Law of Large Numbers
When we buy insurance, we are paying a relatively small amount of money (the premium) and in return we may be receiving a very large claim payout (this concept is called Aleatory, an exchange of unequal amounts).
How can insurance companies do this?
Collect a little from me, but pay out hundreds of thousands of dollars when I file a claim?
First, we must understand that insurance is getting the premium from a lot of people.
They are not getting premium money from just me, right?
But how do they know how much premium to charge me or anyone else?
Predictions and statistics are what allow insurance companies to do this. Insurance companies sort people into groups (homogenous/class) based on things they can get statics on
Predictions and statistics are what allow insurance companies to do this. Insurance companies sort people into groups (homogenous/class) based on things they can get statics on, like a younger new driver vs an older experienced driver. A younger healthy person, vs an elderly sickly person. Once they place us in our group(homogenous/class), they analyze the behavior of the group.
population(riskier/adverse selection). Based on that, insurance companies will charge a premium, the riskier you are, the more you pay because you are more likely to file a claim then someone else.
While younger drivers can expect to pay more for car insurance, when it comes to life insurance, they can expect to pay less. An experienced older driver will pay less in car insurance but can end up paying more for life insurance.
population(riskier/adverse selection). Based on that, insurance companies will charge a premium, the riskier you are, the more you pay because you are more likely to file a claim then someone else.
While younger drivers can expect to pay more for car insurance, when it comes to life insurance, they can expect to pay less. An experienced older driver will pay less in car insurance but can end up paying more for life insurance.
The large of large numbers tells us the bigger the group of young drivers we get to analyze, the more predictable we can get about who will have an accident and when. The bigger group of elderly people we get to analyze, the more accurate we can predict when they will die. Not every young driver will have an accident, but every young driver is paying a premium based on the prediction they will, allowing the hundreds of thousands of dollars to be there when the ones who do crash and file
claims.
The formal way we define law of large numbers is the bigger the group of people with a similar exposure to loss the more predictable actual losses will be.
One last thing for this section – How much will the insurer pay you for a claim?!
First,
we look at the loss. Loss is defined at the reduction, decrease or disappearance of value.
However, no matter what the loss is, it needs to fit within the limit of liability.
The amount that insurance companies pay you for a loss is based on two things. First, the amount of coverage. No matter how horrible the claim is, they will never pay you for more than the coverage you have available. That concept is called the “limit of liability.”
The next thing that insurance companies consider, is a principal called indemnity. The purpose of indemnity is to restore the insured, so however much money that cost to restore them to their previous financial condition before the loss, that is what the insurance will pay-up to the limit of liability of course!
For example,
let’s say I have policy to cover jewelry for $4,000. A necklace is stolen and I make a claim. The necklace itself is only worth $2,000 so all they will send me is $2,000.
Think of indemnity as making you whole.
RECAP
Life comes with risk.
While I have many methods of handling them like a STARR, the best method is to transfer risk and Insurance is the transfer of risk.
However, we can only transfer or buy insurance on risk that are “Pure: loss or nothing” and we cannot transfer gambling type risks, we call those “speculative risk“.
As long as the pure risk is due to chance, definite and measurable, statistically predictable, but not catastrophic it’s an INSURABLE risk.
Insurance companies then use the Law of Large Numbers to determine what your likely hood of loss is by using the Law of Large Numbers which says, the bigger the group of people with a similar exposure to loss the more predictable actual losses will be.
When you have a loss, the insurance company will indemnify you, making you whole again.
Hazard Vs Peril
Let’s talk about how the risk can lead to a loss that insurance companies will cover.
A Hazard is something that will increase the chance of a loss, and there are three types: Physical, Moral and Morale.
Physical
The easiest is physical, you can see and touch it. A tree branch sticking out of the sidewalk is a
physical hazard, you can trip on it and get injured. A can of gas next to rags in the garage is a hazard it could lead to a fire.
Moral
Moral is a hazard where a person makes a choice to lie/do wrong. They know what they are doing is wrong and they do it anyway. This would be like an applicant lying on their insurance application.
Morale
Morale is a sense of carelessness. I like to think of teenagers. Sometimes teenagers do something because they don’t understand the dangers and sometimes, they do something because they think they will live forever and aren’t afraid. They just don’t care. Either way, it’s a Morale Hazard and can increase the chance of a loss. In insurance, this looks like, “I want to speed, so I will. And if I crash, insurance will cover it anyway!” or “I leave my door unlocked all the time, and if someone steals my stuff, I don’t care, insurance will cover it”.
No matter which type a hazard is- something that will increase the chance of a peril happening.
Peril
A peril is the CAUSE of loss, the events that happen that lead to the destruction of property/bodily injury. Perils are the things you either are or not covered for.
- It’s like this: the rags and gas can are a hazard, and it’s likely a fire will occur. The fire is the peril.
- The tree branch makes one more likely to trip, the branch is the hazard. Tripping on the branch(injury) is the peril.
- The chair that fell out of a truck and it now sitting on the highway is a physical hazard, hitting it with your car(collision) is the peril.
- Perils are the cause of loss- and loss is the decrease or disappearance of value. When we file a claim, we are asking the insurance company to pay for the loss.
Insurance companies determine if they cover the peril depending on the policy.
Named Peril vs Open Peril
A peril is the CAUSE of loss, the events that happen that lead to the destruction of property/bodily injury. Perils are the things you either are or are not covered for.
For property insurance, you can either purchase a “named peril” policy or an “open peril” policy.
A named peril policy says “only this is covered.” It’s a policy with a list of perils that you are covered for. Essentially, in order for it to be covered it must be named. One memory trick for a named peril policy, is that “if it ain’t named, it ain’t covered.”
An open peril policy says, “anything BUT this is covered.” It’s the opposite of a name peril policy, instead of saying what is covered, it says what is not covered. An open peril policy is a policy of exclusions. Everything is covered unless it’s excluded. Sometimes an open peril policy is called “all risk.”
An open peril policy is easy, because it’s almost like a one size fits all. It covers everything not
excluded, so they name open peril policies as Special and Comprehensive.
Keep in mind, there is a difference between a “covered peril” and “coverage.”
A Covered Peril is what triggers a policy to provide coverage.
Fire, which is always covered, would trigger the policy to provide coverage. The peril of flood, which is always excluded, would NOT trigger the policy to provide coverage.
Coverages describe two things-what building/thing is covered and for how much money.

Let’s Recap again!
Hazards, whether Physical (material and structural), Moral (lying) or Morale (carelessness), are things that increase the chance of loss. Loss is the decrease or disappearance of value. We can losses based on perils. Perils are the cause of loss like fire, wind or hail. You can buy either an Open Per Policy that covers everything not excluded or a Named Peril Policy that only covers the specific perils.
So how do we get insurance so they can cover our risk and pay for their losses? We need to make an offer to them! When we fill out an application with the insurance company, we are offering them orisks. If they accept them, they will issue a policy for us.