Final answer:
Insurers calculate life insurance premiums by evaluating the risk associated with the applicant and placing them in risk groups, then they use this information to determine an actuarially fair premium.
Step-by-step explanation:
Once an insurer has evaluated the facts about a life insurance applicant, premiums are determined based on the categorization of the risk that applicant represents.
Risk factors include personal habits, genetics, and the likelihood of certain events such as illness or accidents, which form the basis of what insurers call risk groups. These groups share similar probabilities of an adverse event occurring.
An actuarially fair premium is a premium that, on average, covers the claims paid out, the administrative costs of running the insurance company, and includes a margin for profit. The premium reflects the expected costs based on the risk associated with the individual or group being insured.
Actuarially Fair Premium Calculation
To calculate an actuarially fair premium, the insurer multiplies the probability of an event (such as death) by the payout amount (the monetary benefit to the insured or their beneficiaries) and factors in the number of people in the risk group.