In insurance, the term "risk pooling" refers to the spreading of financial risks evenly among a large number of contributors to the program. Insurance is the transference of risks from individuals or corporations who cannot bear a possible unplanned financial catastrophe to the capital markets, which can bear them easily – at least in theory. The capital markets, meanwhile, are generally happy to take on risk from individuals and corporations – in exchange for a premium they believe is sufficient to cover the risk.
Risk pooling in insurance means that there are many contributors to help spread the financial risks from expensive claims more evenly.
History of Risk Pooling
Risk pooling is essential to the concept of insurance. The earliest known insurance policies were written some 5,000 years ago, to protect shippers against the loss of their cargo and crews at sea. Any one of them would be devastated by the loss of a ship. But by pooling their resources, these ancient businessmen were able to spread the risks more evenly among their numbers, so each paid a relatively small amount. Under the Babylonians, those receiving a loan to fund a shipment would pay an additional amount in exchange for a rider cancelling the loan if a shipment should be lost at sea.
Modern Insurance Policies
The insurance industry grew enormously, as individuals and businesses sought to protect themselves from economic catastrophe by transferring their risks to an insurance pool. We still have commercial shipping insurance – just as we did in the ancient world – and we also insure against such diverse risks as fires, floods, theft, auto accidents, kidnap and ransom schemes, defaults on the part of our debtors, lawsuits and judgments, dying too early and even against the risk of living too long.
Risk and Premium
A class of professional experts in finance and probability, called actuaries, work for insurance companies to attempt to predict the probability and severity of risk. They also take lapse rates and interest rates or other expected rates of return on investment assets into account, with the goal of setting acceptable premiums.
The premium is the cost of pooling one's own risk with that of others via an insurance company and includes the insured's share of expected claims costs, administrative expenses, sales and marketing expenses, and a profit for the insurer. If a premium payer is affected by a covered risk, the insurance company, and not the insured, takes the hit. If claims are higher than expected, however, the insurance company may have to raise rates on policy holders across the board.
Insurable vs. Uninsurable Risks
Not every negative economic event is insurable. For risk pooling to be effective, the risk should be unforeseen and infrequent. If a negative event can be predicted in a certain case, it's not a risk, but certainty – and certainties are not insurable (with the possible exception of death, which is insurable because its timing is uncertain).
Furthermore, if a risk is too frequent, it cannot meaningfully be transferred to an insurance company, since the insurance company would only pass on the cost of the negative occurrence to the pool of insureds, along with their expenses and profits. If nearly everyone in a risk pool is filing a claim, then they are likely better off not attempting to pool their risks at all but setting aside sufficient reserves to pay for them themselves.
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