The true nature of insurance is often confused. The word “insurance” is sometimes applied to a fund that is built up to cover uncertain losses. For example, a specialty store that trades seasonal products must raise its price early in the season to build a fund to cover the possibility of a loss at the end of the season, when the price must be lowered to clear the market. . Likewise, life insurance quotes take into account the price the policy would cost after collecting premiums from other policyholders.
This way of covering a risk is not insurance. Forming insurance requires more than just the accumulation of funds to absorb uncertain losses. A transfer of risk is sometimes referred to as insurance. A store that sells television sets promises to service the set for free for a year and replace the picture tube if the television’s glory proves too much for its delicate wiring. The seller may refer to this agreement as an “insurance policy.” It is true that it is a transfer of risk, but it is not insurance.
An adequate definition of insurance should include both fund building or risk transfer and a combination of a large number of separate, independent exposures to loss. Only then will there be real insurance. Insurance can be defined as a social tool to reduce risk by combining a sufficient number of exposure units to make the loss predictable.
The predictable loss is then shared proportionally by everyone in the combination. Not only is the uncertainty reduced, but the losses are shared. These are the most important things about insurance. A man who owns 10,000 small homes, widely distributed, is in almost the same position from an insurance standpoint as an insurance company with 10,000 policyholders each owning a small home.
The former case may be a subject for self-insurance, while the latter is a commercial insurance. From the point of view of the individual insured, insurance is a means of replacing a small, final loss with a large but uncertain loss under an arrangement whereby the fortunate who escape loss will help the unfortunate few. compensate those who suffer loss.
The law of large numbers
Again, insurance reduces the risk. Paying premiums for homeowners insurance reduces the likelihood of a person losing their home. At first glance, it may seem strange that a combination of individual risks would lead to risk reduction. The principle that explains this phenomenon is called the “law of large numbers” in mathematics. It is sometimes loosely referred to as the “law of means” or the “law of probability.” Actually, it’s only part of the subject of probability. The latter is not a law at all, but just a branch of mathematics.
In the seventeenth century, European mathematicians constructed crude mortality tables. From these studies, they found that the percentage of males and females among the births of each year tended to a certain constant everywhere if sufficient numbers of births were tabulated. In the nineteenth century, Simeon Denis Poisson called this principle the ‘law of large numbers’.
This law is based on the regularity of the occurrence of events, so that what appears random in the individual happening simply appears so because of insufficient or incomplete knowledge of what is expected to happen. For all practical purposes, the law of large numbers can be expressed as follows:
The greater the number of shots, the closer the actual results obtained will be to the likely result expected from an infinite number of shots. This means that if you flip a coin a sufficient number of times, the results of your trials approach half a head and half a tail, the theoretical probability of flipping the coin an infinite number of times.