Louisiana P&C Adjuster Practice Exam

What does the law of large numbers state in the context of insurance?

1. Higher premiums lead to lower claims

2. Insuring fewer units increases accuracy

3. Insuring a greater number of units increases the accuracy of loss predictions

4. Claims are reduced with increased insured units

The correct answer is: Insuring a greater number of units increases the accuracy of loss predictions

The law of large numbers is a fundamental principle in the context of insurance that indicates as the number of exposure units increases, the predicted outcomes, particularly regarding losses, become more stable and reliable. This principle is critical for insurers because it allows them to estimate future claims more accurately. When an insurance company insures a greater number of units—such as homes, cars, or lives—it gathers a large sample of data from which it can derive statistical averages. This large sample size helps to smooth out individual variations in claim occurrences, making it easier to predict total losses and set premiums according to actual risk rather than speculative estimates. Consequently, the accuracy of loss predictions improves as insurers can rely on historical data to model the likelihood of future claims. By understanding the law of large numbers, insurers can manage risk more effectively, ensuring that they collect enough premiums to cover the expected losses while remaining financially stable and able to pay claims. This principle is why diversified portfolios of insurance policies are beneficial in the industry.