Final answer:
An insurance company collects premiums from policyholders, which forms a pool of funds used to cover the costs of incidents such as accidents. Premium rates are determined based on the expected risk, which means higher premiums for those with higher risks, such as having a family history of cancer.
Step-by-step explanation:
When an insurance company issues a policy, they are effectively managing risk for their clients. The concept is that a large group of people will pay into a pool via their premiums, and those funds will be used to cover the costs for the few who do incur costs due to the insured risk, such as car accidents. For instance, if each of the 100 drivers pays a $1,860 premium each year, the collective sum of the premiums ($186,000) will be available to handle the expenses stemming from accidents. This is based on the assumption that the total cost from all accidents will not exceed that amount.
However, risk is not spread evenly. To illustrate this, consider a scenario where 50-year-old men can be divided into two groups based on family history of cancer. With a 20% segment having a higher likelihood of dying within the year, an insurance company must calculate the potential payout differently for this subgroup. They are selling a policy that could pay out $100,000 upon the death of the insured within the year. As such, the premium must reflect the expected risk, often resulting in higher premium for those at higher risk.
This basic principle of risk management is foundational to the business of insurance companies, whereby the statistically rare but financially devastating events are covered through the collected premiums of the many.