A risk pool is one of the forms of risk management mostly practiced by insurance companies. Under this system, insurance companies come together to form a pool, which can provide protection to insurance companies against catastrophic risks such as floods, earthquakes etc. The term is also used to describe the pooling of similar risks that underlies the concept of insurance. While risk pooling is necessary for insurance to work, not all risks can be effectively pooled. In particular, it is difficult to pool dissimilar risks in a voluntary insurance market, unless there is a subsidy available to encourage participation.
Risk pooling is an important concept in supply chain management. Risk pooling suggests that demand variability is reduced if one aggregates demand across locations because as demand is aggregated across different locations, it becomes more likely that high demand from one customer will be offset by low demand from another. This reduction in variability allows a decrease in safety stock and therefore reduces average inventory.
For example: in the centralized distribution system, the warehouse serves all customers, which leads to a reduction in variability measured by either the standard deviation or the coefficient of variation.
The three critical points to risk pooling are:
- Centralized inventory saves safety stock and average inventory in the system.
- When demands from markets are negatively correlated, the higher the coefficient of variation, the greater the benefit obtained from centralized systems; that is, the greater the benefit from risk pooling.
- The benefits from risk pooling depend directly on the relative market behavior. This is explained as follows: If we compare two markets and when demand from both markets are more or less than the average demand, we say that the demands from the market are positively correlated. Thus the benefits derived from risk pooling decreases as the correlation between demands from the two markets becomes more positive.
Intergovernmental risk pools (IRPs) operate under the same general principle, except that they are made up of public entities, such as government agencies. Thus, IRPs provide alternative risk financing and transfer mechanisms to their members, through which particular types of risk are underwritten with contributions (premiums), with losses and expenses shared in agreed ratios. In other words, Intergovernmental Risk Pools are a cooperative group of governmental entities joining together to finance an exposure, liability or risk.