What does "pooling of risks" mean in the insurance industry?

Pooling of risks refers to the practice in the insurance industry where similar risks are collectively grouped together. This approach allows insurers to spread out the financial exposure across a larger number of policyholders, thus reducing the impact of any single loss. By gathering a variety of risks, insurers can predict loss more effectively and manage their overall risk more efficiently.

In this context, the pooling concept works under the principle of risk sharing; the occurrence of loss among a larger group means that the cost of those losses can be distributed among all members of the pool. This distribution helps stabilize premiums and ensures that the financial burden of catastrophic events does not fall on a small number of individuals. It reflects the foundational concept of insurance, which is to protect individuals by mutualizing their collective risk.