Why is risk pooling essential for the insurance industry to exist?

• A. It ensures that only high-risk individuals are insured, maximizing profits for the industry.
• B. It guarantees that every policyholder will receive a payout regardless of whether a loss occurs.
• C. It enables insurance companies to avoid paying claims by sharing risks with other firms.
• D. It allows insurers to spread the financial impact of individual losses across many policyholders, reducing the risk for each participant.

Answer: (D)

Verified step by step guidance

1. Understand the concept of risk pooling: it involves combining the risks of many individuals into a single group to manage uncertainty more effectively.
2. Recognize that individual losses are unpredictable, but when many policyholders are pooled together, the overall risk becomes more predictable due to the Law of Large Numbers.
3. Explain that by spreading the financial impact of losses across many policyholders, insurers reduce the risk that any single individual or the insurer itself will face a large financial burden.
4. Note that this risk spreading allows insurance companies to set premiums that are fair and sufficient to cover expected losses while remaining affordable to policyholders.
5. Conclude that risk pooling is essential because it makes insurance viable by stabilizing losses and ensuring the insurer can pay claims without facing insolvency.