Insurance companies take advantage of the portfolio effect by insuring many different homeowners against loss. However, the risks of loss for individual homes in hurricane-prone or earthquake-prone areas such as Florida and California are highly correlated. This suggests that insurance companies should avoid writing (or consider canceling) some customers' policies in Florida and California, even when the policies are both needed by homeowners and expected to be highly profitable to the insurer.

Question

Quizplus · Accepted Answer

The statement is true. The portfolio effect works best when there is low correlation of risk among the insured items. In the case of hurricane-prone or earthquake-prone areas, the risks of loss for individual homes are highly correlated, which means the portfolio effect is not as effective. Insurance companies may avoid writing or cancel policies of some customers in such areas to manage their risk exposure.

Insurance Companies Take Advantage of the Portfolio Effect by Insuring