Society of Actuaries (SOA) PA Practice Exam

Why is factor level reduction important?

1. It decreases interpretability of models.

2. To avoid variables that dilute predictive power.

3. It always increases the number of predictor variables.

4. It focuses only on high exposure factors.

The correct answer is: To avoid variables that dilute predictive power.

Factor level reduction is significant because it aims to avoid incorporating variables that can dilute the predictive power of a model. In statistical modeling, especially within the context of regression and classification, having too many factors or levels can lead to overfitting, where the model captures noise in the data rather than the underlying relationship. By reducing the levels of factors, one ensures that the most important variables are retained, enhancing the model’s ability to generalize well to new, unseen data. This process leads to a more parsimonious model, which is simpler and easier to interpret. Reducing unnecessary complexity helps improve the model's accuracy and robustness, making it more effective for predictive analysis. It also aids in identifying the most impactful variables, allowing analysts to focus on inputs that truly drive the outcome of interest without the distraction of less relevant factors.