It would be quite risky for you to insure the life of a 25-year-old friend . There is a high probability that your friend would live and you would gain $875 in premiums. But if he were to die, you would
lose almost $100,000. Explain carefully why selling insurance is not risky for
an insurance company that insures many thousands of 25-year-old men.
Selling insurance is not risky for an insurance company that insures many thousands of 25-year-old men primarily because of the concept of "risk pooling" and the law of large numbers. To understand this, let me explain:
1. Risk Pooling: Insurance companies operate on the principle of risk pooling, which means they insure a large group of individuals who are exposed to similar risks. In this case, the insurance company would insure many thousands of 25-year-old men. By doing so, the insurance company spreads the risk among a diverse group, reducing the impact of individual losses and ensuring that the costs are shared collectively.
2. Law of Large Numbers: The law of large numbers is a statistical concept that states that as the number of observations (or insured individuals) increases, the more accurately the actual outcomes will reflect the expected outcomes. Insurance companies use statistical probability models to calculate premiums based on the likelihood of certain events happening, such as death in this case. When insuring a large number of individuals with similar characteristics, the law of large numbers allows the insurance company to accurately predict the average number of deaths within that group.
To mitigate the risk, insurance companies rely on extensive data analysis and actuarial calculations to determine the appropriate premiums to charge. They take into account factors such as age, health, lifestyle, and historical mortality rates of the specific group being insured.
In the case of insuring many thousands of 25-year-old men, the insurance company has access to historical data on mortality rates among this demographic. They analyze this data and calculate the expected number of deaths within the group. As a result, they can set premiums at a level that covers the potential payouts for the relatively few claims that will occur, while still ensuring profitability.
So, while insuring the life of a single 25-year-old friend might be considered risky due to the potential loss incurred in the event of death, the risk is significantly diminished when insuring a large group of similar individuals using the principles of risk pooling and the law of large numbers.