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://b
ooks.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/exploratorydataa00t

uke_0) . New York: Addison-Wesley. ISBN 0-201-07616-0.