Texas Property and Casualty License Practice Exam

How do actuaries utilize the law of large numbers in insurance?

1. To reduce the overall risk

2. To estimate claims more accurately

3. To increase policy premiums

4. To limit payouts

The correct answer is: To estimate claims more accurately

Actuaries use the law of large numbers to estimate claims more accurately by analyzing large sets of data over time. This statistical principle indicates that as the size of the sample increases, the average of the sample will get closer to the expected value of the population. In the context of insurance, this means that with a larger number of policies, actuaries can predict future claims with greater reliability. For instance, if an insurance company has a large pool of policyholders, actuaries can calculate the likelihood of claims occurring, assess the average costs, and set premiums accordingly. The law of large numbers helps them smooth out the variability and randomness of claims that might occur in a smaller sample, thereby allowing for more precise forecasting and financial planning. This is crucial for ensuring that the insurance company remains solvent and can cover all expected claims, ultimately enabling more accurate pricing of policies. While reducing overall risk, increasing policy premiums, and limiting payouts are all related to insurance practices, they are not direct applications of the law of large numbers. Instead, the core function of the law in this context revolves around enhancing the accuracy of loss predictions based on larger data sets.