What is risk pooling?

What is risk pooling?

Risk pooling is an important concept that is particularly relevant for areas such as finance, insurance, supply chain management, and healthcare. In this post, we offer a definition of risk pooling, provide examples, and discuss the relevance of risk pooling in different areas. We draw a distinction between risk pooling and risk sharing as well.

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The definition of risk pooling and examples

Within an insurance context, risk pooling can be defined as the practice of pooling similar risks. For example, a home insurance company operates by pooling risks from a large number of homeowners. In a typical home insurance policy, the homeowner pays premiums as a price for shifting risks such as fire, flooding, or theft to the home insurance company (this is also known as a risk transfer). That is, if a house is, say, burnt down in a fire, the homeowner can claim the damages from the insurance company.

Many homeowners would pay premiums for decades without ever making a claim on their home insurance. But, the claims made by a minority can be pretty large (tens of thousands of dollars) on average. Therefore, the premiums paid by many members of the risk pool end up covering the claims of a few members who actually suffer losses.

It is the job of the insurance company to manage this pool, collecting premiums and paying out claims. And, of course, the company would charge for its services.

Captive insurance risk pool

A captive insurance company is essentially a vehicle for a large business organization for insuring its own business risks. Typically, it is a wholly-owned subsidiary of the parent firm. It is common for large corporations to have one or more captives. The idea is to lower insurance costs for the parent firm.

One of the main rationales behind a captive insurance risk pool is to spread risk. In particular, it would be too risky for a captive insurance firm to have a very high concentration of its parent firm’s risk. Therefore, it seeks to gain exposure to unrelated risks through risk pooling. There may be tax benefits associated with captive insurance risk pooling as well.

Risk pooling vs risk sharing

There is sometimes a misconception that a larger risk pool is less risky than a smaller one because of diversification across ‘uncorrelated’ policies. While selling more uncorrelated policies can boost the profitability of an insurance company, the total risk of the pool increases with each policy added to it.

In order to reduce risk, insurance companies engage in risk sharing as well as risk pooling. The idea is to gain exposure to a larger number of uncorrelated policies (this is the risk pooling bit) while keeping the size of the risk pool fixed by selling a portion of the policies to other insurance firms (this is the risk sharing bit). This is related to the concept of reinsurance whereby the reinsurer agrees to take over part of the obligations of the ceding party.

Risk pooling in ancient Rome

risk pooling in ancient rome

Ancient Romans paid great importance to funerals. They believed that a dead person had to be buried in a particular manner. Otherwise, that person’s soul would never find peace and would wander around endlessly.

Of course, one group of professionals who faced a high risk of death on multiple occasions was Roman soldiers. They formed burial clubs, which essentially operated on the basis of risk pooling.

The soldiers who agreed to join a burial club were required to pay a certain sum that would be gathered in a pot. At the end of a war, the funerals of the members who died would be financed by the funds available in the pot.

Later, the idea was extended further to provide a stipend for the families of dead soldiers. This, of course, captures the essence of life insurance.

Risk pooling in supply chains

risk pooling in supply chains

Another area where the concept of risk pooling is highly relevant is supply chain management.

Supply chain managers constantly deal with the consequences of demand fluctuations. For example, they need to maintain (costly) safety stock in order to prevent getting out of stock.

Risk pooling can help towards reducing the required level of safety stock. Specifically, it involves centralizing inventory such that higher-than-expected demand by some customers can be offset by lower-than-expected demand by others.

To illustrate with an example, let’s imagine that you are operating a wholesale bakery, selling croissants to cafes in your city. You’ve got two locations where you bake your product. One in the east end of the city, another in the west end. Let’s say you maintain a safety stock of 580 croissants in the eastern location, and 420 in the western location. This is because the orders you get from cafes vary on a weekly basis, and you need to make sure you have enough croissants to fulfil orders so that the cafes working with you would not consider switching to a rival supplier.

The problem is that croissants are perishable products. In fact, they taste the best when they are consumed on the same day of production. This means that any croissant that you cannot sell would end up going to waste pretty fast.

Suppose that you could purchase a new location in the center of the city that could serve cafes on both ends of the city. Now to the extent that the demands from different cafes are either uncorrelated or have a low degree of correlation, which is a reasonable assumption (perhaps except on the World croissant day!), you could operate with a safety stock of much less than the original level of 1,000 croissants (580 in the east, 420 in the west). Obviously, this would result in significant cost savings for your business.

As you can see, in the context of supply chains, risk pooling works by aggregating demand from multiple sources with the ultimate goal of creating cost savings through reduced demand variability.

summary

Risk is present in many areas of our lives. In many contexts, organizations engage in risk pooling to gather unrelated risks and risk sharing to reduce their exposure to risk.

The concept of risk pooling is particularly important in the insurance industry. It goes back a long time as well. We have discussed examples from ancient Rome, where Roman soldiers set up burial clubs to pool risks. Finally, risk pooling is important in supply chains as well because it helps to reduce the costs of dealing with demand uncertainty.

Further reading:

Manning and Marquis (1996), ‘Health insurance: The tradeoff between risk pooling and moral hazard‘, Journal of Health Economics, Vol. 15(5), pp. 609-639.

Schmitt et al. (2015), ‘Centralization versus decentralization: Risk pooling, risk diversification, and supply chain disruptions‘, Omega, Vol. 52, pp. 201-212.

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