The law or large numbers is a statistical principal relating the accuracy of a past observed probability of an event taking place being able to predict a future probability of the same event. This law is used in the life insurance industry to predict the likely amount of deaths that will be observed in any given time period, for a given pool of people. The larger the pool of people in a sample, the higher the accuracy that the probability of an event taking place can be predicted. 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.
Extremely Important Repercussions To Life Insurance Industry
If the law of large numbers did not hold true, the life insurance industry could not possibly exists. Life insurance works because companies can predict with high statistical accuracy the amount of deaths that are likely to occur each year from their insured clients. 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. 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 amount of insurance policies written are also term life, which by definition will not be in force until the end of most insured person’s lives.
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, 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 amount 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 persons risk is of utmost important to underwriters because it increases the odds that the mortality table statistics will hold true for each underwriting class.