Financial Counseling Certification Program (FiCEP) Practice Exam

By pooling risk, how do insurers manage their financial exposure?

1. They spread risk over a larger group to minimize loss

2. They increase premiums on high-risk individuals

3. They limit the number of claims paid out

4. They cover only low-risk individuals

The correct answer is: They spread risk over a larger group to minimize loss

Pooling risk is a fundamental principle in the insurance industry that enables insurers to manage their financial exposure effectively. By spreading risk across a larger group of policyholders, insurers can minimize potential losses that may arise from claims. This collective approach allows them to predict the overall risk more accurately and set premiums based on the average risk profile of the entire group, rather than individual high-risk cases. When an insurer pools risk, the theory is based on the law of large numbers, which suggests that as the number of insured entities increases, the actual losses will tend to converge with the expected losses. Thus, by having a diverse pool that includes both high-risk and low-risk individuals, the financial impact of any single claim is diluted over many policyholders. This strategy helps stabilize the insurer's financial position and ensures that they can cover losses while remaining solvent. The other options present strategies that are related to managing risk but don't encapsulate the primary function of pooling risk effectively. Increasing premiums on high-risk individuals can help manage individual coverage costs but does not utilize the benefit of pooling. Limiting the number of claims paid out could lead to policyholder dissatisfaction and a breach of trust, while only covering low-risk individuals would restrict the insurance pool, eliminating the potential for risk spreading.