Page 33 - Insurance Times May 2023

The loss in the shape of premium can be distributed only Let's say you're sitting in your office, bored by whatever
on the basis of theory of probability. The chances of loss menial task is sitting in your inbox, and you decide to
are estimated in advance to affix the amount of premium. play a game. You pull out a coin and you see how many
Since the degree of loss depends upon various factors, heads you can flip in a row. You flip one or two heads in a
the affecting factors are analysed before determining row easily. But you start to find that it's much harder to
the amount of loss. With the help of this principle, the keep getting heads (assuming you're flipping fairly).
uncertainty of loss is converted into certainty.
This is because the probability of you flipping a head is 1/
The insurer will have not to suffer loss as well have to 2 or 50%. But 2 heads in a row is (1/2) x (1/2) or 1/4 or
gain windfall. Therefore, the insurer has to charge only 25%. So statistically you'll only flip 2 heads in a row once
so much of amount which is adequate to meet the losses. out of every 4 tries. That's discouraging. The probabilities
The probability tells what the chances of losses are and get lower and lower very quickly. The probability of
what will be the amount of losses. flipping 6 heads in a row is 1/64 or 1.5%. You could try
100 times and have it happen only once or twice.
The inertia of large number is applied while calculating
Suddenly, your neglected paperwork seems much more
the probability. The larger the number of exposed
friendly.
persons, the better and the more practical would be the
findings of the probability. Therefore, the law of large Let's say you get discouraged and you decide you're going
number is applied in the principle of probability. to play a different game instead. Let's also assume that
you've grown up under a rock and you don't know that
In each and every field of insurance the law of large number
the probability of flipping a head is 50%. So you decide to
is essential. These principles keep in account that the past
record the number of heads and tails you flip.
events will incur in the same inertia. The insurance, on
the basis of past experience, present conditions and future The first two coins you flip are heads and It appears as if
prospects, fixes the amount of premium. the rule is that every time you flip a coin, you get a head.
The probability of flipping a head is 100% according to
Without premium, no co-operation is possible and the
your data and You are unsure though, so you keep
premium cannot be calculated without the help of theory
flipping. Next is a tail. So you were wrong and the
of probability, and consequently no insurance is possible.
probability of flipping a head must be 2/3 or 66% right
So these two principles are the two main legs of
and Because that's what you've flipped so far.
insurance.
As you continue playing this game, we both know that
The insurer charges only so much of amount which is
your record will get closer and closer to 50% as you flip
adequate to meet the losses. Pooling of a large number
more and more. In other words, because of what you
of risks is very necessary for the successful operation of
discovered with your first game, it gets harder and harder
the theory of probability. The law of large numbers is a
to 'fudge' the probability the more you flip.
sub principle of the principle of probability.
Mathematicians go one step farther to say that if you
take any event and record lots and lots of trials, the
Concept of Probability Theory and
results get closer and closer to the actual probability
Statistics: with each new trial, eventually getting so close that you
can just accept the result as the actual probability.
A branch of mathematics, predicting random events by
analysing large quantities of previous similar events. So what does this have to do with insurance? We know
Probabilities in statistics are the mathematical odds that an that insurance agencies insure lots of people (they have
event will occur. To obtain a probability ratio, the number of to, or else it wouldn't work, just like the coin). Every
favourable results in a set is divided by the total number of person pays a small amount of money each month and
possible results in the set. The probability ratio expresses the nothing happens to them. But every once in a while, an
likelihood that the event will take place. This ratio is significant insurance company will have to pay lots of money to a
to insurance providers. single person.
An insurance company that insures 1000 people. Let's
Statistical methods: say that 1 house will catch on fire per year. So the
The first concept that insurance relies on is known to probability of a house catching on fire is (1/1000).
statisticians as "the Law of Large numbers" and it's best Therefore the probability of a house not catching on fire
explained by example. is (999/1000)

30 May 2023 The Insurance Times