Economic basis of insurance: pooling of risks
However, an insurer could not sensibly take on a liability of £15,000 for a premium of £500 without entering into other similar contracts. From the perspective of the insurer, the mechanism involves not just assumption of risk, but also the reduction and ideally elimination of risk by a process of risk sharing. At its simplest this may involve no more than a group of people collectively agreeing to share each other’s losses. Suppose 1,000 car owners each have a car worth £10,000. If one car is stolen each owner pays £10 rather than one having to pay £10,000 for a new car. If the 1000 car owners agree to put their estimated contributions into a central fund, and from previous experience they estimate that two cars will be stolen in a year then they will each need to pay £20 plus a share of the cost of administering the fund. If three cars are stolen rather than the two they predicted each will have to pay an additional £10. This is in effect a description of the purest form of mutual insurance and some marine insurance is still conducted on this simple basis in Protection and Indemnity Clubs (P & I Clubs) whose membership consists, for example, of UK and foreign ship-owners.