Final answer:
Insurance is predicated on the principle that the collective premiums must cover claims, company costs, and profits. Policy premiums in an actuarially fair policy match the expected payouts for the risk group. Risk groups categorize individuals with similar levels of risk, and moral hazard is a concern where insured individuals may take fewer precautions.
Step-by-step explanation:
Insurance operates on a fundamental principle that balances risk across a group to ensure financial stability and solvency for the insurance firm. This principle establishes that the payments into insurance by the average person over time must sufficiently cover three key aspects: the average person's claims, the costs of running the insurance company, and a margin to allow for the firm's profits.
Contributing factors such as investment income from reserves and administrative expenses, along with the understanding that different groups bear different levels of risks, are intrinsic to this financial model.
An actuarially fair insurance policy implies that a policyholder's premiums equal the expected benefits, based on the risk profile of the group to which the policyholder belongs.
However, an issue known as moral hazard emerges when individuals insured against certain risks may be less incentivized to mitigate those risks, knowing they are protected financially. Furthermore, people belong to varying risk groups, which are clusters of individuals facing similar risks, whether due to genetic factors, personal habits, or external circumstances, such as living in high-crime areas.