Predictive analytics

Predictive analytics, or predictive AI, encompasses a variety of statistical techniques from data
mining, predictive modeling, and machine learning that analyze current and historical facts to make
predictions about future or otherwise unknown events.[1]

In business, predictive models exploit patterns found in historical and transactional data to identify
risks and opportunities. Models capture relationships among many factors to allow assessment of
risk or potential associated with a particular set of conditions, guiding decision-making for
candidate transactions.[2]

The defining functional effect of these technical approaches is that predictive analytics provides a
predictive score (probability) for each individual (customer, employee, healthcare patient, product
SKU, vehicle, component, machine, or other organizational unit) in order to determine, inform, or
influence organizational processes that pertain across large numbers of individuals, such as in
marketing, credit risk assessment, fraud detection, manufacturing, healthcare, and government
operations including law enforcement.

Definition

Predictive analytics is a set of business intelligence (BI) technologies that uncovers relationships
and patterns within large volumes of data that can be used to predict behavior and events. Unlike
other BI technologies, predictive analytics is forward-looking, using past events to anticipate the
future.[3] Predictive analytics statistical techniques include data modeling, machine learning, AI,
deep learning algorithms and data mining. Often the unknown event of interest is in the future, but
predictive analytics can be applied to any type of unknown whether it be in the past, present or
future. For example, identifying suspects after a crime has been committed, or credit card fraud as it
occurs.[4] The core of predictive analytics relies on capturing relationships between explanatory
variables and the predicted variables from past occurrences, and exploiting them to predict the
unknown outcome. It is important to note, however, that the accuracy and usability of results will
depend greatly on the level of data analysis and the quality of assumptions.[1]

Predictive analytics is often defined as predicting at a more detailed level of granularity, i.e.,
generating predictive scores (probabilities) for each individual organizational element. This
distinguishes it from forecasting. For example, "Predictive analytics—Technology that learns from
experience (data) to predict the future behavior of individuals in order to drive better decisions."[5] In
future industrial systems, the value of predictive analytics will be to predict and prevent potential
issues to achieve near-zero break-down and further be integrated into prescriptive analytics for
decision optimization.[6]

Analytical techniques

The approaches and techniques used to conduct predictive analytics can broadly be grouped into
regression techniques and machine learning techniques.

Machine learning

Machine learning can be defined as the ability of a machine to learn and then mimic human
behavior that requires intelligence. This is accomplished through artificial intelligence, algorithms,
and models.[7]

Autoregressive Integrated Moving Average (ARIMA)

ARIMA models are a common example of time series models. These models use autoregression,
which means the model can be fitted with a regression software that will use machine learning to do
most of the regression analysis and smoothing. ARIMA models are known to have no overall trend,
but instead have a variation around the average that has a constant amplitude, resulting in
statistically similar time patterns. Through this, variables are analyzed and data is filtered in order to
better understand and predict future values.[8][9]

One example of an ARIMA method is exponential smoothing models. Exponential smoothing takes
into account the difference in importance between older and newer data sets, as the more recent
data is more accurate and valuable in predicting future values. In order to accomplish this,
exponents are utilized to give newer data sets a larger weight in the calculations than the older
sets.[10]

Time series models

Time series models are a subset of machine learning that utilize time series in order to understand
and forecast data using past values. A time series is the sequence of a variable's value over equally
spaced periods, such as years or quarters in business applications.[11] To accomplish this, the data
must be smoothed, or the random variance of the data must be removed in order to reveal trends in
the data. There are multiple ways to accomplish this.
Single moving average

Single moving average methods utilize smaller and smaller numbered sets of past data to decrease
error that is associated with taking a single average, making it a more accurate average than it
would be to take the average of the entire data set.[12]

Centered moving average

Centered moving average methods utilize the data found in the single moving average methods by
taking an average of the median-numbered data set. However, as the median-numbered data set is
difficult to calculate with even-numbered data sets, this method works better with odd-numbered
data sets than even.[13]

Predictive modeling

Predictive modeling is a statistical technique used to predict future behavior. It utilizes predictive
models to analyze a relationship between a specific unit in a given sample and one or more features
of the unit. The objective of these models is to assess the possibility that a unit in another sample
will display the same pattern. Predictive model solutions can be considered a type of data mining
technology. The models can analyze both historical and current data and generate a model in order
to predict potential future outcomes.[14]

Regardless of the methodology used, in general, the process of creating predictive models involves
the same steps. First, it is necessary to determine the project objectives and desired outcomes and
translate these into predictive analytic objectives and tasks. Then, analyze the source data to
determine the most appropriate data and model building approach (models are only as useful as the
applicable data used to build them). Select and transform the data in order to create models. Create
and test models in order to evaluate if they are valid and will be able to meet project goals and
metrics. Apply the model's results to appropriate business processes (identifying patterns in the
data doesn't necessarily mean a business will understand how to take advantage or capitalize on it).
Afterward, manage and maintain models in order to standardize and improve performance (demand
will increase for model management in order to meet new compliance regulations).[3]

Regression analysis

Generally, regression analysis uses structural data along with the past values of independent
variables and the relationship between them and the dependent variable to form predictions.[8]
Linear regression

In linear regression, a plot is constructed with the previous values of the dependent variable plotted
on the Y-axis and the independent variable that is being analyzed plotted on the X-axis. A regression
line is then constructed by a statistical program representing the relationship between the
independent and dependent variables which can be used to predict values of the dependent variable
based only on the independent variable. With the regression line, the program also shows a slope
intercept equation for the line which includes an addition for the error term of the regression, where
the higher the value of the error term the less precise the regression model is. In order to decrease
the value of the error term, other independent variables are introduced to the model, and similar
analyses are performed on these independent variables.[8][15]

Applications

Analytical Review and Conditional Expectations in Auditing

An important aspect of auditing includes analytical review. In analytical review, the reasonableness
of reported account balances being investigated is determined. Auditors accomplish this process
through predictive modeling to form predictions called conditional expectations of the balances
being audited using autoregressive integrated moving average (ARIMA) methods and general
regression analysis methods,[8] specifically through the Statistical Technique for Analytical Review
(STAR) methods.[16]

The ARIMA method for analytical review uses time-series analysis on past audited balances in order
to create the conditional expectations. These conditional expectations are then compared to the
actual balances reported on the audited account in order to determine how close the reported
balances are to the expectations. If the reported balances are close to the expectations, the
accounts are not audited further. If the reported balances are very different from the expectations,
there is a higher possibility of a material accounting error and a further audit is conducted.[16]

Regression analysis methods are deployed in a similar way, except the regression model used
assumes the availability of only one independent variable. The materiality of the independent
variable contributing to the audited account balances are determined using past account balances
along with present structural data.[8] Materiality is the importance of an independent variable in its
relationship to the dependent variable.[17] In this case, the dependent variable is the account
balance. Through this the most important independent variable is used in order to create the
conditional expectation and, similar to the ARIMA method, the conditional expectation is then
compared to the account balance reported and a decision is made based on the closeness of the
two balances.[8]

The STAR methods operate using regression analysis, and fall into two methods. The first is the
STAR monthly balance approach, and the conditional expectations made and regression analysis
used are both tied to one month being audited. The other method is the STAR annual balance
approach, which happens on a larger scale by basing the conditional expectations and regression
analysis on one year being audited. Besides the difference in the time being audited, both methods
operate the same, by comparing expected and reported balances to determine which accounts to
further investigate.[16]

Business Value

As we move into a world of technological advances where more and more data is created and
stored digitally, businesses are looking for ways to take advantage of this opportunity and use this
information to help generate profits. Predictive analytics can be used and is capable of providing
many benefits to a wide range of businesses, including asset management firms, insurance
companies, communication companies, and many other firms. In a study conducted by IDC Analyze
the Future, Dan Vasset and Henry D. Morris explain how an asset management firm used predictive
analytics to develop a better marketing campaign. They went from a mass marketing approach to a
customer-centric approach, where instead of sending the same offer to each customer, they would
personalize each offer based on their customer. Predictive analytics was used to predict the
likelihood that a possible customer would accept a personalized offer. Due to the marketing
campaign and predictive analytics, the firm's acceptance rate skyrocketed, with three times the
number of people accepting their personalized offers.[18]

Technological advances in predictive analytics have increased its value to firms. One technological
advancement is more powerful computers, and with this predictive analytics has become able to
create forecasts on large data sets much faster. With the increased computing power also comes
more data and applications, meaning a wider array of inputs to use with predictive analytics.
Another technological advance includes a more user-friendly interface, allowing a smaller barrier of
entry and less extensive training required for employees to utilize the software and applications
effectively. Due to these advancements, many more corporations are adopting predictive analytics
and seeing the benefits in employee efficiency and effectiveness, as well as profits.[19]
Cash-flow Prediction

ARIMA univariate and multivariate models can be used in forecasting a company's future cash
flows, with its equations and calculations based on the past values of certain factors contributing to
cash flows. Using time-series analysis, the values of these factors can be analyzed and extrapolated
to predict the future cash flows for a company. For the univariate models, past values of cash flows
are the only factor used in the prediction. Meanwhile the multivariate models use multiple factors
related to accrual data, such as operating income before depreciation.[20]

Another model used in predicting cash-flows was developed in 1998 and is known as the Dechow,
Kothari, and Watts model, or DKW (1998). DKW (1998) uses regression analysis in order to
determine the relationship between multiple variables and cash flows. Through this method, the
model found that cash-flow changes and accruals are negatively related, specifically through
current earnings, and using this relationship predicts the cash flows for the next period. The DKW
(1998) model derives this relationship through the relationships of accruals and cash flows to
accounts payable and receivable, along with inventory.[21]

Child protection

Some child welfare agencies have started using predictive analytics to flag high risk cases.[22] For
example, in Hillsborough County, Florida, the child welfare agency's use of a predictive modeling tool
has prevented abuse-related child deaths in the target population.[23]

Predicting outcomes of legal decisions

The predicting of the outcome of juridical decisions can be done by AI programs. These programs
can be used as assistive tools for professions in this industry.[24][25]

Portfolio, product or economy-level prediction

Often the focus of analysis is not the consumer but the product, portfolio, firm, industry or even the
economy. For example, a retailer might be interested in predicting store-level demand for inventory
management purposes. Or the Federal Reserve Board might be interested in predicting the
unemployment rate for the next year. These types of problems can be addressed by predictive
analytics using time series techniques (see below). They can also be addressed via machine
learning approaches which transform the original time series into a feature vector space, where the
learning algorithm finds patterns that have predictive power.[26][27]

Underwriting

Many businesses have to account for risk exposure due to their different services and determine the
costs needed to cover the risk. Predictive analytics can help underwrite these quantities by
predicting the chances of illness, default, bankruptcy, etc. Predictive analytics can streamline the
process of customer acquisition by predicting the future risk behavior of a customer using
application level data. Predictive analytics in the form of credit scores have reduced the amount of
time it takes for loan approvals, especially in the mortgage market. Proper predictive analytics can
lead to proper pricing decisions, which can help mitigate future risk of default. Predictive analytics
can be used to mitigate moral hazard and prevent accidents from occurring.[28]

See also

Actuarial science

Artificial intelligence in healthcare

Analytical procedures (finance auditing)

Big data

Computational sociology

Criminal Reduction Utilising Statistical History

Decision management

Disease surveillance

Learning analytics

Odds algorithm

Pattern recognition

Predictive inference

Predictive policing

Social media analytics

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Further reading

Agresti, Alan (2002). Categorical Data Analysis. Hoboken: John Wiley & Sons. ISBN 0-471-36093-7.

Coggeshall, Stephen; Davies, John; Jones, Roger; Schutzer, Daniel (1995). "Intelligent Security
Systems". In Freedman, Roy S.; Flein, Robert A.; Lederman, Jess (eds.). Artificial Intelligence in the
Capital Markets. Chicago: Irwin. ISBN 1-55738-811-3.

Coker, Frank (2014). Pulse: Understanding the Vital Signs of Your Business. Bellevue, WA: Ambient
Light Publishing. ISBN 978-0-9893086-0-1.

Devroye, L.; Györfi, L.; Lugosi, G. (1996). A Probabilistic Theory of Pattern Recognition (https://book
s.google.com/books?id=Y5bxBwAAQBAJ) . New York: Springer-Verlag. ISBN 9781461207115 –
via Google Books.

Enders, Walter (2004). Applied Time Series Econometrics. Hoboken: John Wiley & Sons. ISBN 0-
521-83919-X.

Finlay, Steven (2014). Predictive Analytics, Data Mining and Big Data. Myths, Misconceptions and
Methods. Basingstoke: Palgrave Macmillan. ISBN 978-1-137-37927-6.
Greene, William (2012). Econometric Analysis (7th ed.). London: Prentice Hall. ISBN 978-0-13-
139538-1.

Guidère, Mathieu; Howard, N; Argamon, Sh. (2009). Rich Language Analysis for Counterterrorism.
Berlin, London, New York: Springer-Verlag. ISBN 978-3-642-01140-5.

Mitchell, Tom (1997). Machine Learning. New York: McGraw-Hill. ISBN 0-07-042807-7.

Siegel, Eric (2016). Predictive Analytics: The Power to Predict Who Will Click, Buy, Lie, or Die. John
Wiley & Sons. ISBN 978-1119145677.

Tukey, John (1977). Exploratory Data Analysis (https://archive.org/details/exploratorydataa00tuke

_0) . New York: Addison-Wesley. ISBN 0-201-07616-0.