The Cutting Edge of Strategic Pricing: Price Sensitivity Indexing

Central to the achievement of a financial institution's business goals is the understanding of price sensitivity. This wisdom plays a critical role in setting strategic pricing goals and achieving an optimal trade-off between increasing margin and market share.

A thorough understanding of price sensitivity can in fact generate a 10-20% lift in profits.

In this article, we'll discuss the four main determinants of price sensitivity. We'll also introduce important analytic tools including Nomis Solutions' publicly-offered North American Price Sensitivity Index (PSI) as well as the more granular, proprietary Nomis Score.

The Four Determinants of Price Sensitivity

Price sensitivity reflects the extent by which an increase in price decreases demand. An essential component of effective pricing strategy is to identify the factors that impact such sensitivity. We have identified and analyzed four main determinants of price sensitivity, each having the potential to at least double this sensitivity:

Macro-economic environment

Competitive environment

Product attributes

Customer characteristics

Macro-Economic Environment and the North American Price Sensitivity Index (PSI)

Understanding price sensitivity in the marketplace allows lenders to make pricing decisions relative to overall consumer tolerance. By aligning pricing to consumer tolerance, pricing can be used to grow margins when price sensitivity is low and retain market share when it is high.

In order to measure price sensitivity within the macroeconomic environment, Nomis Solutions has launched the North American Price Sensitivity Index (PSI). Lenders who wish to find new opportunities for business growth can subscribe to the PSI for no-cost guidance in making more strategic and profitable pricing decisions.

The following chart represents the range of price sensitivity within the consumer lending market over a six-year period.

When price sensitivity is high, consumers are less tolerant of price increases. Financial institutions can take advantage of this information to pinpoint prices that will best grow their customer base, without sacrificing too much margin.

Conversely, when price sensitivity is low, lenders can afford to price for large gains in margin - and grow overall profitability.

As shown in the graph above, the current environment is one of historically low price sensitivity. Not only is price sensitivity currently depressed, but given recent economic sputtering, it appears that price sensitivity will remain low in the months to come. Renewed concern about the debt levels will keep credit supply tightly constrained for the rest of 2011. Thus, lenders have an opportunity to gain margin and grow profitability during this time. Lenders need to seize this opportunity because we project the PSI to eventually stabilize between 20 and 25 over the course of the next year as consumers continue to slowly deleverage.

Competitive Environment

Similarly to the macro-economic environment, the competitive environment greatly impacts price sensitivity. Qualitatively, more competitive markets exhibit higher price sensitivity while less competitive markets exhibit lower price sensitivity.

As a first example, we made a comparison between two unsecured personal loan (UPL) markets: the UK Internet channel market and the Canadian branch channel market. The Internet channel is a transparent market with many lenders, in which the attractive prices are listed on aggregator websites. The branch channel is a secluded market, comprised of fewer lenders, whose prices are all unknown to the others. The average price sensitivity of the Internet channel market is 7.4 times greater than the average price sensitivity of the branch channel market. An implication of such a difference in price sensitivity is that in the Internet channel market, a price 100bps greater than the best available price would probably not attract any customers. However, the branch channel market, a price 200bps greater than the best available price would still yield a significant demand.

As a second example, we analyzed the relative price sensitivity of metropolitan statistical areas (MSAs) in the continental US. In the map below, MSAs colored in blue have low price sensitivity and thus have a high profit potential, while MSAs colored in red exhibit high price sensitive and thus have a lower profit potential. Furthermore, circle size represents population. Apart from a weak macro trend, in which the North-East is slightly more price sensitive than the South, there is no broad clear trend of price sensitivity across the country. However, price sensitivity varies widely, at a micro level, within each state. Therefore, pricing of retail financial products needs to be addressed at a very granular geographical level and requires precise analysis tools in order to set the right price (e.g. the volume/profit maximizing price) in each MSA and therefore generate optimal profitability.

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Product Attributes

A more granular determinant of price sensitivity is product attribute. In our experience, the dollar amount of the product is the most significant product attribute relative to price sensitivity. Generally, the larger the amount, the higher is price sensitivity.

This trend is wide spread across the markets. In North America, the 20% highest amount loans have a price sensitivity that is 2.6 times greater than the 20% lowest amount loans. In general, the extent that amount can impact price sensitivity is by a factor of 3 to 4.

Consumer Characteristics

Credit score has historically been used as the segregation variable used to differentiate borrower price sensitivity. However, we have found that the dependence of price sensitivity on credit score is rather mild. Consumers can be much better differentiated using Nomis Score.

Nomis Score is tailored to identify price sensitivity and reveals richer data from which optimal pricing may be derived. Namely, it is a mapping between consumer characteristics and price sensitivity, just as the credit score is a mapping between borrower characteristics and probability of default. There is a factor of 5 between the 20% most and least price sensitive consumers.

The two charts below indicate the respective sophistication of tracking consumer price sensitivity to credit score versus the more informative data associated with Nomis Score.

Conclusion

A thorough understanding of price sensitivity can generate a 10-20% lift in profits, while misalignment of pricing strategies with price sensitivity measures can result in dramatic missed volume and profit opportunities. The dynamic nature of price sensitivity and its correlation with identifiable determinants necessitates rigorous and ongoing tracking.

Partnering with Nomis Solutions is key to setting pricing strategies to meet and even exceed your financial institution's loftiest goals.