Final answer:
Experience rating is the term for when an insurance company adjusts premiums based on an individual or group's loss history, leading to possible premium discounts for those with lower risks. Overcharging for actuarially fair premiums on a group basis rather than individually can result in low-risk individuals leaving the plan, causing financial strain for the insurer.
Step-by-step explanation:
The situation you’ve described in insurance is typically known as experience rating, which is a pricing strategy where insurance premiums are determined based on the actual loss history of an insured individual or group, as opposed to community rating where premiums are the same for everyone regardless of their individual history. When an insured individual or group pays more in total standard premium than what is generally expected, they may be eligible for a premium discount, which is a way the insurer acknowledges the lower risk presented by the insured party and compensates them for their better-than-average claims experience. If, on the other hand, insurance companies attempt to raise premiums across the board to cover high-risk losses, this could lead to a decline in overall policy purchases as low to medium-risk individuals opt out due to increased costs, thereby exacerbating the insurer’s financial strain.
Furthermore, charging an actuarially fair premium—which means premiums are equivalent to the average benefits paid out within that risk group—on a group-wide basis rather than separately for each risk group can lead to adverse selection. This is because those with lower risks could be overcharged while compensating for the higher risk members, thus leading them to drop out of the insurance plan, leaving the insurer with only the high-risk (and therefore more expensive) insured individuals. This emphasizes the delicate balance insurance companies must maintain between fair pricing and financial sustainability.