Pooling Arrangements and Diversification of Risk

Pooling arrangement means sharing loss and risks equally or split evenly any accident costs. As a result pooling arrangements reduce risks (standard deviation) for each participant. In pooling arrangements the average loss is paid by each person.

The probability distribution of accident costs facing each person is reduced by pooling arrangements. The pooling arrangement decreases the probabilities of the extreme outcomes. In pooling arrangements each persons risk is reduced but each persons expected accident cost is unchanged. The whole concept can be shown with this mathematical example:

Suppose, Reza and Fahad each are exposed to the possibility of an accident in the coming year. In particular we assume that each person has a 20 percent chance of an accident that will cause a loss of $2500 and an 80 percent chance of no accident. Because both Reza and Fahad each have a 20 percent chance of having an accident that causes $2500 in losses, the expected costs and the standard deviation for each person without pooling arrangements will be: Expected costs = 0.800 + 0.202500 = $500 Standard deviation = 0.8 (0 - 500) 2 + 0.2( 2500 500) 2 = $1000

Now the probability distribution of accident costs paid by each person with pooling: Possible outcomes 1. Neither Reza nor Fahad has a n accident 2. Reza has an accident, but Fahad does not Total cost 0 $2500 Cost paid by each person (Average loss) 0 $1250 Probability .8.8 = .64 .2.8 = .16

3. Fahad has an $2500 accident but Reza does not 4. Both Reza and Fahad have an accident $5000

$1250

.2 .8 = .16

$2500

.2 .2 = .04

So the standard deviation and expected cost with poling will be, = .64 (0 - 500) 2 + .32 (1250 - 500) 2 + .04 (2500 - 500) 2 = $707

Expected cost = .64 0 + .32 1250 + .04 2500 = $500

The pooling arrangement reduces risks through diversification. In pooling arrangements, the cost has become more predictable. Normally the average loss is much more predictable than each individuals loss.

Pooling arrangement also decreases the additional risks by adding people. By adding more people the probability distribution of each person accident cost will continue to be changed. In all the factors being held constant the risk that can be reduced through pooling arrangement increases as the number of participants increases. In this case the pooling arrangement decreases risk for each participant. The probability distribution would become more and more bell shaped if more participants are added.

To illustrate suppose that Anwar who has the same probability distribution for accident costs as Reza and Fahad joins the pooling arrangements. So at the end of the year each person will pay one third of the total losses (the average loss). The addition of a third person whose losses are independent of the two causes an additional reduction in the probability of extreme outcomes. For example in order for Reza to pay $2500 in accident costs at three individuals must experience a $2500 loss. The probability of this occurring is .2 .2 .2 = .008. As a consequence the standard deviation for each individual decreases with the addition of another participant. While risk (standard deviation) decreases, each individuals expected accident cost again remains constant at $500.

The pooling arrangement has two important effects on the probability distribution of the costs paid by each participant if the losses are independent. First, the standard deviation of the average loss is decreased. Second, the distribution of average losses becomes more bell shaped. Here, an exception can occur if a participant added with a very high standard deviation of losses. Than participants with different expected losses may be unwilling to share losses equally. At this reason insurers charge people with different expected losses with different premiums.

The law of large numbers and the central limit theorem area two important theorems from the probability theory. It measures the effects of pooling arrangements on probability distribution. The law of large numbers states that as the number of participants get large the average outcome is likely to get very close to the expected value. In the central limit theorem, when the number of participants gets large, the distribution of the average outcome becomes more symmetric and bell shaped.

Now we will examine risk reduction through pooling if losses are positively correlated. Pooling arrangements decreases the standard deviation for each participant, provided losses are not perfectly positively correlated. The magnitude of the risk reduction is lower when losses are positively correlated than when they are independent. The reason for that the occurrence for losses is often due to events that are common to many people at the same time. Hurricanes and earthquakes are the examples of that kind of situation. So the pooling arrangements do not decrease the standard deviation of average losses as much when losses are positively correlated. Stated differently average losses are more difficult to predict when losses are positively correlated.

If we consider our previous example regarding Reza and Fahad, the accident costs were implying that the probability of both people having an accident will be greater than .04. Similarly positive correlation implies that the probability of neither woman having an accident will also be greater than .64.

So as whole, the amount of risk (standard deviation) cannot be reduced as much by adding participants when losses are positively correlated, the greater the degree of correlation the less is the reduction in risk.

There are lots of costs regarding the pooling arrangements. The first one is the distribution costs which occur due to the marketing and specifying in terms of agreements. The costs which incur because of the identification of potential participants expected loss is known as underwriting. The prevent people from fraudulently claiming a loss the company has to maintain some services which are incurred as loss adjustment expenses.

We know that individuals and businesses decrease their risk by pooling arrangements but pooling arrangement is also expensive to operate. As a result insurance companies exist in the market and most of the pooling arrangements take place in directly through insurance.

Except pooling arrangement there are lots of other ways that people and business diversify their risks. Like insurance contracts, stock markets etc.

At last we can say that by entering into a pooling arrangement a person pays the average loss of the members of the group as opposed to his or her own losses. Always, the average risk is more predictable than an individuals risk. But the pooling arrangement does not change the expected loss of the participants. So the beauty of risk pooling arrangements is that the risk can be reduced substantially for the participants.