The insurance business relies on the law of large numbers in its operations. According to this law, there should be a large group of people faced with similar risks and these risks spread over a certain given geographical area.
Every person in the group contributes at regular intervals, small amounts of money called premium into a “common pool”. The pool is administered and controlled by the insurance company.
- The fact that risks are geographically spread ensures that insurance does not have a concentration of risks in one particular area.
- The law of large numbers enables the insurance to accurately estimate the future probably losses and the number of people who are likely to apply for insurance. This is done in order to determine the appropriate premiums to be paid by the person taking out insurance.
Pooling of risks
The insurance operation is based on the theory that just a few people out of a given lot may suffer a loss. There is therefore a “pooling of risks” i.e the loss of the unfortunate few is spread over all the contributors of the group, each bearing a small portion of the total loss. This is why the burden of loss is not felt by the individuals because it is “shared” by a large group.
Benefits of the “pooling of Risks” to insurance company
- Pooling of risks enables an insurance company to create a common pool of funds from the regular premiums from different risks.
- It enables the insurance company to compensate those who suffer loss when the risks occur
- The insurance company is able to spread risks over a large number of insured people
- Surplus funds can be invested in for example, giving out loans or buying shares in real estates
- It enables the insurance company to meet its operating costs by using the pool funds
- It enables the insurance company to calculate to be paid by each client
- It enables the company to re-insure itself with another insurance company.