Insurance as a device to manage risk
The true nature of insurance is often confused. The word “insurance” is sometimes applied to a fund that is built up to meet uncertain losses. For example, a specialty store that sells seasonal produce should increase its price at the beginning of the season to create a fund to cover the possibility of losses at the end of the season, when the price must be lowered to clear the market. Similarly, life insurance quotes take into account the price the policy would cost after collecting premiums from other policyholders.
This method of dealing with risk is not insurance. It takes more than the mere accumulation of funds to meet uncertain losses to provide insurance. Sometimes a risk transfer is referred to as insurance. A store that sells televisions promises to repair the set for a year free of charge and replace the picture tube if the glories of the television prove too much for your delicate wiring. The seller may refer to this agreement as an “insurance policy.” It is true that it does represent a transfer of risk, but it is not insurance.
A proper definition of insurance should include both the formation of a fund and the transfer of risk and a combination of a large number of separate and independent loss exposures. Only then is there true insurance. Insurance can be defined as a social device to reduce risk by combining a sufficient number of exposure units so that the loss is predictable.
The predictable loss is then shared proportionally by everyone in the mix. Not only is uncertainty reduced, but losses are shared. These are the important essentials of insurance. A man who owns 10,000 small homes, widely dispersed, is in practically the same situation from an insurance point of view as an insurance company with 10,000 policyholders, each of whom owns a small home.
The first case may be self-insured, while the second represents commercial insurance. From the insured person’s point of view, insurance is a mechanism that allows you to substitute a small, final loss for a large but uncertain loss under an arrangement whereby the lucky ones who escape the loss will help compensate the losers. few unfortunate. who suffer losses.
The law of large numbers
I repeat, insurance reduces risk. Paying a premium on a homeowners insurance policy will reduce the chance that a person will lose their home. At first glance, it may seem strange that a combination of individual risks results in risk reduction. The principle that explains this phenomenon is called in mathematics the “law of large numbers.” It is sometimes loosely called the “law of averages” or the “law of probability.” Actually, it is only part of the probability issue. The latter is not a law at all, but simply a branch of mathematics.
In the seventeenth century, European mathematicians were building crude mortality tables. From these investigations, they found that the percentage of males and females among births each year tended everywhere toward a certain constant if a sufficient number of births were tabulated. In the 19th century, Simeon Denis Poisson gave this principle the name of the “law of large numbers.”
This law is based on the regularity of the occurrence of events, so that what appears to be a random occurrence in the individual happens simply appears so due to insufficient or incomplete knowledge of what is expected to occur. For all practical purposes, the law of large numbers can be stated as follows:
The greater the number of exposures, the closer the actual results obtained will be to the probable result expected with an infinite number of exposures. This means that if you flip a coin a large enough number of times, the results of your attempts will be close to half heads and half tails, the theoretical probability if the coin is tossed an infinite number of times. .
