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The basis of insurance is sharing risk among a large pool of people with a similar exposure to loss (a homogeneous group). The law of large numbers states that the larger the number of people with a similar exposure to loss, the more predictable actual losses will be. This law forms the basis for statistical prediction of loss upon which insurance rates are calculated.
When an insurance company issues a policy on a 35-year-old male, the company really has no way of knowing or accurately predicting when he will die. However, the Law of Large Numbers looks at a large group of similar risks – 35-year-old males of similar lifestyles and health conditions – and makes some conclusions based on statistics of past losses. This allows the insurance company to have a general idea about the predicted time of death for this type of insured and to set the premiums accordingly.
As the number of people in a risk pool increases, future losses become more predictable.