Final answer:
Group life insurance is generally offered as term life policies. Calculating actuarially fair premiums requires accounting for individual risk levels like family history of cancer, to avoid financial risks from adverse selection.
Step-by-step explanation:
Group life insurance policies are generally written as term life policies. These policies provide a death benefit over a specified period or term and do not accumulate cash value. Understanding the actuarially fair premium for life insurance requires considering the probability of insured events occurring and the cost that would need to be covered by the insurance company. For example, if policyholders have different risks such as family history of cancer, premiums must be calculated separately to reflect the individual risk levels, or otherwise, the company may face financial risks.
Actuarially fair premiums for a policy paying $100,000 to the estate of anyone who dies within a year could be calculated as follows:
- For those with a family history of cancer (20% of 1,000 men have one chance in 50 of dying): premium = (1/50) * 200 men * $100,000 = $400,000 total, or $2,000 per person.
- For those without a family history of cancer (80% of 1,000 men have one chance in 200 of dying): premium = (1/200) * 800 men * $100,000 = $400,000 total, or $500 per person.
If the insurance company uses a single actuarially fair premium for the entire group without considering family cancer histories, they face the risk of adverse selection, where those with a higher risk are more likely to purchase the insurance, potentially leading to financial losses for the company.