This item was provided courtesy of the Insurance Education Foundation.

Calculated Risks

Because insurers bear the burden of risk for their policyholders, they are able to decide whether it is economically wise to take on that risk. Then they must decide a reasonable fee (or premium) to charge for this service. Armed with volumes of data from past incidents of injury, damage and death and applying mathematical formulas for figuring probabilities and premiums, they take a gamble on our abilities to stay safe. Consumers can use these tools as well in order to figure for themselves which risks are worth taking. For instance, if statistics show that damage repair costs for one particular make and model car are almost twice those of a different make and model, that information may play a part in deciding which of the two cars to buy.

Surveys and Statistics

Insurers and actuaries must gather statistics based on surveys in order to predict the probability of loss to their policyholders.

These statistics, many of which can be obtained through insurance organizations, can be used by consumers when making choices in considering property and auto purchases in terms of insurance affordability. Consumer Reports is also a helpful source of comparative charts.

The Law of Large Numbers

The “law of large numbers” (or the “law of averages”) is an important insurance principle. Briefly, it states that “actual results tend to equal expected (probable) results as the number of independent events increases.”

For instance, if an insurer wants to find out how many cars are in accidents in Ann Arbor, Michigan, in a year, she or he will not stand on a street corner and count accidents for a day then multiply the amount by 365 to get an annual rate. The most accurate estimate will come from Ann Arbor traffic experts who have kept track of virtually every car involved in an accident.

The law of large numbers also applies when it comes to the number of policyholders in an insurance program: The insurer can more accurately predict losses to a group of 50,000 than a group of 5.

Risk Classification

When insurers figure premiums, they take into account many of the characteristics surrounding the item to be insured. These characteristics are the variables that go into figuring rates for specific policyholders. For instance, in figuring rates for auto insurance, the insurer considers the differences in driving records indicated by the age, sex, marital status and accident record of the driver, as well as the value of the car and the probability (based on statistics) of that particular make and model incurring loss through theft or accident.

When variables represent different probabilities of loss, the rates reflect the difference. For example, when a driver turns 25 years old, his or her insurance premiums should drop in price because according to statistics, drivers in the over-24 age group have fewer accidents than those in the under-25 age group.