Question

Imagine that you can divide 50-year-old men into two groups: those who have a family history of cancer and those who do not. For the purposes of this example, say that 20% of a group of 1,000 men have a family history of cancer, and these men have one chance in 50 of dying in the next year, while the other 80% of men have one chance in 200 of dying in the next year. The insurance company is selling a policy that will pay $100,000 to the estate of anyone who dies in the next year.

a) The insurance policy premium will be higher for men with a family history of cancer.
b) The insurance policy premium will be lower for men with a family history of cancer.
c) The insurance policy premium will be the same for both groups of men.
d) The insurance policy does not account for family history in setting premiums.

Answer 1

Insurance policy premiums are typically set based on the risk associated with the insured group, with higher premiums for those at greater risk. For the group of men divided by family history of cancer, those with a history would pay higher premiums due to their increased risk. Charging a uniform premium to all regardless of risk can lead to adverse selection and potential financial instability for insurers.

Step-by-step explanation:

When setting insurance policy premiums, the risk associated with the insured population is taken into account. Regarding the scenario where you can divide 50-year-old men based on their family history of cancer, different groups have different risks of dying in the next year. The group with a family history of cancer has a higher risk (1 chance in 50) compared to those without a family history (1 chance in 200).

Therefore, the insurance company will likely charge a higher premium to those with a family history of cancer to account for the increased risk. This is known as actuarially fair pricing, which sets premiums based on the calculated risk in order to reflect the expected costs for the insurance provider. If an insurance company charges an actuarially fair premium to the group as a whole, ignoring individual risk factors, it risks undercharging high-risk individuals and overcharging low-risk individuals, leading to adverse selection and potential financial instability for the insurance provider.