The Changing Nature of Risk-Based Pricing

The number of wildfires in the US has increased exponentially over the years, with an average 70K wildfires and a loss of 7MM acres each year since 2000 — more than doubling since the 1990s. Given that a large proportion of fires typically occur in Western states such as California, not only have residents in areas prone to fire activity found it increasingly difficult to get insurance that covers fires, but the cost of fire coverage has soared.To determine whether they will cover a property against fire and how much they will charge, insurance companies rely on fire risk scores determined by factors such as the probability of wildfire impact, the overall flammability of a structure, the vegetation surrounding it, and even how easily accessible a property is to fire personnel. As financial institutions grapple with metaphorical fires of their own amidst the current interest rate environment, the looming threat of a recession, and ongoing bank failures, risk-based pricing has become increasingly important for the financial industry as well.Widespread AppealAs community financial institutions (CFIs) strive to compete with larger peers and nontraditional lenders, providing accessible lending to a wide range of demographics is key to attracting new customers, including individuals, commercial borrowers, and even small businesses just getting underway. But it is equally important to ensure that the loans CFIs make do not introduce unnecessary risk into their lending portfolios — especially when they’re looking to expand their commercial lending. While risk-based pricing strategies for individual borrowers rely heavily on credit scores, commercial borrowers require a more robust strategy. Using risk-based pricing to tailor interest rates to the creditworthiness of business customers is a good way for CFIs to better compete with those nontraditional lenders and larger peers, and to also provide themselves a safety net to cover potential losses related to higher-risk borrowers. A Balancing ActRisk-based pricing should examine anything that could potentially leave your organization left holding the bag or coming up short on expected income from a loan, including early payoffs. As the financial industry embraces this strategy, it is important to ensure that you’re using thorough pricing models or platforms that consider all the factors that could increase the chances of a borrower defaulting. For commercial borrowers, those factors considered should include:

From this information, you can create thorough risk profiles for potential commercial borrowers that help inform their interest-rate decisions. A solid risk-based pricing strategy, however, also incorporates far more careful planning. Your risk-based pricing strategy should incorporate the following:

As CFIs find themselves competing with an ever-increasing number of players in the lending game, providing commercial customers with accessible lending is key to obtaining higher profit margins and supporting a wider breadth of local and regional businesses. Risk-based pricing is the best way for organizations to ensure that the loans they extend are as low-risk as possible, but it must be approached in the most comprehensive and thorough way possible amidst changing market conditions, security risks, and regulatory oversight.