Final answer:
An insurance company charging a group-wide actuarially fair premium instead of individual risk-based premiums may cause lower-risk individuals to opt out, leading to adverse selection and unsustainability for the insurer.
Step-by-step explanation:
Understanding Actuarially Fair Premiums
Insurance companies determine appropriate premiums based on risk assessments. If an insurance company were to offer life insurance without assessing individual risk factors such as family cancer histories, they would need to charge a single actuarially fair premium to the entire group. This premium is set to ensure that the collected premiums cover the expected claims, the costs of running the company, and provide profits. Different groups, defined by varying risk levels, have different expected claims, which can be due to genetics, personal habits, or environment. Therefore, if a company charges a unified premium to everyone, individuals with lower risk effectively subsidize the higher risk ones, leading to potential inequity and market inefficiencies.
Should the company decide to charge the actuarially fair premium for the group as a whole rather than to each group separately, it can result in a situation where people with lower risks may choose not to purchase the insurance as it would be more cost-effective for them not to. This would leave a pool of higher risk individuals, driving up the claims and potentially making the insurance unsustainable for the company. This concept is closely related to adverse selection, where those with higher risks are more likely to purchase insurance, knowing that their premium does not fully reflect their risk level.