Pooling arrangements and diversification of risk

Why do people share risks?

To reduce the impact of risk on any one person.

What happens if people’s risks are connected?

Sharing becomes less effective at reducing risk.

Where else can risk be shared or reduced besides insurance?

In the stock market through diversification; i.e., investing in different companies.

Does sharing risk change the expected loss?

No, the total expected loss remains constant.

What are the benefits of sharing risk?

It makes losses more predictable and easier to handle.

When losses are shared between two people, what changes?

The probability of incurring a large loss alone decreases.

As a result of sharing losses, what is experienced?

Reduced risk for each participant.

Does sharing affect the average loss amount?

No, the average loss stays the same.

How does sharing impact the risk level?

It lowers the risk, making potential losses more predictable.

When more people join the risk pool, what happens?

Each individual's risk diminishes.

What happens to the chances of experiencing significant losses in a larger pool?

The chances decrease for each person.

What outcome is observed in very large risk pools?

Very adverse outcomes become less probable.

How does the pattern of loss appear in large pools?

It approximates a bell-shaped curve, indicating normal distribution.

What implication does this pattern have for individuals in the pool?

Losses become more predictable and less risky.

In a very large group, what happens to individual risk?

It approaches zero.

What principle explains this phenomenon?

The Law of Large Numbers.

What does the Law of Large Numbers stipulate?

With a large population, the average loss approaches the expected loss.

What effect is observed regarding variation in large groups?

It diminishes.

When many individuals are involved, what happens to the risk per person?

It drops to a minimal amount.

What does the Central Limit Theorem say about large groups?

The average loss tends toward normal distribution and becomes easier to forecast.

Define a linked or correlated risk.

A risk where a loss for one person increases the likelihood of losses for others.

How does this type of risk affect risk pooling?

It reduces the efficiency of risk sharing.

What happens to risk reduction when risks are interconnected?

Risk reduction is less significant.

What is the result if risks are perfectly correlated?

Sharing provides no risk reduction.

Is risk sharing beneficial for perfectly correlated risks?

No, it can't reduce risk in those scenarios.

When risks are somewhat correlated, is risk sharing effective?

It helps a little, but not as much as with unrelated risks.

What are distribution costs in risk pooling?

Costs related to attracting new members to the pool.

Define underwriting costs.

Expenses for assessing and determining the risk profile of each member.

What are claim settlement costs?

Expenses for reviewing and handling claims to prevent overpayments.

What are collection costs in risk management?

Expenses associated with collecting contributions from all members.

How do insurance contracts facilitate cost efficiency in pooling?

By structuring the process for greater efficiency.

What specific functions do insurers fulfill in risk pooling?

They recruit new members or distribution, provide contracts, assess individual risks through underwriting, manage claims, and collect payments.

Why are insurance firms regarded as efficient in risk pooling?

They specialize in these specific tasks, reducing overall expenses.

Why do insurance companies collect premiums before actual losses occur?

Because losses can't be shared post-occurrence, funds are gathered in advance.

How is diversifying investments another strategy for risk mitigation?

By allocating funds across multiple investments rather than focusing on one.

What is the primary advantage of diversifying investments?

Reducing dependence on a single investment and protecting against total loss.

What scenarios undermine the effectiveness of diversification?

When all investments are influenced by the same market trends, diminishing individual protection.

What are the distribution costs in risk pooling?

They are the costs of finding and adding new people to the pool.

What are underwriting costs?

They are the costs of checking how risky each person is.

What are claim settlement costs?

They are the costs of checking and managing claims to make sure people aren’t asking for too much.

What are collection costs?

They are the costs of organizing how everyone pays their share of the losses.

How do insurance contracts help with pooling costs?

They reduce the costs by organizing the process more efficiently.

What do insurers do in a pooling arrangement?

They find new members, give out contracts, check who is risky, manage claims, and collect payments.

Why are insurance companies seen as efficient?

Because they specialize in these tasks and help lower the overall cost.

Why do insurance companies charge a premium before the loss happens?

Because they can’t share losses after they happen, so they collect money in advance.

What happens to pooling when there is perfect correlation between risks?

Pooling does not reduce risk at all,