Final answer:
Insurance is a way of sharing risk, where premiums cover claims, costs, and profits. Risk groups are based on shared levels of risk. Actuarial fairness and moral hazard are key concepts.
Step-by-step explanation:
One of the basic characteristics of insurance is that it serves as a means of risk-sharing among individuals or entities. Individuals in a group pay premiums, which are pooled to compensate those who experience covered losses or events. According to the fundamental law of insurance, over time, the total premiums collected must be sufficient to cover: 1) the total claims paid out, 2) the administrative costs of the insurance company, and 3) provide for the company's profits.
Risk groups emerge since not everyone faces the same level of risk. Some individuals may be prone to certain risks due to genetics, personal habits, or geographic location, leading insurers to assess risk and adjust premiums accordingly to maintain what is known as actuarial fairness. However, the challenge in insurance is the concept of moral hazard, where insured parties may take fewer precautions against risks knowing they are covered, potentially distorting traditional risk calculations and premium settings.