Specialization vs Diversification in Insurance

Both specialization and diversification can be successful strategies in the insurance business.  In fact, diversification is one of the fundamentals of our business because it helps spread risk, which allows for the shifting of risk for reasonable pricing.  Diversification can be accomplished through a variety of approaches, including line of business, product line, geographic concentration and distribution diversification strategies.  Certainly no one would argue that diversification is not imperative in writing catastrophe exposed property insurance.

However, specialization is also a strategy that provides some unique benefits, primarily the accumulation of a high degree of expertise in a particular specialty area (see our prior posts here & here).  This expertise can be utilized in underwriting, risk management and claims to produce improved risk selection and reduced loss costs.

A recent study provides empirical evidence that a specialization strategy can produce better results than diversification.  Published in The Journal of Risk and Insurance, the study, by Andre P. Liebenberg and David W. Sommer is entitled: Effects of Corporate Diversification:  Evidence from the Property-Liability Insurance Industry.  The study looks at line of business diversification within the property/liability insurance industry, concluding:

Undiversified insurers outperform diversified insurers…Results indicate that diversification is associated with a penalty of at least 1% of ROA or 2% of ROE.

It would be interesting to review the companies included in each grouping to see if there are any concentrations of types of business.  Examples might include reinsurers and medical malpractice insurers.

Brought to you by Tennant Risk Services.

Comments

[doower]

even i am not overly clear but i can take your point. Its new stuff for me. For beginner in insurance world like me, your explanation about diversification and specification insurance very helpful.

thanks a lot

[Life Insurance]

good company

[DW]

I take your points.

What I was trying to do (poorly) was distinguish between 1. portfolio THEORY where the variances of independent variables cancel each other out and 2. the effect of human control, which screws it all up via unfocused execution.

I'm not sure of any reason to think that a diversified company is more profitable, though. Just less likely to go bust (AIG? ahem...)

But, now that you convinced me to read more than the abstract, I noticed their conclusion that clients are willing to pay more for lower credit risk.

Interesting stuff. Thanks!

[Specialty Insurance Blog]

I was not overly clear. The term diversification, as used here and in the study, is referring to diversification across lines of business. It is referring to the basic function of insurance - to spread risk. I prefer the term spreading risk, but diversification also works.

I do take issue with the point that adding more uncorrelated lines of business makes the capital base more stable. Not necessarily correct, as a number of insurers can attest. Good underwriting and claims practices makes the capital base more stable. And there are a large number of investors in alternative investments (hedge funds, for example) that have discovered that uncorrelated risk does not necessarily mean better returns.

DW notes that adequate diversification, what we call spread of risk, is necessary to reduce retained risk. The conclusion of the study in question, that specialization produces higher returns, can be viewed as counter-intuitive to this.

[DW]

I hope you don't mind if I get a bit semantic, but I don't like the way the word 'diversification' is used here.

The only thing that insurance companies DO is diversify - a large group of people pool their risks together and pay the expected value of the claims plus expenses and margin to the insurer. An insufficiently diversified insurance company, no matter how "monoline", won't have the premium to balance normal claims activity.

Adding more uncorrelated lines of business makes the capital base more stable, but the point of the study is to show that there is a more than offsetting reduction in risk management/pricing discipline/risk selection that reduces profitability.

This is human effect, not a mathematical one.