Risk pooling takes the risk facing individuals and transfers it to a larger group. Each member of the group pays a relatively small insurance premium, resulting in a guaranteed loss of income, but in so doing the risk of incurring a larger loss is avoided.
While the risk facing one specific person is largely unknowable, the risk for a larger group can be calculated with a great deal of certainty. While no one knows who specifically will contract the flu, die of a heart attack, or suffer damage from a tornado, it can be determined with near certainty that 1 person out of 100 will get the flu, 1 person out of 10,000 will die of heart attack, and 1 person out of 100,000 will suffer tornado damage.
InsuranceInsurance is a financial service that exchanges legal claims. Legal claims represent ownership of goods, services, resources, or other real assets. For insurance, the legal claim is the promise of future payment should a loss of goods, services, resources, or other real assets occur. In the insurance market, a provider receives payment from the customer and the customer receives a legal claim of future payment from the insurance provider.
Insurance transfers the risk of loss from an individual to a larger group. The larger group is typically represented by an insurance provider, either a private for-profit company or a government agency. The insurance provider is able to take over the risk from individuals through risk pooling. Risk averse people, those who prefer certain income over risky income, are also willing to pay a premium to avoid risk, and are the ones most inclined to purchase insurance. The risk averse individual agrees to incur a small guaranteed loss (the premium) but avoids incurring a less likely, but much bigger, loss.
Transferring RiskThe provision of insurance is relies on risk pooling. Risk pooling makes it possible to calculate the prospect of a future loss associated with a risky situation with near certainty.
For example, the single flip of a single coin could come up heads or tails. Which one occurs on that flip is unknown and unknowable. It could go either way. However, flipping 10,000 coins is virtually guaranteed to produce 5,000 heads and 5,000 tails.
Risk pooling allows an insurance provider to calculate, with near certainty, the total losses incurred by a group. This total loss can then be pooled and divided among members of the group.
Suppose that the risk of encountering an illness that will incur $10,000 worth of health care expenses is 1%. That is, in a group of 100,000 people this $10,000 illness expense will fall on 1,000 people, 1% of the total. An insurance provider can insure this group of 100,000 against individual expenses through risk pooling, by spreading the expense over the entire group.
Here's how. If 1,000 people incur an expense of $10,000 each, the total expense is $10 million. Dividing this total $10 million expense over the 100,000 people works out to $100 per person. If the insurance provider collects $100 per person, then it can cover the $10 million total expense incurred by the group.
In effect, risk pooling spreads the expense facing an individual over the larger group. All members of the group share in the cost, not just the affected party.
RISK POOLING, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2020. [Accessed: April 4, 2020].