What Is Transfer?

The second component of the insurance mechanism is transfer. The financial consequences of unanticipated events can be transferred to an insurer, thus reducing the uncertainty associated with these costs. For example, if Juan has an insurance policy that covers property damage to his home, he has to budget for the insurance premium, but not for the full cost of rebuilding his house (which would be unreasonable).

What Is Pooling?

The third component of the insurance mechanism is pooling. Insurers combine all of the premiums collected from customers into a fund that is used to pay losses as they occur. Pooling means that all insureds share the costs of each other's losses, which, in turn, means that premiums are relatively small.

Here is an example of how pooling works. Frank has just purchased a new car and is concerned that an auto accident could cause a large financial loss for him (risk). Frank pays Insurance Company $1,500 to insure his car for one year (transfer). Fortunately, Frank has no accidents during the year.

Karla pays Insurance Company $1,700 to insure her car for one year. During a rainstorm that year, Karla's car skids into another vehicle, and Karla is injured. Insurance Company pays $7,450 to repair her car, $8,300 to repair the other car, and $9,000 for Karla's medical bills. Karla's insurer can pay this loss because it has collected adequate premiums from Frank and many other insureds who did not have losses (pooling).

Frank, Karla, and all of the other insureds were willing to pay a premium to transfer their risk to the insurer. In effect, all of the premiums went into a pool from which Karla's loss was paid. In other words, Frank and others shared the cost of Karla's loss.

Some people may think, "Didn't Frank waste $1,500 by insuring his car when he didn't have any losses?" But the answer is no. For one thing, Frank is probably legally obligated to have auto insurance. Purchasing auto insurance also gives Frank more freedom with his finances (because he's not worried about replacing his car or being sued), and it may give him an incentive to be a better driver to achieve a lower premium.

It's important to remember that insurance benefits not only those whose losses it pays but also society as a whole.