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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27. Dhar, Vasant; Chou, Dashin; Provost, Foster (2000-10-01). "Discovering Interesting Patterns
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titute/Journal-54-Insurance/Using-Risk-Analytics-To-Prevent-Accidents-Before-They-Occur-
The-Future-Of-Insurance). Journal of Financial Transformation.

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 (http
s://books.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/exploratorydataa0
0tuke_0). New York: Addison-Wesley. ISBN 0-201-07616-0.

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