On Modeling Diversification Benefits in Insurance Portfolios--An Australian Perspective

Empirical measurement of dependency between different lines of non-life insurance business remains an open problem. International regulatory requirements and accounting standards are moving towards increased disclosure of the variability of insurance liabilities. In estimating the variability, it is required to take diversification benefits into account, as it is generally believed that different lines of business are not perfectly dependent on one another. Due to data limitations and the complicated nature of non-life insurance business, however, direct quantification of dependency and so diversification benefits between individual lines is a difficult task. In this article, we set forth some practical considerations in modeling dependency and diversification benefits under Australian regulatory environment. We start with providing a summary of the underlying factors causing dependency and examining the reasonableness of some industry correlation figures based on these factors. We also study the correlations between the historical loss ratios of several lines of Australian business. Afterward we carry out extensive simulation studies to investigate the effects of applying some recently suggested methodologies for tackling the problem of evaluating diversification benefits.