Insurance companies determine risk exposure by which principle?

• A. Actuarial fairness
• B. Time value of money
• C. Law of large numbers and risk pooling
• D. Capital asset pricing

Answer: (C)

The main idea is that risk exposure in insurance is determined by pooling a large number of independent risks and relying on the law of large numbers. When you insure many people, the variation in total claims tends to average out, so the insurer can predict total losses more accurately. This predictability lets the insurer set premiums that cover expected claims plus expenses while spreading the risk across a big pool so that no single claim can derail the company. As the pool grows, actual losses converge toward the expected losses, reducing uncertainty about total claims.

Other concepts describe related ideas but don’t capture the mechanism insurers use to gauge and manage risk exposure. Time value of money concerns discounting future payments; actuarial fairness relates to pricing policyholder risk fairly but not to how overall risk exposure is stabilized; capital asset pricing is about investment risk in financial markets.