What is the concept of 'risk pooling' in insurance?

The concept of 'risk pooling' in insurance refers to the practice of combining the risks of multiple policyholders to create a larger pool, which allows the insurer to provide financial protection more effectively. When individuals or entities contribute to this pool by paying premiums, they collectively share the financial burden of losses that may occur. This collective approach means that when a loss occurs, the funds collected from all participants in the pool can be used to cover that loss, thus spreading the risk more widely.

Risk pooling is fundamental to the functioning of insurance because it enables insurers to predict losses more accurately and stabilize their financial position. By having a broader base of policyholders, an insurer can calculate expected losses, allowing them to maintain sustainability even if some policyholders experience losses.

The other provided choices illustrate different aspects of insurance but do not encapsulate the essence of risk pooling. Charging higher premiums for high-risk individuals relates to underwriting, while analyzing and categorizing risks pertains more to risk assessment practices. Diversifying investments is a strategy for managing an insurance company's overall financial health but is separate from the concept of risk pooling itself.