Pooling Arrangements and

Diversification of Risk
Pooling of Losses

• Pooling and sharing of losses is the essence of insurance.

• Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average
loss is substituted for actual loss.
• Thus, pooling implies

1. the sharing of losses by the entire group and

2. the prediction of future losses with some accuracy based on the law of large numbers.
Risk Reduction through pooling independent losses

• The most important risk management concept may be the diversification of risk. Diversification is an
essential aspect of insurance and financial markets.
• We analyze diversification in this chapter, highlighting the factors influencing the extent to which risk can
be and is diversified.
• We illustrate diversification in several different contexts, beginning with a simple pooling arrangement
between two people and ending with diversification among thousands of people or business through
insurance and financial markets.
Risk Reduction through Pooling Independent Losses

Two Person Pooling Arrangement

• Suppose that X and Y each are exposed to the possibility of an accident in the coming year.
• In particular, assume that each person has a 20 percent chance of an accident that will cause a loss of 2,500
and an 80 percent chance of no accident.
• Distribution is very skewed, that is, there is a high probability of zero loss and a much smaller probability
of a large loss.
• Also assume that X’s and Y’s accident losses are uncorrelated.
• Now , we want to examine what will happen if X and Y agree to split evenly an accident costs that the two
might incur. That is, they agree to share losses equally, each paying the average loss. This arrangement
often is called a pooling arrangement, because X and Y are pooling their resources to pay the accident
costs that may occur.
Risk Reduction through Pooling Independent Losses

Expected Costs and the Standard Deviation for each person without a pooling arrangement:
• Expected Cost = (.80) (0) + (.20) (2,500) = 500
• Standard Deviation =
√.08 (0-500)^2 + .02 (2,500-500)^2 = 1,000
• Table 1. Probability distribution of accident losses for each person ( X and Y) without pooling.

Outcome Probability
0 .80
2,500 .20
Risk Reduction Through Pooling Independent Losses

• Our goal is to determine how the pooling arrangement will affect the expected cost and standard deviation
for each person.
• Note that the pooling arrangement changes the distribution of costs paid by each person in table 1. this is
because the costs paid by X now depend on the accident losses incurred by Y and vice versa.
• Specifically, with pooling, the cost paid by each person is the average loss of the two people.
• The first column of table 2. lists the possible outcomes for X and Y with pooling.
• If neither women has an accident, total accident costs zero and each woman pays zero.
• If either of the woman has an accident, total accident costs are 2,500 and each woman pays 1250 tk.
• If both women have an accident, total accident costs equal 5,000 and each pays 2,500 tk.
• Table 2 . Given below:
Risk Reduction Through Pooling Independent Losses

Possible outcomes Total Cost Cost paid by each Possibility

woman (Average
Loss)
1. Neither X and 0 0 (.8) (.8) = .64
Y has an accident
2. Y has an 2,500 1,250 (.2) (.8) = .16
accident, but X
does not
3. X has an 2,500 1,250 (.2) (.8) = .16
accident but Y
does not
4. Both X and Y 5,000 2,500 (.2) (.2) = .04
have an accident
Risk Reduction Through Pooling Independent Losses

• The pooling arrangement changes the probability distribution of accident costs facing each person.
• The probability that X will have accident costs equal to 2,500 is reduced from .20 to .04.
• This is because in order for X to pay 2,500 , both X and Y must experience an accident.
• Given that accidents are independent, the probability that both X and Y will have an accident is lower than
the probability that only X (or only Y ) will have an accident.
• Because the pooling arrangement reduces the probabilities of the extreme outcomes, the standard deviation
(risk) of accident costs paid by both X and Y is reduced.
• Recall that, without pooling, the standard deviation of accident costs in this example is 1000 tk.
Risk Reduction Through Pooling Independent Losses

• With pooling, the standard deviation of accident costs decline to 707

• Standard Deviation
√.64 × (0-500)^2 + .32 × (1,250-500)^2 + .04 × (2,500- 500)^2 = 707
• While both X and Y’s risk is reduced by pooling, each person’s expected accident cost is unchanged by
pooling, it still equals 500

• Expected cost = (.64) (0) + (.32) (1,250) + (.04) (2,500) = 500

• The pooling arrangement does not change either person’s expected cost, but it reduce the standard
deviation of costs from 1000 to 707 tk.
• Accident costs have become more predictable. The pooling arrangement reduces risk(uncertainty) for each
individual.
Risk Reduction Through Pooling Independent Losses

• Pooling arrangement provide a major example how risk is reduced through diversification.
• Simply stated, diversification means that you do not “put all your eggs in one basket,”.
• By entering into a pooling arrangement, X and Y made their accident costs for the year equal the average
loss for the participants.
• If they had not entered into the pooling arrangement, their accident costs would equal their own losses.
• The key point is that the average loss is much more predictable than each individual’s loss.
• Applying the egg analogy to the pooling arrangement,
1. each woman puts half of her eggs into one basket and half into another basket, and
2. X carries one basket and Y carries the other. After reaching their destination, they divide the surviving
eggs equally.
Risk Reduction through Pooling Independent Losses

Pooling Arrangement with Many People or Businesses

• Additional risk reduction can be obtained from pooling by adding people (or Business) to the arrangement.
• To illustrate, suppose that Z, who has the same probability distribution for accident costs as X and Y, joins
the pooling arrangement.
• At the end of the year, each woman will pay one-third of the total losses ( the average loss).
• The addition of a third person whose losses are independent of the other two causes an additional reduction
in the probability of the extreme outcomes.
• For example, in order for Y to pay 2,500 in accident costs, all three individuals must experience a 2,500
loss.
• The probability of this occurring is (.02) (.02) (.02) = .008
Risk Reduction Through Pooling Independent Losses

• As a consequence, the standard deviation for each individual decreases with the addition of another
participant.
• While risk (standard deviation) decreases, each individual’s expected accident cost again remains constant
at 500 tk.
• The probability distribution of each person’s accident cost will continue to change as more people are
added.
• As the number of participants increases, the probability distribution of each person’s cost (average loss)
becomes more bell shaped, that is less skewed.
• Pooling makes the amount accident of accident losses that each person must pay less risky (more
predictable), because pooling reduces the standard deviation of the average loss for all the participants and
thus the standard deviation of the payment by each participant.
Risk Reduction Through Pooling Independent Losses

• When losses are independent, pooling arrangements have two important effects on the probability
distribution of the accident cost paid by each participant.
• First, the standard deviation of the average loss is reduced. As a consequence, the probability of extreme
outcomes for participants-both high and low- is reduced.
• Second, the distribution of average losses becomes more bell shaped.
• In the extreme( i.e. as the number of people in the pooling arrangement becomes very large), the standard
deviation of each participant’s cost becomes very close to zero and the risk thus becomes negligible for
each participant. This result reflects what is known as the law of large numbers.
• In addition, as the number of participants grows, the probability distribution of the average loss (each
participant’s cost) becomes more and more bell shaped until it eventually equals the normal distribution.
Pooling Arrangement

• Since in many instances losses will be positively correlated, we need to examine risk reduction through
pooling in this case.
• Pooling arrangement reduce risk for each participants continues to hold provided losses are not perfectly
positively correlated.
• However, the magnitude of risk reduction is lower when losses are positively correlated than when they are
independent (uncorrelated).
• Losses across many different businesses or individuals may be positively correlated for a number of
reasons.
• The occurrence of a loss is often due to events that are common to many people.
• Catastrophes, such as hurricanes and earthquakes are examples of events that cause property losses to
increase for many individuals at the same time.
Pooling Arrangement

• Consequently, losses in certain geographical regions during a given time period are positively correlated.
• Similarly, since epidemics can cause medical costs to increase for many people during a given time period,
the medical costs across people can be positively correlated.
• The severity or magnitude of losses also is often influenced by common factors.
• For example, unexpected inflation can cause everyone who needs health care to pay more than expected.
• The probability of receiving medical care may be independent across people ( in contrast to the epidemic
example), but the magnitude of the medical costs incurred by different people is related to a common
underlying factor- inflation.
Pooling Arrangement

How do positively correlated losses affect pooling arrangements?

• Intuitively, positively correlated losses imply that when one person has a loss that is greater than the
expected loss, then other people(or business) also will tend to have losses that are above the expected loss.
• Similarly, when one person has a loss that is less than the expected loss ( no loss), then other people also
will tend to have losses below the expected value.
• Thus, when losses are positively correlated, there is a greater chance that lots of people will have high
losses and a greater chance that lots of people will have low losses, relative to the case of uncorrelated
losses.
• Consequently, pooling arrangements do not decrease the standard deviation of average losses as much
when losses are positively correlated.
• Stated differently, average losses are more difficult to predict when losses are positively correlated.
Pooling Arrangements

• Positive correlation between X’s and Y’s accident costs implies that the probability of both women having
an accident is greater than .04.
• Similarly, positive correlation implies that the probability of neither woman having an accident is greater
than .64
Insurers as Managers of Risk Pooling Arrangements

• Individuals or businesses can reduce their risk by forming a pooling arrangement.

• As a result, risk-averse individuals and businesses that value lower risk would have strong incentive to
participate in pooling arrangements if they could be organized at zero cost.
• However, risk pooling arrangements obviously are not costless to operate.
• Indeed, the cost of organizing and operating pooling arrangements is the main reason why insurance
companies exists and why most pooling arrangements take place indirectly through insurance contracts.
• In essence, insurance contracts are a way of lowering the costs of operating pooling arrangements.
Insurers as Managers of Risk Pooling Arrangements

Types of Contracting Costs

• Consider a risk pooling arrangement like the one introduced earlier, in which X and Y agree to share losses
equally.
• The greater the number of people who participate in a pooling arrangement, the greater is the reduction in
risk.
• There are several important costs associated with writing and enforcing contracts among participants,
which in general are referred to as contracting costs.
• To illustrate how insurance companies economize on these costs, this section describes the major types of
contracting costs associated with pooling arrangements.
Insurers as Managers of Risk Pooling Arrangements

Distribution Costs
• Consider first the costs associated with adding participants to risk pools.
• In practice, risk pooling arrangements incur substantial costs in marketing and in specifying the terms of
agreement.
• Insurance employ a variety of distribution systems, including exclusive agents and independent agents and
brokers.
Underwriting
• Once a potential participant in a pooling arrangement has been identified, it must be decided whether to
allow the individual to participate.
• For example, suppose that existing participants in a pooling arrangement all have expected loss of 200.
Then those participants will be reluctant to allow a person with an expected loss of 400 to join on the same
terms.
Insurers as Managers of Risk Pooling Arrangement

• Thus, the pool members will want to evaluate each potential participant’s expected loss.
• The process of identifying (estimating) a potential participant’s expected loss is known as underwriting,
and the costs of doing so are called underwriting expenses.

Loss adjustment Expense

• When a participants in a pooling arrangement experience a loss, the person must inform and seek payment
from the other members.
• To prevent people from fraudulently claiming that a loss has occurred or exaggerating loss amounts, the
pooling arrangement must monitor claims.
• The costs associated with this process usually are called loss adjustment expenses ( or claims settlement
expenses)
Insurers As Managers of Risk Pooling Arrangement

• Pooling arrangements also involve collection Costs.

• If, for example, a particular member has a valid claim of 10,000, each participant will ultimately have to be
assessed the specified share of the 10,000 loss (e.g. 10 each if there are 1,000 members that agree to share
losses equally).
• Alternatively, each member will have to be billed periodically for his or her share of total claim costs since
last payment.
• In either case, the collection of funds will involve costs in sending a bill to each member and attempting to
ensure that each member pays his or her assessment.
Insurers as Managers of Risks Pooling arrangement

• You can think of insurance companies as organization that have emerged to reduce the costs of operating
pooling arrangements.
• For example, without a central organization to recruit new members and distribute contracts (marketing
and distribution), screen applicants (underwriting), monitor claims ( loss Adjustment), and collect
assessment, each member of a pooling arrangement would need to contract with each of the other
members.
• With 1,000 members, 499,500 separate contracts would be needed ( 1,000 members × 999 contracts per
member ÷ 2, since only one contact per pair is needed).
• With a central organization, only 1,000 contracts between the organization and the members are needed.
• In addition, without a central organization, each member would have to 1.become involved in underwriting
each of the other members, 2. investigate each claim, and 3. individually collect assessments.
Ex Ante Premium Payments Versus Ex Post Assessments

• In contrast to pure pooling arrangements, insurance companies usually do not have the legal right to assess
members of the pooling arrangements (policyholders) for losses that have occurred.
• Instead, policyholders pay an ex ante premium- that is, prior to knowing the magnitude of losses-without
giving the insurer the right of assessment if more money is ultimately needed to pay claims (ex post).
• One explanation for having fixed ante premiums as opposed to ex post assessments is that collecting
assessments from people who do not have losses is costly.
• Some people will attempt to delay and in some cases avoid paying assessments.
• Moreover, with a pure assessment system, funds might not be available to pay losses quickly.
Ex Ante Premium Versus Ex Post Assessment

• The resulting delay in claim payments would be costly to those participants that have experienced losses.
• Finally, assessments impose risk on participants. They do not know in advance how much they will have to
contribute.
• For these reasons, insurers commonly charge policyholders a fixed advance premium without having the
right to assess policyholders for losses during the coverage period if realized losses for the insured group
turn out to be higher than expected.
• Fixed ex ante premiums imply that the insurer obtains revenue (premium payments) prior to paying claims.
• There are many ways that people and businesses diversify risk in addition to pooling arrangements through
insurance contracts.
• Stock market, for example provide a mechanism for entrepreneurs to share risk associated with new
business ventures with other people.
Thank You