Final answer:
Charging an actuarially fair premium to the group as a whole rather than to each group separately could lead to adverse selection and financial instability for the insurance company. High-risk individuals would benefit from lower premiums, while low-risk individuals may be overcharged, potentially causing them to opt out of insurance coverage.
Step-by-step explanation:
Insurance companies calculate premiums for different risk groups to ensure that premiums collected cover the claims, operational costs, and profits. If an insurance company tries to charge an actuarially fair premium to a group as a whole without differentiating between high-risk and low-risk individuals, the result would likely be a less optimal distribution of insurance costs. High-risk individuals would usually get charged lower than if they were charged individually, and low-risk individuals would get charged higher than necessary. This could lead to adverse selection, where high-risk individuals would take insurance and low-risk individuals might opt-out, resulting in unbalanced risk pools and potential financial instability for the insurance company.
Actuarially fair insurance works on the principle that each insured individual should pay a premium that accurately reflects their individual risk. However, setting premiums based on individual risk can result in high-risk individuals facing considerably high insurance costs, possibly leading them to forgo insurance altogether. Therefore, insurance companies must find a balance between fair premiums and maintaining a viable risk pool. In some cases, this may mean that the company will have to subsidize high-risk individuals to prevent them from opting out, therefore slightly increasing the premiums for lower-risk individuals.