The true nature of insurance is often confused. The word “insurance” is sometimes applied to a fund that is accumulated to cover uncertain losses. For example, a specialty store that sells seasonal items must increase its price early in the season to create a fund to cover the possibility of losses at the end of the season, when the price must fall 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 just accumulating funds to meet uncertain losses to build insurance. Risk transfer is sometimes referred to as insurance. A store that sells televisions promises to repair the television for a year free of charge and to replace the picture tube if the glories of 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.
An adequate definition of insurance must include both the formation of a fund or the transfer of risk and a combination of a large number of separate and independent exposures to loss. 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 among 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, widely scattered houses is in almost the same position from the point of view of insurance as an insurance company with 10,000 policyholders, each of whom owns a small house.
The first case can be subject to self-insurance, while the second represents commercial insurance. From the point of view of the insured person, insurance is a device that enables him to substitute a large but uncertain loss for a small and definite loss, under an arrangement in which the many lucky ones who escape loss will help to compensate to the unfortunate few. who suffer loss.
The Law of Large Numbers
To repeat, insurance reduces risk. Paying a premium on a homeowners insurance policy will reduce a person’s chance of losing their home. At first glance, it may seem strange that a combination of individual risks results in reduced risk. The principle that explains this phenomenon is called in mathematics the “law of large numbers.” It is sometimes loosely known as the “law of averages” or the “law of probability.” Actually, it is only a part of the subject of probability. The latter is not a law at all, but simply a branch of mathematics.
In the 17th century, European mathematicians were constructing crude mortality tables. From these investigations they found that the percentage of male and female births in each year tended everywhere toward a certain constant if a sufficient number of births were tabulated. In the 19th century, Simeon Denis Poisson called this principle the “law of large numbers.”
This law is based on the regularity of the occurrence of events, such that what appears to be a random occurrence in the individual 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 toss 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.