Risk Transference and the Law of Large Numbers

When an insurance company takes part in risk transference, also known as

pooling, it shifts risk from an individual policyowner to a pool of the insurance
companys clients. By paying a premium, each individual places his payment into a
collective reserve to fund and accept the risk of the accident actually occurring. For
example, if 1000 policyholders pay $1000 each for car insurance premiums, the pool
would have up to $1,000,000 to cover claims and reimburse losses.

According to the law of large numbers, the larger the number of risks that an
insurance company insures, the closer they will be able to predict the actual chance
of the accident occurring. This principle, along with risk transference, plays a key
role in factoring the cost of premiums. Insurance companies find it useful to record
claims over a very large population to calculate a fairly accurate estimate of the
number of claims that they can expect to be filed. In terms of car insurance,
premiums are higher for adolescents because teenagers tend to have higher
statistical rates for accidents than those for the middle-aged population.