Understanding Diversification of Risk and Three Ways Insurance Companies Achieve It

In risk management and insurance, the accumulation of losses can lead to an insurance company’s insolvency. An insurer must have a strategy concerning the lines of business (types of insurance) it plans to write and where the accepted risks will be located. The insurer’s main concern should be to ensure that its portfolio of written business is not excessively exposed to potential losses from a single event (or series of events) and that changes in business conditions and covered perils does not leave the company exposed to a higher incidence of claims and losses. Diversification (i.e. the spreading) of risk is an essential component in an insurer’s underwriting strategy and it is a means for an insurer to ensure that poor results affecting one part of its portfolio will be compensated by good results in other parts. Diversification can be achieved through the insurance company’s writing coverage across different: lines of business, territories and markets.

In writing different lines of business, an insurer achieves the goal of diversifying its exposure to loss in the sense that losses affecting one class of business are less likely to affect others. For example, an insurer may write auto (motor) insurance and commercial property insurance risks on behalf of its insureds in the hopes that increased claims arising from distracted drivers can be offset by reduced property losses due to improved construction methods. There is the possibility of the insured classes of business being affected by the same event such as a fire burning an insured parking structure containing insured vehicles. However; the types of perils that affect buildings and other commercial property is not directly correlated to the perils affecting motor vehicles therefore a loss to both classes of business from the same event is less likely. Writing more classes of business will help increase the insurer’s spread of risk. By adding marine, aviation, and general liability insurance to its product offerings, the insurer will be more diversified and thus poor results in one area can be offset by good results in more classes of business.

Diversification may also be achieved based on the territories where the insurer decides to write business. If an insurer writes business in one city or one postal code, then the probability of a single event causing losses to large portions of the insurer’s portfolio of written business is higher than if the insurer’s business was written across a wider geographic spread. The reason for the higher probability of an accumulation of losses arises due to the proximity of the risks written by the insurer to one another. If a hurricane, tornado or other catastrophic event was to affect the location where the insurer’s written business is concentrated, then losses will accumulate with no reprieve from good results from an area that is not affected by the loss event. Ideally, the risks written by an insurer will be spread in such a way as to ensure that a single event will not affect the entire portfolio, or significant portions of it. If the insurer writes business in Florida, which is heavily exposed to hurricanes, the insurer may also want to write business in California which does not have an appreciable hurricane exposure but it does have an earthquake exposure. The goal is for the poor results of an active hurricane season in Florida to be offset by periods of reduced earthquake activity in California or vice versa. The greater the geographic spread between the risks written by an insurer, the less likely that a single event will affect said risks.

Finally, diversification may be achieved through writing business across different markets. This type of diversification is useful in instances where the economic environment in a market becomes disadvantageous. When economies are growing, it is more likely that new insurance business will become available to be written and that the need of businesses to insure their loss exposures will increase. During recessions (periods of economic decline) the opposite is likely to happen in that less insurance business will be available to be written and businesses will likely reduce the amount of risk they transfer to insurance companies, the goal being to reduce premium outflow to retain more funds to operate the business. In addition, recessionary periods are more likely to affect moral hazards. Insureds may see insurance settlements as means of acquiring additional funds therefore loss values may be inflated or worse, the loss may be caused by an insured. Diversifying across different markets such as construction and technology may help ensure that a decline in one market segment will be offset by growth in the other. The same applies across countries. An insurer writing business in the United States and in Latin America may help offset slowdowns and the adverse effects of recessions in the United States with growth in Latin America and vice versa.

Diversification is an important concept and an essential component in the successful management of risk and the operation of insurance. Through diversification across different: lines of business, territories, markets, etc. an insurer may better improve its chances of achieving positive results in the aggregate and help ensure its survival following adverse loss periods.