Last week we looked at insurance as part of your investment strategies. This week we will talk about the concept of risk-pooling and the financial leverage gained from the prudent use of insurance products.

The idea that 'a burden shared is a burden' lessened is the basic concept behind insurance. It is premised on sharing or pooling a risk. Everyone puts something in the pool to help out when one of us is in need. Of course the actual design and implementation of insurance and reinsurance products is much more complex.

There is a simple tool for you to use in deciding about the use of insurance in your financial plan. It's called a decision matrix, with the magnitude of the financial impact and the likely frequency of any risk occurrence.

Basically, a low-magnitude low-frequency risk is unlikely to affect your financial wherewithal, so is not insured. Whereas a low-magnitude high-frequency risk can be self -insured, by covering them out of your pocket or in combination with insurance. Health insurance for doctors visits and medicines are in this category.

A high-magnitude low-frequency event is the prime candidate for insurance. This is where you benefit from risk-pooling. A costly event may happen to someone, but it is not likely to happen to everyone.

Here we are talking about a critical illness or a house fire. The last category is a high-magnitude high-frequency event. It may surprise you that is group is not insurable. The burden cannot be adequately shared.

The best bet here is avoidance or mitigation to manage the risk. Examples here include sky-diving or climbing Mount Everest. Either don't attempt it or if you do plan very carefully.

Planning to have sufficient assets over your lifetime may seem like climbing a mountain. That is why you need a plan. You can save and invest cautiously.

That is a big step. But there are ways to leverage your investments toward your financial security. The concept of risk-pooling comes in play here as well when you consider longevity. For how long will you need to support your self in retirement?

Not everyone will live till 100. Some people pass when they are young. And most of us will see 80 years of age. If everyone put a penny in the pool as if we live until our eighties, the amount could cover all of us.

This is a broad exaggeration, but is the basis of the work of an insurance actuary. They assess longevity, the likely income required, and the target rate of return on investments. That is used to develop premium rates, which are spread over a large number of policies.

Last week we have talked about types of life insurance to cover income to support families or final expenses when someone passes-away. By spreading the pool of money from all the policies written, means that one individual is not out-of-pocket for the whole amount.

This is leverage. You can be saving for emergencies or a future retirement, but what if something happens and you cannot work. It is unlikely, but who will pick-up the slack?

Insurance will make up the difference. Or you may save meticulously to have income until you are in your eighties. But what if you exceed the average and live until you are 100?

A life-annuity policy would provide coverage. These are examples of leverage.

Why is it financial leverage? Because in theory if you end up drawing on the benefits you might receive more than you paid in. Of course there are others on the other side of the coin who pay in more than they receive from a policy, but they off-set a potential financial risk instead.

Here is a very simple example of the leverage on the upside. You buy a life annuity for $500,000 to receive $2,500 a month for life.

The actuaries calculate the average life span is 82 years, whereas you live until the good age of 95.

In this event, the policy would pay out $900,000 even though you paid $500,000.

That would 1.8 times leverage. Of course the insurance company would not be in business if everyone gained like this.

It is a sharing of the longevity risk for the insurance point of view. Some people live longer than average, whilst a balancing number are not so lucky.

This type of leverage is evident again and again in insurance. The objective however is not to anticipate a financial gain from buying insurance.

That is not the purpose. The intent is to guard against the downside risk. The intent is to transfer the risk to a pool that spreads the risk amongst a larger number of people.

By paying a premium you then avoid a potentially damaging financial risk.

Patrice Horner holds an MBA in Finance, a FINRA Series 7 License, and is a Certified Financial Planner (CFP-US). Any opinions expressed in this article are not specific recommendations, nor endorsements of any productions. Individuals should consult with their banker, insurance agent, lawyer, accountant, or a financial planner for advice to address their personal situations.