Final answer:
Insurance premiums are determined by assessing individual risk levels through actuarial science, but setting premiums at actuarially fair levels may lead to high costs for those in high-risk categories. To prevent high-risk individuals from opting out, insurance systems may spread risk among a larger pool, resulting in cross-subsidization between low and high-risk individuals.
Step-by-step explanation:
Insurance companies determine monthly premiums by assessing the risk associated with an individual or group. This process, known as actuarial science, involves calculating the probability of claims based on various risk factors. For example, a young male driver may be charged higher car insurance premiums than a young female driver because statistics show that young men tend to be involved in more accidents.
However, while setting premiums at actuarially fair levels ensures that individuals pay rates commensurate with their risk, it can result in very high charges for high-risk individuals. This can lead to a situation where those in high-risk groups might opt out of insurance due to the cost. To avoid this, and to provide more equitable coverage, some systems spread risk across a larger pool of insured individuals, which can result in lower-risk individuals effectively subsidizing the higher risks of others. The example given illustrates how 100 drivers could end up paying the same premium, but those with lower accident costs are effectively covering the higher costs of those with more expensive accidents.