South Dakota Crop Insurance Practice Exam

What is the main benefit of the law of large numbers in insurance?

1. Reduction of administrative costs

2. Increased accuracy in claims processing

3. Greater predictability of losses

4. Lower premiums for policyholders

The correct answer is: Greater predictability of losses

The main benefit of the law of large numbers in insurance is greater predictability of losses. This statistical principle states that as the number of insured risks increases, the actual loss experience tends to align more closely with expected losses. This alignment allows insurance companies to estimate future losses with a higher degree of accuracy, which is crucial for effective pricing and decision-making in risk management. When insurers have a larger pool of policies, the variability in potential losses diminishes. This results in a more reliable understanding of how many claims might be expected and the amount of payout required. This predictability enables insurers to set premiums at an appropriate level to cover expected losses while also maintaining a profit margin. In contrast, while reducing administrative costs, increasing accuracy in claims processing, and potentially lowering premiums can be beneficial outcomes associated with overall efficiency in the insurance process, they do not directly stem from the law of large numbers. Instead, these outcomes are more about operational improvements and competitive strategies rather than the statistical foundation that enables insurers to manage and predict losses effectively.