Brainstorms:Price Vs. Value

by Stephen W. Philbrick

"What's the value of this item?"

"Well, the price is $100."

Thus we conflate the very different concepts of price and value. One of the first economists, Adam Smith, was troubled by the disparity between price and value. Why did water, necessary for life, fetch so low a price? Why did diamonds, glittering to the eye, but unnecessary to sustain life, fetch so high a price? He tried to solve the dilemma by defining two different concepts of value-value in use and value in exchange.

Subsequent developments in economics taught us the answer to the dilemma, that price is determined by the interaction of supply and demand. A high demand for water, coupled with an extremely high supply, leads to a low price. Relatively low demand for diamonds coupled with extremely low supply, leads to a high price. Value helps determine demand, but this new paradigm for price, based upon supply and demand, pushed Adam Smith's concept of value to the back seat.

At any given time, supply and demand curves cross at a single point, creating a single price for an item at that time. However, it would be misleading to assume that the value of the item to a person making a purchase at that time is equal to the price. Different people assign a very different value to an identical item, even when they are not conscious of this action. People will not enter into a transaction unless the value of the item is at least equal to the cost. When many items trade at a given price, some consumers (by definition) receive a value equal to the cost, while others receive a value in excess of the cost. The excess of value over the price is referred to as the consumers' surplus.

Producers attempt to capture this surplus through a variety of means. A classic example involves airline seats, where advance purchase restrictions allow an airline to price the otherwise identical product higher for the business traveler than for the vacation traveler, thus capturing some of the increased value of the seat to the business person.

How does this relate to insurance or actuarial science?

Many actuarial "pricing" models are two steps removed from an analysis of price versus value. First, "pricing" is often a misnomer, as many of the models attempt to measure costs, but do not formally assess prices that consumers might be willing to pay. Second, few, if any, models attempt to assess the value that customers receive from an insurance policy. Indeed, it is arguable that the principles of ratemaking do not even consider such an assessment, as the principles refer to all costs associated with a policy.

A unique feature of an insurance product is that the costs of the product are determined after the product is sold. These costs are random variables, partly dependent on future states of the economy (itself a random process) and partly dependent on random events. We can view the recent development of dynamic financial analysis (DFA) models as an attempt to evaluate the stochastic nature of the product, as well as the interactions between the future liabilities and asset returns. As such, it represents a major improvement over the use of expected values supplemented by a risk margin. Nevertheless, the current implementation of most DFA models represents (merely) an improvement to a costing model. Virtually no models (at least in the public literature) attempt to model either the marketplace of multiple insurers and insureds, or attempt to evaluate the value of an insurance product.

There have been some attempts to incorporate the insurance cycle into DFA models. However, these attempts generally model the cycle in an aggregate way, without attempting to consider or model the range of values that customers may assign to an insurance product. Greater analysis of the value of the insurance product may help in two respects: providing insight into how to develop products with greater value for their customers, and providing insight into how to incorporate the changing insurance marketplace into DFA models.