Final answer:
Actuaries calculate actuarially fair premiums for life insurance based on factors like age, health history, and mortality rates. If the insurance company cannot access specific information about an individual's health history, they may use average mortality rates for a specific group. If the insurance company charges the actuarially fair premium to a group as a whole instead of separate premiums for each group, it may lead to adverse selection.
Step-by-step explanation:
An actuarially fair premium is the premium amount charged by an insurance company that accurately reflects the risk involved. In the case of life insurance, actuaries consider factors such as age, health history, and mortality rates to calculate the premium. However, since actuaries may not have complete information about a person's health history, they often use statistical models and assume an average mortality rate for a specific group.
For example, let's consider a group of 50-year-old men divided into two groups: those with a family history of cancer and those without. If the insurance company could sell life insurance separately to each group, the actuarially fair premium for the group with a family history of cancer would be higher than the premium for the group without. This is because the risk of dying in the next year is higher for the group with a family history of cancer.
If the insurance company cannot find out about family cancer histories and offers life insurance to the entire group, the actuarially fair premium for the group as a whole would be calculated based on the average mortality rate for 50-year-old men. This premium would be lower than the separate premiums for each group.
If the insurance company tries to charge the actuarially fair premium to the group as a whole instead of separate premiums for each group, there may be adverse selection. Adverse selection occurs when individuals with higher risks are more likely to purchase insurance. In this case, individuals with a family history of cancer would be less likely to purchase insurance since the premium would be higher for the entire group. This can lead to an imbalance in the insurance pool and potentially impact the financial stability of the insurance company.