Final answer:
Insurance is a financial protection method where individuals or entities pay premiums to an insurance company, which then provides compensation for covered financial losses. It allows for risk sharing among a group and can create moral hazards.
Step-by-step explanation:
Insurance is a method of protecting individuals or entities against financial loss. It involves policyholders making regular payments, known as premiums, to an insurance company. These premiums are priced based on the probability of certain events happening among those insured. When someone covered by the policy experiences a significant financial loss due to a specified event, they receive compensation from the pooled resources of all the premiums paid. This system is designed to spread the risk among a large group of people, which helps mitigate the financial impact on any single individual or firm.
Moral hazard is a term that describes a situation where having insurance may lead people to be less cautious about avoiding the insured event, as they know they are financially protected. An actuarially fair insurance policy is where the premiums that a person pays are equal to the average benefits received by a person within that risk group.