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Pooling and Insurance

While both risk management and insurance and finance treat diversification of risk through risk pooling as a central concept, the approach to pooling taken by risk management and insurance has several key distinctions that include:

  • Risk management and insurance focuses on non-systematic risks that can reduce business value;
  • Most risk management and insurance risks are not amenable to cost effective hedging in financial markets; and
  • Behavioral responses to pooling, including adverse selection and moral hazard, are a central aspect of the risk management and insurance discipline and of the institutions that have been developed to pool risk.

Finance tends to focus on risks that are either related to market movements (so called “systematic” risks) or subject to hedging.  Asset pricing models in finance rely upon the distinction between systematic risk and non-systematic risk (also known as “idiosyncratic” risks) with the purpose of pricing systematic risk.

More recently, finance has devoted considerable attention to the management of certain types of non-systematic risk through hedging in financial markets.  While these risks can be reduced from the perspective of shareholders through portfolio diversification, such risks nonetheless can significantly affect business value through their adverse affects on business and contractual relationships (e.g., customers, suppliers, and vendors) and on investment decisions.

In contrast, risk management and insurance focuses on non-systematic risks that are not generally hedgeable (e.g., most risks of property damage and legal liability).  Risk management and insurance, therefore, addresses many risks of critical concern which finance tends not to address.

Furthermore, risk management and insurance involves risks that are more readily amenable to loss control.  A risk and insurance analyst will develop action plans that can reduce fluctuations in loss-producing outcomes.  For example, loss prevention or loss mitigation programs might include implementation of training programs that reduce back injuries; building of levees, which hold flood water away from structures; or establishing testing programs that will reduce the likelihood of injury from use of a product.  These are actions that can reduce the expected value and/or variability of loss.

Risk management and insurance addresses the possibilities that behavioral outcomes may be altered and exacerbated in risk pooling arrangements.  As a result, the problems of adverse selection and moral hazard are pervasive in risk management and insurance and have major effects on the design of risk pooling arrangements.  While finance appreciates these problems, their impact on hedging arrangements is limited.

More generally, a basic understanding of risk pooling is fundamental to how businesses deal with risk and enhances general business literacy.  Such an understanding includes (1) the economics of risk pooling arrangements, (2) the limitations of risk pooling arrangements, (3) the effects of those limitations on the development of alternative loss financing arrangements, and (4) how these arrangements relate to portfolio diversification and hedging.