Principle Component Analysis and Partial Least Squares: Two Dimension Reduction Techniques for Regression

_____________________________________________________________________________ Abstract: Dimension reduction is one of the major tasks for multivariate analysis, it is especially critical for multivariate regressions in many P&C insurance-related applications. In this paper, we’ll present two methodologies, principle component analysis (PCA) and partial least squares (PLC), for dimension reduction in a case that the independent variables used in a regression are highly correlated. PCA, as a dimension reduction methodology, is applied without the consideration of the correlation between the dependent variable and the independent variables, while PLS is applied based on the correlation. Therefore, we call PCA as an unsupervised dimension reduction methodology, and call PLS as a supervised dimension reduction methodology. We’ll describe the algorithms of PCA and PLS, and compare their performances in multivariate regressions using simulated data.