How does an insurance company spread the cost of possible losses?

An insurance company spreads the cost of possible losses primarily through premiums paid by many individuals. This practice is rooted in the principle of risk pooling, where the insurer collects premiums from numerous policyholders. This collective pool of funds is used to pay for the claims made by a relatively smaller number of policyholders who experience losses. Since not all policyholders will experience losses at the same time, the insurance company can manage risks more effectively and ensure that it has enough resources to cover claims.

By having a diverse group of insured individuals, the range of potential losses is broadened, which helps stabilize the financial position of the insurer. This is crucial for maintaining the company's solvency and ensuring that it can meet its obligations to policyholders. In contrast, options that discuss only investing in specific assets, focusing on high-risk clients, or limiting coverage do not effectively address the fundamental mechanism through which insurers manage risk and costs.