Takaful - What Is a Smaller Risk Pool and Lack of Diversification?

A smaller pool of risk and lack of diversification are related, but they are not exactly the same thing.

1. Smaller Pool of Risk

• A smaller risk pool means there are fewer risks, fewer participants, or less business being combined together.
• Because the pool is small, one large claim can have a much bigger impact on the fund.

Example

Suppose a Retakaful operator covers only 10 large factories.

• Total Retakaful fund = RM100 million
• One factory suffers a RM30 million loss

That single claim uses:

RM30m ÷ RM100m = 30% of the fund

Now suppose another Retakaful operator covers 1,000 different risks and has a fund of RM2 billion.

A RM30 million claim is much easier to absorb.

Simple Idea

Smaller pool = Fewer risks sharing the burden

Therefore:

One big loss → Bigger impact on the fund

2. Lack of Diversification

• Lack of diversification means the risks in the pool are too similar or too concentrated.
• Even if there are many risks, they may all be exposed to the same event.

Example

A Retakaful operator covers:

• 500 factories
• All located in the same flood-prone area

This is a large number of risks, but the pool is poorly diversified.

If a major flood occurs:

• Many factories may suffer losses at the same time
• The Retakaful operator may receive many large claims together

Simple Idea

Many risks does not automatically mean good diversification

If all the risks are similar:

One event may hit many of them at once

3. Example of Good Diversification

Suppose a Retakaful operator covers:

• Motor risks in Malaysia
• Property risks in Saudi Arabia
• Marine risks in Indonesia
• Family Takaful risks in UAE
• Engineering risks in Turkey

Now a flood in Malaysia may affect some Malaysian property or motor risks, but it is unlikely to affect all the other risks simultaneously.

Simple Idea

Different countries + Different types of risks = Better diversification

4. Smaller Pool vs Poor Diversification

Smaller Pool

• Problem is quantity
• There are too few risks
• One claim represents a large part of the total fund

Poor Diversification

• Problem is concentration
• Risks are too similar
• Many claims may occur from the same event

Example

Small pool but diversified

• 20 risks
• Different countries and industries
• Still small, but not highly concentrated

Large pool but poorly diversified

• 1,000 properties
• All in the same earthquake zone
• Large number, but still dangerous concentration

Why Retakaful Can Face Both Problems

Retakaful may have:

• Fewer Takaful operators contributing risks
• Smaller global business volume
• Large individual risks
• Concentration in particular countries or industries

Therefore:

Small pool + Poor diversification = Greater volatility

Example

A Retakaful operator covers only:

• 15 Takaful companies
• Mostly property risks
• Mostly in one region

A major earthquake occurs.

Several Takaful companies make large claims at the same time.

The Retakaful fund may be severely affected.

Easy Way to Remember

Smaller risk pool

= Not enough risks

Poor diversification

= Risks are too similar or concentrated

Best situation:

Large number of risks + Different types of risks + Different locations = Stronger and more stable pool

Simple Formula

Large Pool + Good Diversification → More Predictable Claims + Lower Volatility + Stronger Retakaful Fund