The law of large numbers is a statistical principle that stipulates that if you have a large enough group that you are predicting an outcome for, you are almost certain of experiencing the expected result. The fact that this law holds true is critical to the foundation of life insurance. This makes life insurance affordable for each insured person so that the payouts can be so high when someone dies. Given a large enough group of insured people, a life insurance company can accurately predict how many from the group will die each year.
The larger the pool of people, the higher the accuracy of the prediction. Because life insurance deals with a very large group of clients, and data exists for so much of the population of those living in the United States of America, the law of large numbers can be used by insurance companies to predict the amount they will need to pay out in death claims each year. This allows companies to accurately price insurance policies and commit money to reserves so they will always have enough to make good on all claim payments.
Life insurance companies employ teams of actuaries because each client has her own health rating, age, and death benefit. In addition, life expectancies are constantly changing overall and for specific medical concerns as new treatments are invented. Having enough of each type of client risk profile to reap the predictability of the law of large numbers is important, as is not concentrating their risk in any one area too much. The actuaries’ predictions are the basis for pricing life insurance policies.
Extremely Important Repercussions To Life Insurance Industry
If the law of large numbers did not hold true the life insurance industry could not possibly exist. Life insurance works because companies can predict with high statistical accuracy the number of deaths that are likely to occur each year from their client base. This allows the insurance company to price a life insurance policy knowing that while a large pool of people will pay money for their insurance every year, only a relatively small amount will actually have death claims. Overall, they will need to pay out a lesser amount of money in death claims than the premiums they collect in payments. Without predictability as to the rate of death amongst clients, life insurance companies would have no way to price their insurance in a way that was both fair to clients and would cover all costs. They also would not know how much money would need to be committed to reserves and how much could be redistributed as dividends to policy owners.
Definite Risk And Amount
Life insurance works because the risk is quantified. Some may wonder how, when 100% of people are guaranteed to die, life insurance companies can possibly stay in business in the long run. The answer lies in the long-term value of insurance premiums paid to the insurance company, the fact that many policy owners will not hold a policy for their entire lives, and that a large number of insurance policies written are term life policies, which by definition will expire.
A life insurance company can predict the amount of money they will receive on average from a pool of clients, the life expectancy of the group, the rate of death amongst them, and the approximate rate of return they will achieve from the premium payments made. They also know the exact amount at risk for each policy because each policy has a face amount. By quantifying the risk exactly with the law of large numbers, the insurance company has the elements it needs to provide insurance and for its business to exist. A life insurance company can also calculate the approximate rate of return that they will receive on their own investments. This allows the life insurance company to charge enough so that with the time value of their investments, they will make money.
To quantify the risk of a certain risk class passing away, or to be more exact to estimate the number of people of a certain age and certain risk class who will die each year, a life insurance company will use mortality tables, alternately known as morbidity tables. These tables give the exact percentage chance that someone will die in a given year. Underwriters and risk planners use these tables with information about current clients and face values of outstanding contracts to estimate how much the company will be obligated to pay out in claims to beneficiaries in a given year. This allows the company to plan premium amounts, dividend payments to whole life owners, and the amount of substandard risk (if any) a company is willing to bear. Accurately classifying a person’s risk is of utmost importance to underwriters because it increases the odds that the mortality table statistics will hold true for each underwriting class.