Final answer:
Life insurance premiums vary based on numerous factors, including age, health history, and lifestyle. An actuarially fair premium accurately reflects the risk to the insurer. Averaging risk across a diverse group can result in adverse selection and financial issues for the insurer.
Step-by-step explanation:
Life Insurance Premium Determinants
When considering life insurance premiums, it's critical to understand that they are influenced by a myriad of factors, making it beneficial to compare different policies from various insurance companies. Among the factors are age, health history (including family medical history), lifestyle choices (such as smoking or engaging in high-risk activities), the length and amount of the insurance policy, and the company's operating costs and needed profits.
An actuarially fair premium is one where the premium charged reflects the true risk of payouts for the insurance company. Considering a group of 50-year-old men, where 20% have a family history of cancer with a 1 in 50 chance of dying within a year, and the rest have a 1 in 200 chance, the premiums would differ if sold separately. For those with a family history of cancer, the premium would need to be higher to offset the greater risk. If the insurance company could not differentiate these groups due to lack of information on family cancer histories, the fairness of pricing gets complicated.
If the company charges a single actuarially fair premium based on the entire group's risk, this may lead to adverse selection, where healthier groups seek insurance elsewhere, leaving the company with a pool of higher-risk individuals, ultimately leading to potential financial losses.
A fundamental principle in insurance is that the average contributions from all insured parties must cover the claims, the operational costs of the insurance company, and allow for profits. Thus, understanding the composition of the risk pool is crucial for setting premiums that are both fair and financially viable for the insurance company.