The law of large numbers enables an insurer to do what?

The law of large numbers is a key principle in insurance that allows insurers to predict losses with greater accuracy. This statistical theorem states that as the number of similar risks increases, the average outcome (or the expected loss) becomes more predictable.

For instance, when an insurer has a large pool of policyholders, they can analyze historical data and trends to estimate how many claims are likely to occur within that pool over a given period. This predictive capability is essential for setting premiums accurately and ensuring that the insurer can cover expected losses without incurring significant financial strain.

While the law of large numbers does aid in other areas of insurance practice, such as risk classification and management (which can contribute to avoiding adverse selection), its primary function lies in enhancing the insurer's ability to predict and manage losses effectively. This predictive power is vital for the financial stability of an insurance company, enabling it to plan and allocate resources efficiently.