Pooling and Diversification of Risk through Insurance – This is one of several important insurance concepts. Individuals and firms can reduce the pure risks they face through insurance mechanisms designed to transfer and diversify risk across a wider base of exposures and/or over time. This is accomplished by pooling losses for a group of individuals or firms in some manner. Members of the group share all losses that are incurred by its members. In effect, members of the group exchange a smaller, more certain financial contribution for protection against a larger, uncertain loss. Combining losses for a group and sharing them in some manner among group members makes this possible.
Uncertainty and the law of large numbers make insurance valuable, as well as feasible. As the number of members of an insurance pool increases, the random or uncertain aspect of the occurrence of accidents and claims for benefits is reduced, and there is greater certainty about the total losses that the pool will suffer. This allows the pool to allocate its costs among members in the form of smaller, certain premiums or assessments. In essence, pool members exchange their fair share of total pool costs in return for protection against the risk of a potentially much larger loss that they would otherwise face individually.
Risk and uncertainty is reduced through sharing all losses among the group members and the greater predictability of losses achieved by increasing the number of members of the pool. As the size of a pool increases, its actual losses will tend to come closer to its expected or predicted losses based on the risk levels of its members. Assuming that pool members are risk averse — i.e., they value greater certainty and the reduction of risk — pool members will be willing to pay some additional premium over their expected loss to cover the costs of administering the pool in return for the reduction in risk. This is called a risk premium. It means that the expected loss is essentially equal to the probability that a loss will occur, multiplied times the amount or severity of the loss. A premium equal to the expected loss but that contains no provision for expenses or profit is sometimes called the “actuarially fair premium.”
It should be stressed that pooling losses does not necessarily mean that every pool member will make an equal contribution to the pool. In theory, equal contributions only make sense if every member of the pool has the same risk of loss.
In practice, most pools contain members whose risk varies. Individual pool contributions can be based on each member’s relative degree of risk, so that individuals with greater risk pay higher premiums. As explained at the others articles, this maintains low-risk pool members’ incentives to remain in the pool. Pools can be organized in various ways (e.g., group self-insurance, insurance companies, etc.), but the basic concept is the same.