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January 05, 2009

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.

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