Pooling of risks

Insurance works on the principle of pooling of risks.

Take an example. There are 100,000 houses in a community. Each year, an average of 100 houses are totally destroyed by fire or other perils. The chance of a total loss is 1 in 1000 houses.

Each owner cannot take the risk of a total loss of his house. Suppose all the owners agree to participate in an insurance scheme, they only need to pay a pure premium of $1 to cover every $1,000 of the value of the property. A property worth $300,000 will need a premium of $300.

The insurance company will probably add a loading to the premium to cover the operating expenses and a profit margin, say $450. Each owner will probably find that it is worth paying a premium to cover the risk.

The insurance policy usually cover other losses as well, such as partial loss or damage caused by flood, burglary and other perils.

The insurance company will work out the total claims based on its past claim experience, and compute a premium rate for every $1,000 of insured value. A loading is added (for expenses and profit) to obtain the gross premium charged to the policyholder.

In practice, the risks are divided into separate groups according to the likelihood of a claim, to obtain the premium rate for each group.