Risk Pooling

Risk pooling is the basic principle behind insurance. Any individual might suffer a large, unpredictable loss, but across a large group, the total amount of losses becomes much more predictable.

For example, if one in a thousand homes is expected to suffer a serious fire each year, causing an average loss of 200,000, then a pool of 10,000 homes can expect about 10 fires and total losses of about 2 million. If each homeowner pays 200, plus an amount for costs and safety margin, the pool can cover the losses. No single homeowner has to face the risk of losing 200,000.

Risk pooling works because of the law of large numbers: the larger the group, the closer the actual losses will be to the expected average.

It is used not only by insurers but also by public health systems, pension schemes, mutual societies and government social security programmes. Pooling works best when risks are independent, meaning one person's loss does not make others' losses more likely. Risks that affect many people at once, such as major floods or pandemics, are harder to pool.