Paper 4049 handout_2471_0

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Customer Lifetime Value
Opportunities and Challenges
Mohamad Hindawi, PhD, FCAS
March 11, 2015

● Background
● How to build a successful CLV roadmap
● Case Study: The mechanics of modeling CLV
● Final thoughts
Agenda
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Background

CLV – What it is and what it is not
“You can’t manage what you can’t measure” – Bill Hewitt
 CLV is just a metric – not a strategy to attract or retain customers
 Knowing CLV of customers is necessary but not sufficient to attract
or retain high value customers
 High-value customers have high CLV because they bring money to
you – resist “rewarding” existing high-value customers with discounts
 CLV helps you to manage resources – if a service does not cost you
money to provide, provide it to everyone
CLV enables you to make smarter decisions
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Our experience with CLV tells us that…
 Organization-wide CLV implementation is a major process change
 Pricing is the obvious – but only one possible – application of CLV
 A successful deployment of CLV results in meaningful competitive
advantage
 A robust roadmap requires the right mix of skills and ingredients
 Deep knowledge of insurance, insurance companies, their internal
processes and functions, and their specific culture
 Agnostic view of the tools, platforms, and solutions which will support
roadmap implementation
 Ability to produce an objective, factual, and neutral assessment of
possible activities
 Experience is key to effectively and efficiently deliver a robust CLV
framework
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Possible CLV business applications
Risk cancellation
selection
Retention companions
Cross-sell companions
Win backs
New product
offering/design
Agent compensation
Employee
compensation
Service quality
Claims handling
CLV as rating variables
Expense allocation based
on PLE/CLV
Lead prioritization
Affinity programs
Search engines vs. price
comparison sites
Marketing
&
Distribution
Quotes
PricingServicing
Compensation
Others
CLV
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A technical definition of CLV in insurance
Simple definition of CLV:
the net present value of the cash flows
attributed to the relationship with
a customer
 Ideally, all sources of value should
be included
 Might not always be practical
 Critical decision around what to include and what to exclude
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T
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AC
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cp
CLV
1 )1(
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Current
Product
Cross-
sell
Referral
Up-sell

Customer value measures
 There are different CLV metrics for different applications
 Focus on a measure that supports your business and know its
limitations
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Acquisition
lifetime
value
Profit
Year
Whole of wallet
lifetime value
Client
Profit
Future lifetime
profitability
Increase in profit
Value at Risk from Churn

More customer value definitions
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 There is no single measure of customer value that is suitable for all purposes.
 Potential CLV measures include:
 Future lifetime value: The expected future value of an existing customer at a specific
point in time
 Past lifetime value: The past value of an existing customer until this point in time
 Value at Risk from churn: The difference between the value of a customer assuming
no churn and the expected value allowing for the probability of churn
 Acquisition lifetime value: The expected value of the customer at the time of
acquisition, including acquisition costs specific to the distribution channel
 Expected cross-sales lifetime value: The expected lifetime value resulting from
cross-sales
 Whole of wallet lifetime value: The potential lifetime value taking into account all P&C
insurance, life insurance and financial products
 …and more definitions exist!

Choosing a definition can be a challenge
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“The most important observation is that ‘value’ is a relative concept and will
vary depending upon your business objectives.”
“This ambiguity [of the definition of value] is the cause of most of the difficulties
experienced. Without clear framework and set of objectives, every calculation
will be wrong for somebody within your organization, and you will remain mired
in politics, almost from day one.”
— Valoris Abram Hawkes

Unique complications of CLV in insurance
 Much more than a function of volume
 Revenues and costs vary by customer and over time for a specific customer
 Some customers are risker than others
 Capital/surplus allocation adds further complexity
 Highly-variable cost structure yields small contribution to margins –
small changes in price can have a dramatic impact on CLV
 Walmart can offer 30% discount to sell more – you cannot
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How to build a successful CLV roadmap

Key steps for building a roadmap
What will you do differently if you know the value of each
customer/lead?
 Form team
 Identify and interview stakeholders from different internal functions
 Identify possible use cases
 Create comprehensive list of possible applications
 Rank your options from “short term” to “long term”
 Rank your options by dependencies where relevant
(e.g. identify pre-requisites)
 Based on American Family’s assessment and
external experience / market knowledge
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Claims
handlingAgent /
Employee
compensation
Differentiated
service
Rating plan
enhancement
Retention
win backs
companions Affinity
programs /
channel
optimization
Product
design
and delivery
Prioritizing different CLV applications
Acquisition
cost
allocation
Effort / Time
Impact
Relevant applications will vary for each company
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Possible evaluation criteria
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Column Symbol Description
Comparisons to market practice Behind common practice
In line with common practice
Market-leading practice
Benefits Worthwhile benefits
Significant benefits
Very significant benefits
Implementable Directly implementable
Partially implementable with workarounds
Not implementable with reasonable time and cost
Win Horizon Implementable in 6-9 months
Implementable in 9-24 months
Implementable in 24+ months
Priority Priority ranking within same horizon category

 Identify quick wins – build and keep momentum
 Retain tasks with medium/high impact and low/medium effort
 Identify areas where you have strong champions who can facilitate adoption
 Create a clear and compelling business case for the selected top
applications
 Buy-in and momentum will only materialize if tangible – and ideally
measurable – benefits arise
 Recognize that individual CLV applications will evolve over time
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Key steps for building a roadmap – Pitfalls
 Do not underestimate communication effort required
 Future-stages activities typically require more, better, and wider
communication across the organization as the stakeholder group expands
 Prioritization rationale is typically questioned – more justification and
education are required
 Communication goes both ways – feedback loops play a key role in
refinement and continuous improvement
 Do not underestimate deployment effort required
 Incentives
 Training
 Systems
 Sunk costs paralysis
 History / Morale
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Phase 1
Phase 2
Phase 3
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TIME
ACTIVITIES
Refine
Expand
Refine
Expand
Natural
Next Step
Enhanced
Quick Wins
New Activity
Refine
Expand
Quick Wins

Case Study: The mechanics of modeling CLV

Key questions to ask before starting
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Strategic questions:
 What is the purpose of the model? Who will use it?
 Marketing
 CRM
 or something/someone else?
 Is the model meant to inform micro or macro decisions?
 Models that optimize local decisions often provide suboptimal answers from
the broader business prospective and vice versa
 Decision would impact how to include fixed expenses and/or cost of capital
Tactical questions:
 What lines of business should I include?
 What time horizon should I use?
 Aggregate over households or customers?…or something else?

Calculation framework — one possible approach
 Framework for calculating future lifetime value of either a newly
acquired customer or an existing customer
 Estimate policy lifetime value of each existing policy
 Estimate a one-year expected value of each policy
 Estimate expected value of each policy for each future year
 The policy lifetime value is the sum of all future year values, reduced by the
probability of churn
 Estimate the potential value of cross-sales
 Add the policy lifetime value of each existing policy and the potential
value of cross-sale to estimate the customer lifetime value
 Need to decide on which lines to include (part of the roadmap exercise)
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Calculation of a policy lifetime value
A simple definition of value:
Profit = Revenue – Cost
Revenue
Premium Investment
income
Expected
Claims
Cost
Acquisition
Cost
Profit Future
Profits
Modelling Over TimeExpenses
Fixed
Expenses
Taxes Cost of
Capital
Policy
Lifetime
Value
Cost of
capital
Comm Renewal
Probability
+ * =
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Revenue
 Estimate the premium that you expect to charge in the
future – this involves:
 Deciding on which rating plan to use
 Aging each policy
 Alternative approaches:
 Build a premium multiplier model
– Use historical view of your current book of business
– Score it using your current premium model
– Build a model to calculate a multiplier to apply to this year’s
premium to estimate future premium
– Beware of double counting the impact of churn
 Assume premium increases at a constant rate
– Could have large impact on some policies, e.g., a couple
adding/dropping a teen driver
 At minimum, investment income should depend on the
product type
Revenue
Premium Investment
income
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Expenses
 Expected claim loss is different
from losses used to calculate
premium
 Be careful about treatment of
strategic and conscious subsidies
 Do not forget to add expected
excess and CAT losses
 Do not use acquisition cost for
current customers; however, add
the cost of retention efforts if you
can estimate it
Expected
Claims
cost
Acquisition
cost
Expenses
Fixed
expenses
TaxesComm Cost of
capital
Cost of
capital
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Should we include fixed expenses and cost of capital?
It depends on the application
 If you decide to include fixed
expenses, be consistent
 Flat cost per policy
 Flat cost per risk (e.g., fixed fee per
vehicle)
 …or something else
Expected
Claims
cost
Acquisition
cost
Expenses
Fixed
expenses
TaxesComm Cost of
capital
Cost of
capital
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Retention
 In contractual products, a common
assumption is that customers who do not
renew are considered “lost for good”
 Reasonable assumption, but underestimates
the CLV of a customer
 Based on your book of business you may
need up to two models:
 Mid-term cancellation
 Renewal acceptance
 Standard techniques to model retention:
 Logistic regression
 Survival analysis
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Profit Future
Profits
Modelling Over Time
Policy
Lifetime
Value
Renewal
Probability

Putting it together
Cross-sell modeling:
 Focus on the lines that will have an impact on the CLV
 The value of a $100 policy that has a 5% probability of being sold in the next five years is a
rounding error
 Focus first on Auto and Home unless you write a large volume of specialty products
 Modeling a one-line cross-sell becomes easier — logistic regression could be used
 Calculating the value of the cross-sold product is not straightforward
— We only know the customer Auto policy information, but we need to calculate the value of the home
policy that will be sold!
Final step:
 CLV is the sum of the policy lifetime value of the policies that the customer has plus
the value of the cross-sell opportunity
 Difficult to include value of life and annuity policies
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Final thoughts

Final thoughts
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 Is using profit as a measure of value operational?
 Maybe!
 Profit could be very volatile
 Assuming a 10% profit load, an increase of 5% on an underpriced segment
could double its value
 Answer will change significantly based on assumptions
– Cost of capital
– Expenses

Final thoughts
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 Alternative definitions to profit (be warned):
 Customer lifetime premium
 Customer lifetime policies (vehicles)
 Customer life expectancy
 These definitions are easier to calculate, intuitively related to the
customer value, but could provide inaccurate answers if pricing
deviates too much from the true cost

Conclusions
 Customer lifetime value does not capture all values a customer brings
to the firm, but can be a very useful tool to manage your business
 CLV enables you to make smarter decisions
 CLV implementation is a major process change and needs a
roadmap
 Customer Lifetime Value roadmaps must be customized to fit your
company’s unique needs, goals, and available resources
 Getting buy-in and quick wins early will build momentum and help
ensure success
 A successful roadmap will grow and evolve over time
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Contact
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Mohamad Hindawi, PhD, FCAS
Towers Watson
+1 860.264.7257
Mohamad.Hindawi@towerswatson.com

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