The Organizational Economics of Risk Pooling

Abstract

The need to share or pool risk is an important economic determinant of cooperation among firms, but the economic theory of risk pooling has been clouded by an error made in a seminal paper in the 1960s. Even into this decade, writers on risk and insurance have asserted that the market mechanism cannot bring a risk pool to an economically efficient outcome, concluding therefore that the risk pool must be analyzed as an n-person cooperative game. This paper describes clearly the economic structure of a risk pool and shows how the market mechanism can function to solve the organizational problem of a risk pool. This analysis reveals a twin interpretation of risk pooling, both as a competitive market and as a centrally administered cooperative organization. One significant feature of organized risk pooling is that the centralized solution is not incentive compatible, meaning that self-interested participants could misrepresent their attitude toward risk and skew the allocation of risk in their favor. However, there are economic conditions that mitigate the incentive incompatibility and tend to restore efficiency to the centralized pooling solution.