Alone, no one can bear the risk of a fire or a shipwreck. Shared among many, the misfortune becomes bearable: that is risk pooling. But once the risk is pooled, someone holds it, and the whole promise depends on their ability to pay when the day comes. That is counterparty risk.
1 What is risk pooling?
Sharing among many a hazard none would carry alone.
Definition
Diluting misfortune in numbers
To pool risk is to combine the premiums of a large group in order to compensate the few struck by a loss. The risk does not vanish, it dilutes: what would ruin one person becomes a light charge spread over thousands of shoulders. It is the founding principle of all insurance.
2 The law of large numbers
Why it works, on one condition.
Uncertainty becomes forecast
Chance observed over a crowd
No one knows whether a given house will burn, but across a hundred thousand houses, one knows how many will burn in a year. The larger the group, the more reliable the forecast: individual uncertainty turns into collective near-certainty. The hidden condition is that losses be independent, unrelated to one another.
3 Counterparty risk
Once pooled, the risk is held by someone. Can they pay?
A promise is only as good as the one who holds it
The risk you transfer to the insurer, the insurer passes part of it to the reinsurer, who passes it to the capital markets. At each link, a promise to pay. Counterparty risk is the risk that one of these links defaults at the worst moment. A claim payment is never sturdier than the counterparty that must make it.
4 When risk becomes correlated
When pooling and counterparty are tested at once.
Correlation, the enemy of insurance
①
Independent losses dilute. An isolated fire is absorbed easily by the mass of premiums.
②
Correlated losses add up. A catastrophe strikes thousands of policyholders on the same day: there are no longer enough spared to pay the stricken.
③
The counterparty is put to the test. It is precisely when everyone claims at once that one finds out whether the link can keep its promise.
5 Takeaways
A few sentences to remember.
✓
Pooling dilutes a risk among many; it does not vanish, its holder changes.
✓
Pooling assumes independent losses; correlated risk defeats it.
✓
Counterparty risk is that the link meant to pay defaults, above all when losses strike together.
This notion illuminates an analysis
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Insurers in retreat, where risk migrates from the insurer to the financial markets, then to the taxpayer.