We found an interesting introductory article on the concept of risk based pricing from what seems to be an ex pat South African, Brandan Le Grange, who works for Experian in Scandinavia and is credit risk professional:

“….Risk based pricing strategies seek to assign a fair price to each customer – or, more accurately, to each group of customers.  The measured difference in risk between each customer is used to assign differentiated prices.  The logic is that operationally every customer costs the same to service, it is only the cost of risk that fluctuates – or at least, it is the cost of risk that fluctuates the most.

One way to think about this is to imagine a company that produced two version of its product, both essentially the same except that one comes fitted with an extra resilient outer shell to protect it if it is dropped.  Customers who only use the product at home would have little need for the costly outer shell and could therefore buy the cheaper version while customers who use it regularly outside might buy the more expensive but safer model.  Although each group of customers are buying essentially the same product, they have paid a different price and that difference in price is based on their risk.  It is the same with loans.  High risk customers must pay higher prices in order to cover the higher cost of potential write-offs.  The only difference really between the imagined scenario and the real one is that in the imagined scenario it would be the purchaser of the product who would carry the cost of the risk while in the latter it is the lender who carries it.  So, in the first case the purchaser would decide which option was cheaper in the long run and voluntarily pick the more expensive option where applicable while in the second case that premium must be enforced.

Unless risk based pricing is implemented, lower risk customers will be subsidising the cost of higher risk customers.  This situation is doubly problematic as it doesn’t only lead to sub-optimal profit but also to a sub-optimal portfolio structure.  The lowest risk customers (who are being over-charged) can be tempted to leave for cheaper competitor offers while the higher risk customers (who are being under-charged) will gravitate towards your product; leading to a riskier portfolio on average.  Risk based pricing redresses this by lowering the rates charged to low risk (cheaper to serve) customers and raising the rates charged to high risk (expensive to serve) customers.”

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