How might an insurer use the 'law of large numbers' to their advantage?

The law of large numbers is a fundamental principle in insurance that helps insurers manage risk and predict losses more accurately. By increasing the number of similar risk exposures—essentially a larger pool of clients—insurers can observe a more reliable average of outcomes. This means that when they have a larger number of policyholders, they can better predict the expected loss ratios based on historical data and trends.

When insurers apply this principle, they are effectively able to smooth out the uncertainties that come from individual claims. For example, while a few clients may experience significant losses in a given period, the majority may not, and with a statistically significant number of policyholders, the overall losses can be anticipated more accurately. This allows insurers to set premiums more effectively, ensuring they are sufficient to cover expected claims while still being competitive in the market.

Using the law of large numbers, insurers can also enhance their financial stability and profitability by setting aside reserves that are based on predicted claim ratios rather than sporadic, unpredictable losses. As a result, this principle is crucial for both underwriting practices and financial management in the insurance industry.