Individuals can implement numerous different risk management strategies to combat the issue of risk. Because people are generally risk averse (discussed below), one of the most common risk management strategies are risk pooling. Risk pooling is a strategy that allows a large group of people to all bear a small percentage of the cost of a negative consequence that happens to any member of the group. By agreeing to bear a portion of the cost, all participating members protect themselves from bearing the full cost in the event that the negative consequence happens to them.
This is the basic principle behind insurance. For example, consider the risk of a house fire and the risk pooling offered by home owners insurance. In 2012 there were approximately 365 thousand house fires resulting in $5.7 billion of damage. If each of the 365 thousand homeowners whose houses were involved in a house fire had to pay for his damages individually, the average coast would be just over $15 thousand per incidence. However, if all homeowners grouped together to bear the cost of damages, the impact for each homeowner would be much smaller. There are approximately 125 million homes in the U.S. The cost of $5.7 billion split evenly between all of these homeowners would be $45.60. This is the advantage of spreading risk over a large consumer base.
A key characteristic that helps risk pooling, and thus insurance markets, function is risk aversion. Risk aversion is a concept used in behavioral economics to describe people’s preference for certainty. In general, when people are faced with the choice between two outcomes—one with a high degree of certainty and low cost and the other a low degree of certainty but high cost—they place greater value on the certainty of the outcome than on the expected cost of their decision. People will often choose the outcome with a high certainty even if this outcome has higher expected costs. The greater the individual’s risk aversion, the more cost they are willing to take on in exchange for greater certainty.
Using the example mentioned above, homeowners are faced with the option of purchasing insurance or opting out. If they purchase insurance they have a 100 percent chance of paying $45.60. If they opt out of insurance they have a 0.3 percent chance (found by dividing the number of homes that were involved in a house fire by the total number of homes, 365,000/125,000,000) of paying $15 thousand. The expected costs are similar in either equation. (The expected cost is calculated by multiplying the probability of the outcome occurring by the cost of the outcome. $45.60 * 100% = $45.60. $15,000 * .3% = $45.00.) Given the choice between these two options, risk aversion leads people to purchase insurance because it is the more certain outcome. But the risk aversion principle suggests that people would be willing to pay even more than $45.60 in exchange for the certainty that insurance provides. How much more an individual would be willing to pay depends on how risk averse that individual is.
Insurance companies have overhead costs of administering policies. In order to pay for these overhead costs and still have enough money to pay for claims, insurance companies must charge premiums that are higher than the expected costs of claims. Because of risk aversion, insurance companies can charge these higher rates and people are still willing to purchase insurance.