Economic basis of insurance: spread of business
The central point is that the risk borne by the insurer is not the sum of the risks transferred but rather the possibility of an adverse deviation from the desired outcome.
The law of large numbers only works when the risks are independent of each other. The risk of a car being stolen is largely independent of the risk that a neighbour’s car will be stolen; but if a house is damaged by a storm it is quite likely that the same will happen to a 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 in 1990 when an economic downturn simultaneously threw people out of work and depressed house prices.