Massachusetts State Life Insurance Practice Exam

What principle does the Law of Large Numbers rely on in insurance?

1. Higher risk environments

2. The sharing of risks among a large group of people

3. Individual assessments of risk

4. Insuring only high-value assets

The correct answer is: The sharing of risks among a large group of people

The Law of Large Numbers is a fundamental principle in insurance that emphasizes the importance of pooling risks among a large group of individuals. Essentially, it states that as the number of insured participants increases, the actual loss experience will become more predictable and closely align with the expected loss. This is because the uncertainties of individual risks average out, allowing insurers to better estimate potential losses and set appropriate premiums. By sharing risks among many people, insurance companies can smooth out the variability of claims that any single individual might experience. For instance, while one policyholder may face significant losses, others in the pool may not, leading to a situation where the overall impact on the insurance company is manageable. This principle is crucial for the financial viability of insurance operations, as it allows insurers to effectively predict costs and manage their reserve requirements. The other choices do not encapsulate the essence of the Law of Large Numbers. Risk environments, individual assessments, and insuring high-value assets all pertain to aspects of insurance but do not directly reflect the core tenet of fostering predictability through collective risk sharing.