Insurance’s true nature is often misunderstood. Sometimes, insurance is used to describe a fund that is built up to cover uncertain losses. A specialty shop that sells seasonal goods may increase its price in order to create a fund that can cover losses at the end of the season. The price must then be decreased to clear the market. Life insurance quotes also consider the cost of the policy after paying premiums from other policyholders.
This is not insurance. Insurance is more than just the accumulation of funds to cover uncertain losses. Insurance is often defined as a transfer of risk. A retailer selling television sets will guarantee to service your set for one-year free of charge, and replace the picture tube if the television’s delicate wiring is damaged by the glory of television. This agreement may be called an “insurance policy” by the salesman. Although it is true that the agreement transfers risk, it is not insurance.
A proper definition of insurance must include the building up of a fund, the transference risk, and the combination of many separate, independent losses. True insurance can only exist if these two elements are combined. Insurance can be described as a social device that reduces risk by adding enough exposure units to make loss predictable.
All members of the group share in the predictable loss. Uncertainty is reduced and losses are shared. These are the essential elements of insurance. A man with 10,000 small dwellings scattered around the country is almost in the same place as an insurance company that has 10,000 policyholders.
While self-insurance may be available in the former, commercial insurance is available in the latter. Insurance is an instrument that allows the insured to replace a small, definite loss with a larger, uncertain loss. This arrangement will allow the lucky few to offset the loss.
The Law of Large Numbers
Insurance reduces risk. A premium on a homeowners insurance policy will lower the likelihood that an individual will lose their house. It may seem odd that risk reduction could be achieved by combining individual risks. This phenomenon is explained mathematically by the “law of large number”. Sometimes it is referred to loosely as the “law on averages” or “law of probabilities.” It is only one part of the subject matter of probability. This is not a law, but a part of mathematics.
European mathematicians created crude mortality tables in the seventeenth century. These investigations revealed that the percentage of males in each year’s births tends to be constant if enough births are tabulated. Simeon Denis Poisson, a nineteenth-century mathematician, gave this principle the title “law of large number”.
This law relies on the regularity in the occurrence of events. What seems random in an individual’s happening is simply due to insufficient or incomplete information about what is expected. The law of large numbers can be described as follows:
The more exposures you have, the closer the actual results will be to the expected result with infinite exposures. If you flip a coin enough times, your results will be close to one-half heads or one-half tails. This is the theoretical probability of the coin being flipped infinitely many times.