Final answer:
The relative risk is a measure comparing the risk of a certain event happening in one group to a reference group. In insurance, premiums are based on relative risks to ensure fairness and solvency. Failing to accurately price this can lead to financial losses due to adverse selection.
Step-by-step explanation:
An estimate of the risk of death in a group of individuals compared to a reference group is known as relative risk. This measure is used in the fields of epidemiology and public health to compare the risk of a certain event (like death) occurring in a group that is exposed to a certain factor against a group that is not. For instance, if we were to evaluate the risk of death in 50-year-old men with a family history of cancer versus those without, the relative risk could be calculated by dividing the incidence rate of death in the exposed group (those with a family history of cancer) by the incidence rate in the non-exposed group (those without a family history of cancer).
To find the actuarially fair premium for a life insurance policy, one would consider the risk associated with each group of individuals and adjust the premium accordingly. Calculating this for each group separately ensures that premiums are in line with the expected payout, which reflects the underlying risk. If an insurance company does not adjust for the different risks and charges one premium for all, it may end up with financial losses, particularly if the higher risk group is larger than estimated, or if individuals with higher risk are more likely to purchase the insurance (known as adverse selection).