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1/12 W01/March 2017 Award in General Insurance
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Chapter

For example, the unknown financial risk that an individual faces should their home burn down is
transferred to the insurer and replaced by the much smaller and certain cost of the premium.
In the next few sections we look at some other key concepts of insurance.

G Pooling of risks

The basic concept of insurance is that the losses of the few who suffer misfortune are met by the
Losses of the few are
met by the contributions of the many who are exposed to similar potential loss.
contributions of the
many An insurance company gathers together relatively small sums of money from those people who want to
be protected financially from similar kinds of perils. The insurer sets up a separate ‘pool’ for each
different class of insurance. Contributions, in the form of premiums paid by policyholders, go into the
pool and payments are then made to compensate the losses of the few.
The total premiums must be large enough to meet the losses in any one year as well as cover the costs of
operating the pool, while providing an element of profit for the insurer. The premium which each
policyholder pays is proportionate to the risk they bring to the pool.

G1 Law of large numbers

In operating the pool, insurers benefit from the law of large numbers. This states that where there are a
large number of similar situations, the actual number of events occurring tends towards the expected
number. The law of large numbers can be illustrated by considering the flip of a coin, which can result in
a head or a tail. Flipping a coin 20 times may result in any combination of heads and tails; there may be
twelve heads and eight tails or any other combination. On the simple mathematics of the situation, you
would expect to get the same number of heads and tails, because the chance of getting either is 50%.
However, flipping the coin just 20 times may not give us the 50/50 split we would expect. Flipping the
coin 10,000 times would almost certainly see a result of approximately 5,000 heads and 5,000 tails. The
law of large numbers, therefore, operates to give a result which is in keeping with the underlying
probability (likelihood of something happening) of 50% heads and 50% tails. Reference copy for CII Face to Face Training

Applying the principle of large numbers to insurance enables the insurer to predict fairly confidently the
final cost of claims in any one year. This is because insurers provide cover against a large number of
similar risks, and the final number of actual loss events tends to be very close to the expected number,
provided the conditions under which the original data was gathered remains constant. This enables the
insurer to calculate likely losses and so confidently charge a fixed premium, meaning that the
policyholder knows what their costs will be for the year, irrespective of the number or size of their own
particular losses from insured causes.

G2 Equitable premiums

To operate a pooling system successfully, a number of pools must be set up, one for each main group of
risks. This could be an individual pool for motor insurance and another for household insurance, for
example. Each person wishing to join the pool must be prepared to make an equitable (fair) contribution
to that pool.

When deciding on an equitable contribution, insurers take into account the different elements of risk
brought to the pool by each of the policyholders. These are often referred to as discrimination factors.
Arriving at a premium is a complex process and the correct assessment of risk is extremely important.
The correct assessment will ensure that a fair premium is charged, and a fair profit can be made. This is
the task of an underwriter when considering an individual risk.
Sample examination question 1

By operating a pooling of risk system, the law of large numbers assists insurers in making:
a. reliable claim payment predictions. F
b. reliable investment return predictions. F
c. reliable new business predictions. F
d. reliable premium income predictions. F