculated. The price-production graph is assembled ing the existing product, we have a standard of value
from these figures. with which to compare the other choices of product
Before the price is selected, it is useful to begin with price. Based on the price-production graph, we can
a profit "benchmark." This is done by analyzing the determine the level of production necessary for each
existing product in the same manner as the possible product price such that the marginal profit of that choice
replacement products. In other words, the existing prod-
Figure 13
Neutral Price-Production Pairs
30
7.5%
7.5% 30.91V
~. 24
8.0%
8.5%
46.4M
94.3M J
Q-O
9.0% 3636.4M
J 8.0%
12
/
JJ 8.5%
f f
J
f J
7- 9.0%
20 40 60 80 100
Annual Premium Production (Millions)
Eigure 14
Proposed UL Plan
Price-ProductionGraph
..Ooo:Oo°°O--
°o
2~
0
""oo °°
Another example of an intangible marginal cost is the value of the product, either at the wholesale or retail
bearing risk. Although beyond the scope of this paper, level, the less the effect of displacement.
the cost of bearing risk should be treated as a marginal The expected decline in UL sales as a function of the
expense in pricing analysis. price of the VUL product (in relation to the price of the
A particular intangible marginal cost that has a sig- UL product) can be represented graphically, as shown
nificant impact on the profitability of many insurance in Figure 16.
ventures is the effect of a new product on the sales of To what extent, if any, should the effect of displace-
existing products. There are consumers who would ment be considered in the pricing process? As with
have purchased one of the company's products regard- other, more tangible forms of expense, consideration of
less of whether the new product was offered. Sales of only the marginal portion is conducive to optimal deci-
the new product to these consumers have displaced sion-making. Again, the marginal displacement can be
sales of existing products. We refer to the total level of determined only within the context of the decision set.
this activity as "displacement" For example, assume that the XYZ Life Insurance
To illustrate, consider the following example. XYZ Company, in the absence of the VUL product, could
Life Insurance Company has been marketing a Univer- reasonably expect to sell $50 MM (annualized pre-
sal Life product for several years at an annualized rate mium) of the UL product next year. Further, suppose
of $50 MM of new premium per year. The company is that if the VUL product is offered, then all production
planning to offer a Variable Universal Life product as of of the UL product ceases. Obviously one cost of offer-
the beginning of next year. A certain number of con- ing the VUL product is the lost profit on the UL busi-
sumers who would have purchased the UL plan next ness that would have been sold had the VUL product
year will now purchase the VUL policy. 14 Also, the not been offered. Considered another way, the expected
lower the price of the VUL plan, the more this situation profitability of the decision to offer the VUL plan is
will arise. In other words, the greater the value to the equal to the expected profit from VUL sales less the
consumer (or the greater the value to the producer), the expected profit from the UL business that could have
more displacement will occur. Conversely, the worse been sold.
Figure 17
i
6o~
UL Displacement
70%
~ 30% 8o%
2O%
i
6o%
10% I I I
ImllVl UL EQulvlkl~l ~plnlll~l
V1JL "PRIOE"
__ T¢~II O l l ~ i c l m e n l
2O%
Note, however, that the lost profit on the UL business
is a cost of deciding to offer the VUL product only in I I I
10% I
relation to the option of not marketing VUL. In other ll~xpenllve 4 UL Equivalent
VUL *PRICE"
Expenldve
words, the lost profit on the UL business is a marginal __ Total OlsolaCemant m M l r g l n l l Dl|pl~t=man!
Figure 18
UL Sales Displaced
(%)
%Ooo
IB
14
%0
- o o° 'Oo %
The final step is to include in the analysis of VUL 1. Determine Competitive Focus
business the cost of displacement appropriate to the
combination of VUL price and production under analy- The process begins with a discussion of the major
sis. Such expense is deducted directly from the facets of the pricing structure that are used to evaluate
expected present value of VUL profit. the "price" of the product. In general, the approach
involves a determination of the characteristics of the
product that are most desirable to the marketing depart-
IX. The Macro Pricing Algorithm ment. For example, should the plan compete favorably
in terms of early duration cash values, late duration
The general macro pricing algorithm has been out-
cash values, necessary premium outlay, or some other
lined; here, the algorithm is detailed.
policy cost factor?
No attempt has been made to present the totality of
The answers to such questions help determine the
the product development process. Rather, we list the
methods of contrasting the price structures to be devel-
significant steps involved in arriving at the product's
oped with those of competitors' plans. A similar discus-
wholesale and retail price structure. The focus of the
sion should deal with the wholesale price structure.
procedure is the interaction between the actuarial and
Questions should be raised about the appropriate form
marketing departments. Any comprehensive product
of producer compensation, as well as desired levels.
development algorithm would include the interaction of
other significant parties in the process (such as the
legal, data processing, and underwriting departments). 2. Determine Particular Design
A few of the steps are common to more widely used Constraints
algorithms. Several of the steps can be accomplished in
differing ways. However, we found the following algo- This stage of the algorithm focuses on the external
rithm is the most useful in practice. The macro pricing constraints that limit product design. In general, the
algorithm is shown in flow chart form in Figure 20. departments involved include data processing, market-
ing, actuarial, and legal, although other management
representatives may be valuable to the process.
Determine I Develop I J
Competitive
Focus
-I Wholesale
Price
Structures
t
Price/
Assemble
Production
Graph
.~
Determine I
Design
Constraints
Balance II
Products
OverVariousI
Usages ]
ii
I Decision
Meeting
J-"l No Analysis
Required
I
iA
I Retail
Develop I
Price
Structures
I Determine
Profile of 1
Anticipated
Bookof
Business
I'-I I
Refine
Determine I Product
C°mpiis°ns ] NonUnitBasedJ Design
Marginal CostJ
l Unit
Determine
AssumptionsI
t
1
Product
Based Develop Detail
MarginalCost ModelOffice Filing
Assumptions Projections
The purpose of the discussion (and perhaps fol- found it efficient to construct a minimum of four price
low-up research) is the discovery of constraints that structures. At least one of the structures should follow
limit possible product designs. For example, it might be the desires of the marketing department. For example, if
determined that the company's administration system marketing would like to compete with XYZ Life's
will not support a zero cost loan feature, 15 and it has "product X " then the product designer would assemble
previously been decided that the addition of such a fea- one price structure that performs in similar fashion to
ture would be cost-prohibitive. As a result of this dis- product X. The performance might be measured in
covery, no time would be spent in the product terms of cash value, necessary outlay, overall rate of
development process analyzing such a policy provision. return to the policyholder, or death benefit. The mea-
Items to be discussed would include policy loading surement (or measurements) used is dependent upon
structures, bonus structures, banding features, commis- the results of step 1.
sion payment methods, and any other features under Another price structure should perform similarly to
consideration for the new product. Although the pri- one of the company's existing products. The existing
mary thrust of design limitation usually originates with product chosen for comparison is usually that being
the administration system, players from actuarial, mar- replaced by the product under development. Alterna-
keting, legal, or management may deem certain features tively, if the new product will not replace an existing
undesirable for a variety of reasons. product, the price structure is developed to match the
product in the company's portfolio most likely to be
3. Develop Retail Price Structures compared by the field force.
A third price structure should produce a product that
Here, the product design actuaries develop the vari- performs better than the desires of marketing, and a
ous retail price structures to be considered. We have fourth price structure should perform worse than the
Mr. Chalke is to be commended for challenging how I have not managed to solve the problem of deter-
we think about pricing insurance products. The paper is mining what conditions o n f w i l l lead to an equilibrium.
sure to stimulate heated debate for many years. Assuming that f ( s , p ) > O, f ' ( s , p ) < O, and f ' ( s , p ) exists,
Most of the paper assumes that the demand curve is one set of sufficient conditions i s f ' ( s , p ) < 0 a n d f ( p , p ) is
known at a few points and that it is unchanging: in par- constant. That these conditions are not necessary can be
ticular, that the insurer's pricing will have no effect on seen by letting
demand. In a competitive market other insurers may f ( s , p ) = p3 _ 3sp2 + ks 3
react by also changing their prices and thus change the
quantity that will be sold by the original insurer. The with 2 < k < 4. This satisfies neither condition but
following is a way of modeling this effect that will shed reaches an equilibrium at p = 3 e / ( 5 - k ) .
some light on the appropriateness of macro pricing. I suspect that many insurance markets can be charac-
Let the amount sold be a function not only of the terized by the value of u = - f ( p , p ) l f ' ( p , p ) . In very com-
petitive markets the value of u is very small. In
insurer's price, p, but also of the market's price, s. Thus,
the amount sold q =f(s,p). For simplicity let us assume relatively noncompetitive markets, such as individual
that there are only two insurers in the market, so that s life insurance, u will be large. In these u may be large
can be thought of as the other insurer's price. The enough so that an equilibrium is reached at R>0.
extension to three or more insurers is straightforward In more competitive markets, such as casualty insur-
ance, the small value of u can lead to cycles as follows.
and the conclusions are similar. Then total profit, R, is a
Start at a point in which traditional pricing used by all
function of s and p; that is:
insurers gives R>0. Some new insurers, or the current
R = r(s,p) = (p - e) q - eI = (p - e ) f ( s , p ) - eI ones, increase their return by using macro pricing,
46 Product D e v e l o p m e n t Section M o n o g r a p h
which lowers their price because currently p > e + u. through premiums and dividends, nonmarginal
This lowers the sales (and profits) of the other insurers, expenses are allocated to units of insurance.
who are then convinced to also use macro pricing and The second answer is based on the regulated nature
lower their prices. Eventually equilibrium is reached at of insurance. It is particularly powerful for coverages
R<O. Now most of the insurers are losing money and that have become business necessities. The necessity is
decide to leave the market or do the equivalent: raise created by lenders or the law for many property and lia-
their prices to traditional pricing levels. After this hap- bility coverages and by competitive pressure from
pens, the profits return and we come f~ll cycle. employees for life and health coverages. When insur-
Many insurers would prefer to break this cycle by ance prices are regulated or business necessity compels
always using traditional pricing, but all the insurers an insurance purchase, the demand side of the sup-
would have to do so. Of course, any agreement might ply-demand equation is altered. In these situations, the
be in violation of antitrust laws. This situation resem- economic actors think in terms of cost-plus pricing.
bles a game in which players can realize an advantage Marketing becomes less important.
at the expense of their neighbors for the short term and The sections of the paper on the macro pricing con-
hurt everyone in the long run. In such a situation some cept are related to a contemporary revolution in mana-
people would argue that macro pricing is immoral. gerial accounting. The name of Robert S. Kaplan,
Professor of Accounting, Harvard Business School, is
James C. Hickman associated with the revolution. In recent years Kaplan
and his colleagues have developed the proposition that
The title of this interesting paper is slightly redun- firms have mispriced their outputs and made capital
dant. A comprehensive product development process is budgeting blunders because of the increasing irrele-
given the snappy rifle, "macro pricing." A student of vance of traditional cost accounting methods. An
economics will recognize the early sections of the paper approach labelled activity-based costing (ABC) has
as an excellent review of classical pricing theory. This been developed. The ideas are outlined in a series of
theory is one of the foundation stones of microeconom- Harvard Business Review articles [1], [2], [4], [5] and a
ics. The paper, however, goes far beyond reviewing the book [3].
application of microeconomics to life insurance pricing. There is a startling similarity between the ideas of
Elements of modern managerial accounting and guid- Chalke and Kaplan. For example, in Figure 9 Chalke
ance for the intracompany process for selecting the identifies various decision and cost levels in an insur-
price-benefit structure are also presented. ance price-benefit decision. These are called the prod-
Section I is devoted to criticisms, from the viewpoint uct, project, line of business, and company levels.
of classical microeconomics, of the cost-plus algorithm Kaplan and Cooper [4, p. 132] display a similar chart
and the arbitrary allocation of nonmarginal costs as for manufacturing decisions in which unit of product,
used in insurance pricing. The criticisms are valid and batch level, and product- and facility-sustaining levels
have appeared before, but seldom so persuasively. The of activity are identified, along with the associated costs
question that remains is why did these ideas remain part of each. Chalke states that "Expenses that were over-
of insurance theory and practice for so long? I believe head with respect to lower-level decisions have become
that there are two answers. marginal with respect to higher-level decisions" Cooper
First is the importance of participating life insurance. and Kaplan [4, p. 135] express the same idea as follows:
During most of the past century, dividend determination "Costs are not intrinsically fixed or variable." They
in life insurance has been a relatively more important claim that "ABC analysis permits managers to under-
activity than the setting of premiums. In addition, poli- stand the sources of cost variability and reveal actions
cyholders own mutual companies. Ultimately all they can take to reduce demands on their organizational
expenses, both marginal and nonmarginal, must be allo- resources."
cated to some set of policyholders. Despite the absence I hope that Chalke's article will motivate more actu-
of a completely satisfactory theory in classical macro- aries to study current thought in cost accounting. A
economics to guide the process, actuaries have felt challenge will be to adapt these ideas to the determina-
compelled to create a price-benefit structure in which, tion of dividends in participating life insurance.