The true nature of insurance is often confused. The word “insurance” is sometimes applied to a fund that is built up to cover uncertain losses. For example, a specialty store that sells seasonal items must increase its price at the beginning of the season to create a fund to cover the possibility of losses at the end of the season, when the price must be reduced to clear the market. Similarly, life insurance quotes take into account the price the policy would cost after premiums are collected from other policyholders.

This method of coping with risk is not insurance. It takes more than the mere accumulation of funds to meet uncertain losses to constitute insurance. Risk transfer is sometimes referred to as insurance. A store that sells televisions promises to repair the television for a year free of charge and replace the picture tube if the glories of the television prove to be too much for its delicate wiring. The seller may refer to this agreement as an “insurance policy.” It is true that it does represent a transfer of risk, but it is not insurance.

An adequate definition of insurance should include both the formation of a fund or the transfer of risk and a combination of a large number of separate and independent exposures to loss. Only then is there true insurance. Insurance can be defined as a social device to reduce risk by combining a sufficient number of exposure units so that the loss is predictable.

The predictable loss is then shared proportionally among everyone in the pool. Not only is uncertainty reduced, but losses are shared. These are the important essentials of insurance. A man who owns 10,000 small, widely dispersed dwellings is in about the same insurance position as an insurance company with 10,000 policyholders, each of whom owns a small dwelling.

The first case can be the subject of self-insurance, while the second represents commercial insurance. From the point of view of the insured person, insurance is a device that allows him to substitute a large but uncertain loss for a small and definite loss, under an arrangement in which the many lucky ones who escape the loss will help compensate. to the unlucky few. who suffer loss.

The Law of Large Numbers

To repeat, insurance reduces risk. Paying a premium on a homeowners insurance policy will reduce a person’s chance of losing their home. At first glance, it may seem strange that a combination of individual risks results in risk reduction. The principle that explains this phenomenon is called in mathematics the “law of large numbers”. It is sometimes loosely referred to as the “law of averages” or the “law of probability.” Actually, it is only part of the topic of probability. The latter is not a law at all, but simply a branch of mathematics.

By the 17th century, European mathematicians were building crude life tables. From these investigations, they found that the percentage of males and females among the births of each year everywhere tended towards a certain constant if a sufficient number of births were tabulated. In the 19th century, Simeon Denis Poisson gave this principle the name “law of large numbers”.

This law is based on the regularity of the occurrence of events, so that what appears to be a random occurrence in the individual simply appears so due to insufficient or incomplete knowledge of what is expected to occur. For all practical purposes, the law of large numbers can be stated as follows:

The greater the number of exposures, the closer the actual results obtained will be to the probable result expected with an infinite number of exposures. This means that if you toss a coin a large enough number of times, the results of your guesses will approximate half heads and half tails, the theoretical probability if the coin is tossed an infinite number of times.