Risk pooling (mutualization)
The mechanism by which the premiums of a community of policyholders finance the losses of a few, the foundation of insurance technique.
Jacob Bernoulli's Ars Conjectandi was published in 1713, eight years after his death. It sets out the law of large numbers, on which risk pooling rests. Risk pooling is the founding principle of insurance: a large number of policyholders pay premiums, and those premiums indemnify the minority who will suffer a loss. It rests on the law of large numbers, which makes the loss experience of a large portfolio statistically predictable, and on the relative independence of risks, so that they do not all materialize at once. It reaches its limit when risks become strongly correlated. A single event that strikes many insureds simultaneously, like a war, a pandemic or a systemic cyber-attack, destroys the independence assumption. This absence of boundary and this correlation are what make fundamental risks hard to pool. They call for other mechanisms: reinsurance, transfer to capital markets or public support.
Textbook case: the premiums of millions of motorists finance the losses of the fraction who will have an accident; but no risk pooling can absorb a loss that would strike all the insureds at once.
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