Definition
Pooling of Risk
Pooling of risk is the core insurance mechanism whereby premiums from many insured parties are pooled to pay the losses of the unfortunate few.
Insurance works by collecting small, certain premiums from a large group and using the pool to compensate the members who actually suffer losses. The larger and more homogeneous the pool, the more predictable the aggregate losses become, thanks to the law of large numbers.
Pooling spreads the financial impact of misfortune across the community of policyholders rather than leaving individuals to bear catastrophic costs alone. Effective pooling depends on managing adverse selection so the pool is not dominated by high-risk members, which would make premiums unsustainable.
Related terms
- Adverse SelectionAdverse selection is the tendency for higher-risk individuals to seek insurance more eagerly than lower-risk ones, skewing the risk pool.
- Law of Large NumbersThe law of large numbers is the statistical principle that the larger the number of similar risks pooled, the more predictable the average loss becomes.
- Self-InsuranceSelf-insurance is the practice of setting aside one's own funds to meet potential losses instead of buying an external insurance policy.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.