Question

The Law of Large Numbers is important to the successful operation of the insurance mechanism because:

a. The probability of occurrence of loss declines as the number of exposure units increases.
b. It permits individuals to estimate whether or not a given loss might happen to them.
c. It prevents too many insurance companies from being formed.
d. Past experiences may be used as an indication of probable results in the future.

Answer 1

The correct answer is d: Past experiences may be used as an indication of probable results in the future. The Law of Large Numbers enables insurers to predict and cover losses more accurately, justifying the collected premiums based on past data.

Step-by-step explanation:

The Law of Large Numbers is crucial to the operation of the insurance industry because it allows insurers to predict losses more accurately over time. The correct answer to the student's question is option d: Past experiences may be used as an indication of probable results in the future. This principle underpins the insurance business model where large numbers of policyholders contribute premiums into a pool from which claims are paid out. As the number of exposure units (policyholders) increases, the insurer's ability to estimate future claims becomes more precise due to the average loss approximating the expected loss more closely.

This law also implies that with large sample sizes, the relative frequency of claims will converge on the theoretical probability, thus allowing insurers to set premiums that cover the average person's claims, operating costs, and still leave room for profits. In other words, it ensures that the collected premiums are adequate to compensate the few who are hit by the risk insured against, without being exorbitant for all the insured.