What Is Risk Pooling in Insurance?

For any type of insurance coverage, some people and businesses are more likely to file a claim at some point during the policy’s term. Whether the policy covers health care, professional malpractice or loss of any other type, there will be some insured people who are at a greater risk of needing that coverage. One definition of risk pooling could be "a group formed by insurance companies to provide catastrophic coverage by sharing costs and potential exposure." Risk pools help insurance companies offer coverage to both high- and low-risk customers. They also lessen the risk borne by any single insurance company by spreading it among many.

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Insurance risk pools are a risk management mechanism by which insurance companies can offer insurance products to more high-risk individuals and businesses for certain catastrophic losses by sharing costs and potential exposure more evenly across the board.

Individuals and businesses generally purchase insurance policies to protect themselves against unusual but potentially costly damages and losses. The losses may be more or less unlikely from a statistical perspective, but if the unfortunate event does occur, it could have the potential to be financially catastrophic for the business or person in question. Some types of insurance are required. For example, state governments require all drivers to maintain adequate car insurance.

By creating risk pools, insurance companies help spread the risk and avoid the type of massive payout required after a catastrophic loss. It is a form of risk management for insurance companies. If a claim is made for reimbursement due to that catastrophic loss, the participating insurance companies spread the loss among themselves. This helps protect smaller claimants from being left uncovered due to their insurance company’s bankruptcy or closure.

The larger the risk pool, the more consistent and stable the premiums should be. However, this doesn’t always translate to the lowest premiums. For example, a large health insurance risk pool should carry stable premiums (that is, the premiums shouldn’t change significantly or quickly), but those premiums wouldn’t necessarily be the lowest available or even on the low side of a range of costs. Lower premiums are instead associated with the least amount of health care costs on average per pool member (i.e., insured person).

This is because on average, high-risk insured people cost their insurance companies more money over the life of a policy, statistically speaking. For example, a person with cancer who is undergoing long-term treatment for the illness will incur far greater medical costs than a healthy individual would for the same period of time. Older people will generally pay more for life insurance than young adults, and new drivers in their teens will pay more for automobile insurance than seasoned, careful drivers with excellent driving records. As you’d expect, lower-risk people receive insurance premiums that are generally much less expensive. By combining high- and low-risk insureds in a single pool, the potential costs presented to the insurers become more manageable and stable.

Actuaries provide detailed analyses of the likelihood of a particular kind of loss and the severity of the resulting damage. Actuaries are professionals who are highly skilled in finance and statistics. Insurance companies take the actuarial analyses and come up with rates that are acceptable and (hopefully) reasonable. Actuaries are have crunched the numbers to back up the general assertions on which policies are issued and premiums are based.

In the case of risk pools, premiums are calculated to strike a balance between the extra anticipated costs of high-risk individuals or businesses and the likelihood of their need for the policy.

Many types of insurance work with a risk pool. Health insurance is probably the most familiar context. Most recently, proposed federal legislation in the U.S. would have created high risk pools as an alternative to the provisions of the Affordable Care Act, which barred insurance companies from refusing to cover pre-existing conditions.

Prior to the ACA, health insurance policies traditionally excluded coverage for pre-existing conditions, sometimes for a specific waiting period. The ACA required insurance companies to do away with these exclusions, thus guaranteeing coverage for people with pre-existing conditions. However, premiums may still reflect an assessment of higher than usual risk.

Essentially, the ACA established a risk pool in each state, which is used by companies when they set premium schedules. Basically, the companies pool together all insurance plans that comply with the ACA requirements, which then spreads out the costs of insuring higher-risk individuals, such as the chronically ill, the elderly and others who incur greater health costs.

A special form of insurance risk pool is the governmental or public entity risk pool. These risk pools basically work in the same way as insurance company pools. The difference is that instead of being created and operated among insurance companies, these pools are made up of public organizations or governmental units. As an example, a state’s city governments could join together to create a risk pool for worker’s compensation insurance. Other examples of governmental bodies or public organizations that might create risk pools are county governments, state agencies and school districts. The intergovernmental risk pool provides an alternative for the member governments or bodies to self-fund their own insurance coverage, sharing losses and agreeing on premium calculations. Governmental units sometimes prefer this approach over traditional insurance coverage due to their ability to control costs and payouts.