By: Amanda Roth
To refine your risk-based pricing another level, it is important to analyze where your tiers are set and determine if they are set appropriately. (We find many of the regulators / examiners are looking for this next level of analysis.)
This analysis begins with the results of the scoring model validation. Not only will the distributions from that analysis determine if the score can predict between good and delinquent accounts, but it will also highlight which score ranges have similar delinquency rates, allowing you to group your tiers together appropriately. After all, you do not want to have applicants with a 1 percent chance of delinquency priced the same as someone with an 8 percent chance of delinquency. By reviewing the interval delinquency rates as well as the odds ratios, you should be able to determine where a significant enough difference occurs to warrant different pricing.
You will increase the opportunity for portfolio profitability through this analysis, as you are reducing the likelihood that higher risk applicants are receiving lower pricing. As expected, the overall risk management of the portfolio will increase when a proper risk-based pricing program is developed.
In my next post we will look the final level of validation which does provide insight into pricing for profitability.
