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FRM Part I · FRM Exam Part I · The Building Blocks of Risk Management

Which statement best explains why an insurance company can bear risks that individuals find difficult to bear?

Insurers pool many largely independent exposures, so total losses become more predictable relative to expected losses through diversification and the law of large numbers. This lets them price and absorb risks that would be unmanageable for an individual, although correlated catastrophes still limit diversification.

  1. AIt pools many largely independent exposures, so aggregate losses are more predictable relative to the meanCorrect
  2. BIt eliminates all systematic risk by holding diversified policies
  3. CIt transfers all underwriting losses to policyholders through retrospective premiums
  4. DIt guarantees that claims across policies are perfectly positively correlated

Explanation

Insurers rely on the law of large numbers: with many independent exposures, the average loss per policy becomes more predictable. Systematic risk cannot be fully diversified, and perfect positive correlation would eliminate pooling benefits.

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