What is risk pooling?
Risk pooling is the process of spreading exposure to potential financial losses among multiple policyholders, investors, companies, organizations or individuals. Risk pooling reduces the overall risk of significant financial loss for a given entity. However, it also reduces the potential gain for the single entity since the rewards must be shared among other parties who bear some of the risk.
Key points to remember
- Risk pooling refers to the sharing of financial costs and risks often required for business between a group of investors or companies.
- The process is designed to limit the extent of financial loss that a particular business could face, and therefore spread that risk across multiple parties.
- However, by taking less risk, the games in question are also primed for less reward, as any advantage must also be shared with the group.
Understanding risk pooling
Risk pooling generally refers to spreading the risk of insurance loss among hundreds or thousands of individual policyholders, but the term can be broadly applied in many other business situations.
Based on the concept of a joint venture, risk pooling is a tool often used in oil exploration, which is a long and expansive process that may not result in a profitable discovery. For example, an energy company’s geological studies suggest that a large deposit of natural gas exists at a certain location. She wants to drill but the financial risk is too high for her alone. The company is therefore looking for a joint venture partner to assume half the risk in exchange for half the potential rewards if their exploration is successful.
Pooling of risk arises from a joint venture business agreement, in which two or more parties agree to work together and combine their resources to complete a task or develop a new product or business.
Examples of risk pooling
Here are other examples of risk pooling applied to different industries.
A corporate bank won the lead role to underwrite a term loan for a company. The loan is too large for the bank to place on its own books, so it forms a syndicate in which several other banks agree to extend part of the total credit to the customer. Each syndicate member now has some exposure to term loan risk.
A property and casualty insurance company wishes to purchase a policy that would cover major property losses due to a natural disaster. He approaches a reinsurance company share some of the risk. The reinsurer accepts some transfer of risk in exchange for bonus payments with the main insurer.
A venture capitalist plans to finance a start. However, due to the high failure rates of start-ups, she does not want to invest too much on her own. He persuades other venture capitalists to participate in the deal to spread the risk.
An investment bank wants to buy a struggling financial institution. He covets the target’s assets but dislikes the extent of his passive. The investment bank seeks to pool risk with the federal government for liabilities. The government agrees to guarantee the bank’s potential losses.