Final answer:
Insurance protects individuals and businesses against potential significant financial losses before they occur by collecting premiums and providing compensation to those who experience covered events. A fair insurance policy balances the premiums with the average benefits but can lead to moral hazard.
Step-by-step explanation:
Insurance is a method employed by households and firms to hedge against the risk of a catastrophic financial loss before it happens. By paying regular amounts to an insurance company, known as premiums, policyholders are essentially contributing to a collective pool of funds managed by the insurer. The insurer calculates these premiums based on the likelihood of an insured event occurring within a defined pool of insured individuals or entities. If a policyholder experiences a significant negative event that is covered under their insurance policy, they are eligible to receive compensation from this pool of money. This process of risk-sharing helps protect against uncertainties and the potential for large, unexpected financial burdens.
An actuarially fair insurance policy equates the premiums paid to the average benefits received by individuals within a risk group. However, this could lead to a moral hazard, where individuals who are insured might take fewer precautions against the risk they are insured for, knowing that they have financial protection from the insurance policy.