Insurance Law Lesson 63: Risk Pooling

Insurance works when a subset of people acknowledge risk that could substantially harm any one of them, and instead choose collectively to bear that risk so that none has to worry about being the statistic, financially speaking at least.

To illustrate, let’s assume there is a .001% chance of $200,000 loss happing to each member of a group of 100,000 individuals. That loss would financially cripple most members of the group and even the wealthy members would rather avoid the risk. So, they all get together and throw $2 into a pot. This money will go to whomever incurs the loss. Now, everybody is protected. That $200,000 is insurance.

Real life is more complicated. There is no way to predict the value and chance of a risk with pinpoint accuracy. Using our example again, there will be times that nobody incurs the loss, and the money sits in the pot, and there are times that more than one person will incur the loss — if the “pot” doesn’t have enough money to cover all of the losses, what then?

In addition to traditional insurance companies, many entities create their own “risk pools.” This is like the bank versus a credit union. One is a for profit entity that offers a service, the other works for its members, with the idea that it will be less profit focused and more service centric.

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