Certified Financial Consultant (CFC) Practice Exam

Which law is the foundation of the statistical prediction of loss upon which rates for insurance are calculated?

1. Law of Averages

2. Law of large numbers

3. Law of Probability

4. Law of Demand

The correct answer is: Law of large numbers

The law of large numbers is fundamental to the statistical prediction of loss in insurance because it states that as the number of trials or observations increases, the sample mean will converge to the expected value. In the context of insurance, this means that the larger the pool of insured individuals or entities, the more accurately an insurer can predict the overall losses and thus set appropriate premium rates. Insurers rely on a large dataset to calculate the likelihood of claims based on historical data. This statistical foundation allows them to spread risk among a broad base of policyholders, ensuring that premiums collected can adequately cover the expected claims. As a result, the law of large numbers underpins the entire process of rate-setting in the insurance industry by facilitating accurate estimations of loss and maintaining the stability of the insurance market. In contrast to the other options, while the law of averages relates to expectations in the long run, it does not directly apply to insurance calculations in the same robust manner as the law of large numbers does. The law of probability provides the framework for analyzing events, but it does not address the volume aspects that the law of large numbers does. Lastly, the law of demand pertains to economic principles regarding consumer behavior and market prices, which is not relevant to the calculation of insurance