MR. WATSON: So the law of large numbers, gives us the mortality tables and morbidity table.
MR. WATSON: Insurance is also based on something called loss sharing, sharing the loss or risk pooling.
MR. WATSON: Here is a good example. Let's say that every guy my age (40) wanted to leave his wife $10,000 when he died. Without interest, how much would I have to save to leave her $10,000? It's a simple number. $10,000. Do you agree? If I wanted to leave her $10,000, and it's just a number we're using, I'd have to set aside, without interest $10,000. Do you agree with that?
STUDENTS: Yes.
MR. WATSON: But what if we had a thousand men, all of them, say, age 40, willing to pool their money. And we knew that three were going to die, and each one of these guys wanted to provide their spouse with $10,000. We know how many are going to die. How many? Three. (We got that from the mortality tables). Do you agree?
STUDENTS: Um-hmm.
MR. WATSON: So you need three buckets with how much in each bucket? $10,000. So if we add up the three buckets of $10,000, the total loss to the group would be what? $30,000. So the total loss is $30,000. Agree?
STUDENTS: Yep.
MR. WATSON: If we divided the total loss ($30,000) by the thousand men in the group, each guy would have to come up with $30. That's insurance. So each guy needs to ante up 30 bucks. We know how many are going to die, we just don't know which ones they are. Do you agree? So if every guy came up with 30 bucks, they would create three buckets with $10,000 in each. Do you agree?
STUDENTS: Um-hmm.
MR. WATSON: Now let's say it was me that died, and this gentleman and that gentleman. They'd take a bucket and they'd give it to your wife. They'd give a bucket to my wife and a bucket to his wife. How much did it cost me now to provide that $10,000? 30 bucks. Instead of how much?
STUDENTS: $10,000.
MR. WATSON: Guys, where I come from, I would rather set aside 30 bucks to provide her with $10,000 than having to set aside the full $10,000. That is insurance. It is called risk pooling or loss sharing.
MR. WATSON: Because what is it you want when I die if you are my spouse? Money! We decided on a number, $10,000, and we provided it for a fraction of the cost. Does that make sense?
STUDENTS: Um-hmm.
MR. WATSON: That is insurance. It's based upon the law of large numbers, which gives us the mortality and morbidity tables, and it's based upon loss sharing, sharing the loss, and risk pooling.
MR. WATSON: What if they said 100 men wanted to do the same thing? 100 men wanted to provide their wives with $10,000 and three were going to die? Now we are dividing the total loss of $30,000 by only 100 men. So now how much would each guy have to come up with? $300. Y'all got it?
STUDENTS: Um-hmm.