Final answer:
Insurance serves to transfer the financial risk of losses from an individual to an insurer, with people contributing premiums into a collective pool. To balance this and reduce moral hazard, policies include deductibles, copayments, and coinsurance that share costs and encourage caution.
Step-by-step explanation:
Insurance operates as a system of transferring and sharing the costs of potential losses. People pay into an insurance pool through premiums, and those who experience a covered loss receive compensation, effectively transferring the financial burden from the individual to the insurance company.
However, to mitigate the risk of moral hazard—where the insured might take fewer precautions as they do not bear the full cost of losses—insurance policies often have mechanisms like deductibles, copayments, and coinsurance. A deductible is an amount the policyholder pays before insurance coverage kicks in, transferring some of the loss cost back to the policyholder.
For instance, in auto insurance, coverage may start for losses greater than $500. Copayments are a small out-of-pocket expense that the policyholder must pay, such as $20 per doctor visit, sharing the cost between the policyholder and the insurer. Lastly, coinsurance is a cost-sharing method where the insurer pays a set percentage of the cost, such as 80% of home repairs after a fire, while the homeowner covers the remaining 20%.
An actuarially fair insurance policy implies that the premiums paid roughly equal the expected benefits, ensuring that, on average, what people pay in premiums matches what they receive in compensation over time. These features are designed to share costs, prevent overutilization of insurance, and encourage responsible behavior despite the coverage.