Definition
The term risk pooling institution refers to an organization that provides a service, while at the same time spreading financial risk among a large number of entities. Insurance companies are considered risk pooling institutions.
Explanation
Risk pooling is the concept that a financial institution can lower the probability of a catastrophic financial event by aggregating customers across many different dimensions. That is to say, risk can be reduced if the operating characteristics of the entities in their portfolio are diverse.
The insurance industry is founded on the concept of risk pooling. The insurer collects premiums from a large number of customers. While some of these companies will experience a covered event, it's very likely the expense associated with these claims will be offset by the premiums collected from those customers not eligible to file a claim.
As is the case with the insurance industry, risk pooling institutions can only spread the financial risk among a larger number of customers if they do not share the same operating characteristics. For example, claims associated with damage from a coastal hurricane are offset by the premiums collected from customers living in inland communities.
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