What does "risk pooling" refer to in the context of insurance?

"Risk pooling" in the context of insurance is a fundamental concept referring to the practice of spreading financial risk among a group of policyholders. When individuals or entities purchase insurance, they each contribute premiums into a common fund. This pooling of risks allows an insurer to manage the potential losses more effectively because the likelihood of any one individual suffering a loss at the same time as others is statistically lower. By distributing the financial burden of claims among all policyholders, the insurer can ensure that it has sufficient funds available to cover those losses when they occur.

In essence, risk pooling is about collective security; the impact of a single individual's claim is minimized when shared with a larger group. This mechanism is crucial for the sustainability of the insurance model, allowing insurance companies to offer coverage at affordable rates while also maintaining profitability.