Diversification Credit
I have a bit of difficulty to understand the difference between companies with larger reserves from those with smaller reserves.
It is said at p.24 : "rating units with smaller reserves balances tend to show lower line-by-line correlation than the industry due to their higher volatility"
By reading this, I understand that there is less correlation than with the industry for units with lower reserves. However, I'm not sure if this means more diversification or less. I guess that depends on if the correlation is positive or negative.
But just after, it is written: "Rating units with smaller reserve balance will receive more diversification benefit by applying a larger reduction".
So in the first sentence, were we talking about less positive correlation ? I'm just not sure how to link the correlation and the diversification reduction
Comments
What it is saying is that there is an "industry" correlation matrix and for companies with smaller reserves, their own correlation matrix would show lower correlation than the aforementioned industry correlation matrix.
AM best uses the industry matrix and scales it based on the size of the company's book to calculate the diversification credit. So if you are smaller, you get a larger reduction since you are scaled more aggressively as you are more "different" than the industry.
I would assume they are referring to positive correlation as you can see in the next page (Exhibit C.6) where the correlation matrix has all values > 0
Makes sense, thank you!