How do insurance companies manage the risk of paying out claims?

Insurance companies manage the risk of paying out claims primarily through the pooling of risks. This concept involves gathering a large group of individuals or entities who pay premiums into a fund. When any one individual experiences a loss, the claims are paid out of this collective fund. By spreading the financial risk across many policyholders, companies can ensure that the overall risk is manageable, as not all policyholders will file claims at the same time.

Pooling of risks allows insurance companies to statistically predict losses and set premiums appropriately based on the likelihood of claims. This process enhances the stability and predictability of their financial performance, making it possible for companies to meet their obligations to policyholders while remaining financially viable. Additionally, this approach allows for more affordable coverage options for individuals, as the costs of claims are distributed among many rather than falling solely on one person or business.

In contrast, simply rejecting all claims would undermine the purpose of insurance, and only covering high-risk individuals or raising premiums indiscriminately could lead to unmet needs for coverage and a lack of affordable options for many potential customers.