The Law of Large Numbers It is a statistical principle that states that if you have a large enough group to expect an outcome from, you are almost certain to experience the expected outcome. The fact that this law is true is critical to establishing life insurance. This makes life insurance so affordable for everyone insured that payments can be very high when someone dies. Given a large enough group of insured people, a life insurance company can accurately predict how many of the group die each year.
The more people, the more accurate the prediction. Because life insurance deals with a very large group of clients, and data exists for much of the population living in the USA, insurance companies can use the Law of Large Numbers to predict how much they will need to pay in death claims each year. This allows companies to set insurance policy rates accurately and allocate funds to reserves so that they always have enough to meet all claims payments.
Life insurance companies employ teams of actuaries because each client has their own health rating, age, and death benefits. Additionally, life expectancy is constantly changing in general and for specific medical concerns as new treatments are invented. It is important to have enough of each type of client risk profile to reap the predictability of the law of large numbers, as their risk is not concentrated in any one area too much. Forecasts of actuaries are the basis for pricing life insurance policies.
Critical implications for the life insurance industry
If the Law of Large Numbers were not true, the life insurance industry would not 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 customer base. This allows an insurer to price a life insurance policy knowing that while a large group of people will pay money for their insurance each year, only a relatively small amount will actually have death claims. Generally, they will need to pay less in death claims than the premiums they collect in payments. Without the ability to predict mortality among clients, life insurance companies would have no way of pricing their insurance in a way that is fair to clients and covers all costs. Nor will they know how much money should be set aside for reserves and how much can be redistributed as dividends to policy owners.
Specific risks and amount
Life insurance works because the risks are quantified. Some may wonder how life insurance companies can survive in the long term when 100% of people are guaranteed to die. The answer lies in the long-term value of the premiums paid to the insurance company, the fact that many policyholders will not hold an insurance policy for their lifetime, and that a large number of written insurance policies are life insurance policies, which by definition will expire.
A life insurance company can predict how much money they will get on average from a group of clients, the life expectancy of a group, the death rate among them, and the approximate rate of return they will earn from the premiums paid. They also know the exact amount at risk for each policy because each policy has a nominal amount. By measuring risk exactly according to the law of large numbers, an insurance company has the elements it needs to provide insurance and for its business to exist. The life insurance company can also calculate the approximate rate of return that they will receive on their own investment. This allows the life insurance company to charge enough fees so that they can make money with the time value of their investment.
To estimate the risk of death for a given class of risk, or more accurately to estimate the number of people of a given age and risk class who will die each year, a life insurance company will use death tables, alternately known as disease scales. These tables give the exact percentage of a person’s chance of dying in a given year. Underwriters and risk planners use these tables containing information about current customers and the nominal values of outstanding contracts to estimate the amount the company will be obligated to pay in claims to beneficiaries in a given year. This allows the company to plan the amounts of premiums and dividend payments for whole life owners and the amount of substandard risk (if any) the company is willing to take. Accurate grading of a person’s risk is of paramount importance to underwriters because it increases the odds that the mortality table statistics for each underwriting class are correct.