Final answer:
Charging an actuarially fair premium to a whole group instead of separate groups can lead to adverse selection, resulting in potential financial losses for the insurance company as higher risk individuals buy insurance and lower risk individuals opt out.
Step-by-step explanation:
When an insurance company tries to charge the actuarially fair premium to a group as a whole, rather than to each group separately, it faces the risk of adverse selection.
If the insurance company sets premiums based on the average risk of the entire group, those at higher risk are more likely to purchase insurance, knowing that they are receiving a better deal than their actual risk would indicate.
Meanwhile, those at lower risk might opt not to purchase insurance because the premium is higher than the actuarially fair price for their individual level of risk.
In trying to balance this out, if the insurance company increases premiums to cover potential losses from high-risk individuals, it may further dissuade low-risk individuals from buying insurance, which can lead to a disproportionately risky pool of insured individuals and potential financial losses for the company.