Law of Large Numbers

Insurance companies must determine

what premium to charge that will
cover losses, and be competitive with
other insurance companies. To do
this, insurance companies hire
actuaries, who use statistics and
the law of large numbers to
determine expected losses and the
probability of how much actual losses
can deviate from expected losses.

Probability and Statistics

Sometimes, the probability of an
event can be determined a priori.
Such is the case with the flip of a fair
coin, or the roll of a fair die, because
the possibilities are both limited and
known. However, the probability of
most insurable events cannot be
known a priori, because there are
too many factors that can influence
the outcome, and the outcomes are
highly variable. Thus, actuaries apply

statistical analysis to past events in

an attempt to determine the
frequency of losses and the extent of
those losses within a population, and
how much they vary from year to
year.
A probability distribution
summarizes this data by plotting
possible events against their
probabilities. If there are only a
limited number of possibilities, then
the distribution is said to be
discrete; otherwise, it is
continuous. Plotting the roll of a die
creates a discrete probability
distribution, because there are only 6
possibilities. However, most insurable
events have a continuous distribution
because the outcomes have a
continuous range of possibilities.
A probability distribution can be
characterized by its central tendency
and its dispersion. Central
tendency is the expected value,
or mean (common symbol: ) of the
distribution, and is equal to the sum

of each possible event (X) times the

probability (P) of that event. In the
case for insurable losses, the mean is
equal to the sum of the amount of
each possible loss times the
probability of that loss.
Equation for Mean: = Xi Pi

Example Calculating the Mean of 2 Samples of 3 Events

Amount

Probability

of

of

Loss (Xi)

Loss (Pi)

XiPi

$0 x

.10

$0

$500 x

.20

$100

.05

$50

Xi Pi

$150

$1,000

=
Amount

Probability

of

of

Loss (Xi)

Loss (Pi)

XiPi

$100 x

.15

$15

$500 x

.20

$100

.035

$35

Xi Pi

$150

$1,000 x
=

However, the mean does not measure

dispersion, which is a measure of
how widely the individual events vary.
A measure of dispersion is important

because, in determining risk for

insurance purposes, the greater the
dispersion, the greater the variation
in losses, and, thus, the greater the
objective risk. Wide variations in
dispersion can average to the same
mean, as can be seen in the 2 tables
above. Both have the same mean of
$150, but the losses in the 1st table
has a greater dispersion that varies
from $0 to $100, and in the 2nd table,
the losses vary from $15 to $100.
Because the range is more limited in
the 2nd example, it poses less risk
objective riskand is, therefore,
more predictable.
The statistical measure of dispersion
is the variance (common symbol:
2), which is equal to the square of
the difference between the possible
values and the mean.
Equation for Variance: 2 = Pi(Xi - )2

To make the units of central tendency

and variance the same, the square
root of the variance is used to
represent dispersion, and is called the

standard deviation (common

symbol: ).
Example Calculating the Variance and Standard Deviation of the
Above 2 Samples
For the 1st distribution, the variance and
standard deviation are
2 = .1(0-150)2 + .2(500 - 150)2 + .
05(1,000 - 150)2 = 2,250 + 24,500 +
36,125 = 62,875
= 62,875 = 250.75 (rounded).
For the 2nd distribution:
2 = .15(100-150)2 + .2(500 - 150)2 + .
035(1,000 - 150)2 = 375 + 24,500 +
25,287.5 = 50,162.5
= 50,162.5 = 223.97 (rounded).

The greater the standard deviation

for a loss event, such as fires, the
greater the uncertainty of the event
within a given time frame, and,
therefore, the greater the potential
for losses. However, the standard
deviation can only be calculated from
an observed population or a
representative sample of the
population. The law of large numbers
is a useful tool because the standard

deviation declines as the size of the

population or sample increases, for
the same reason that the number of
heads in 1 million flips of a coin will
probably be closer to the mean than
in 10 flips of a coin.

Central Limit Theorem

The central limit theorem states
that as the sample size (n) grows,
the distribution becomes more like
the normal distribution of the entire
population, with the mean of the
sample more nearly equal to the
mean of the population, and the
standard error ( s), which is the
standard deviation of the sample,
approaches the standard deviation of
the population ( p).
Equation for Standard Error: s = p/n

Thus, the difference between the

standard error and the standard
deviation of the population diminishes
as the sample size, n, increases.
The normal distribution is
represented by the bell-shaped

curve, with 68% of the distribution

lying within 1 standard deviation,
95% lying within 2 standard
deviations, and 99.7% of the
distribution lying within 3 standard
deviations.
As the size of the sample increases, dispersion decreases. The
normal distribution curve for the sample size of 100,000 is
narrower than the curve for 10,000, and they both have the same
mean. Thus, losses are more predictable for the larger sample
size.