GIM1140 - Economic basis of insurance: spread of business

The essential point is that the risk borne by the insurer is not the sum of the risks transferred but the possibility of an adverse deviation from the desired outcome.

This is significant when considering captive insurance  (see GIM11000) and financial insurance and reinsurance ( GIM8000).

It is also worth noting that the law of large numbers only works when the risks are independent of one another. The risk of my car being stolen is largely independent of the risk that my neighbour’s car will be stolen; but if my house is damaged by a storm it is quite likely that the same will happen to my neighbour’s house.

An insurer writing property insurance therefore needs to ensure that it has a good geographical spread of business.

In the past some UK insurance companies suffered large losses on mortgage indemnity business, which protects lenders against the risk that the sale of a repossessed property will not provide sufficient money to pay off the outstanding debt. Such risks were not independent, as insurers discovered when an economic downturn simultaneously threw people out of work and depressed house prices.