Texas Property and Casualty License Practice Exam

How can the law of large numbers affect claim predictions?

1. By ensuring all claims are approved

2. By allowing for more accurate predictions as similar loss exposures increase

3. By making predictions less reliable

4. By decreasing the total number of claims

The correct answer is: By allowing for more accurate predictions as similar loss exposures increase

The law of large numbers is a statistical principle that states that as the number of exposure units (such as policyholders or insured items) increases, the actual loss experience will get closer to the expected loss experience. This principle is fundamental in the field of insurance because it provides a mechanism for insurers to predict future claims more accurately. When the number of similar loss exposures increases, the variability in the predictions decreases, allowing actuaries and insurers to calculate expected losses with greater precision. For instance, if an insurer has a large pool of homeowners' insurance policies, the total claims made will tend to average out to a predictable amount based on historical data. This enhanced accuracy helps in setting appropriate premium rates, reserves for future claims, and overall risk management strategies. This principle is why diversification in an insurance portfolio is encouraged. With a larger pool of insured individuals or items, and assuming the risks are similar, the insurer can have confidence that the actual loss will come closer to the expected loss, enabling them to operate effectively and sustainably.