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Chapter 16: Q. 11 (page 398)

What is an actuarially fair insurance policy?

Short Answer

Expert verified

The actuarially fair insurance policy is one in which the total premium paid equals the total compensation to be received.

Step by step solution

01

Definition of insurance.

A contract in which an individual or entity receives financial protection in the form of a policy against an asset is known as insurance. Difference types of insurance are life insurance, health insurance, car insurance, etc.

02

Explanation

In health insurance, a few persons are at higher risk due to bad behaviors or hereditary abnormalities, while in property insurance, a few regions have a greater risk of theft and fire, and some drivers are safer than others.

The insurance firm will categorize risk groups based on the likelihood of negative consequences from events that occur and do not occur and will charge lower premiums for lower-risk locations or persons and higher premiums for higher-risk areas or people. When the expected net payoff from an insurance is zero, it is said to actuarially fair.

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Most popular questions from this chapter

What are some ways that someone looking for a loan might reassure a bank that is faced with imperfect information about whether the borrower will repay the loan?

How do you think the problem of moral hazard might have affected the safety of sports such as football and boxing when safety regulations started requiring that players wear more padding?

How might adverse selection make it difficult for an insurance market to operate?

Imagine that you can divide 50-year-old men into two groups: those who have a family history of cancer and those who do not. For the purposes of this example, say that 20% of a group of 1,000 men have a family history of cancer, and these men have one chance in 50 of dying in the next year, while the other 80% of men have one chance in 200 of dying in the next year. The insurance company is selling a policy that will pay $100,000 to the estate of anyone who dies in the next year.

(a) If the insurance company were selling life insurance separately to each group, what would be the actuarially fair premium for each group?

(b) If an insurance company were offering life insurance to the entire group, but could not find out about family cancer histories, what would be the actuarially fair premium for the group as a whole?

(c) What will happen to the insurance company if it tries to charge the actuarially fair premium to the group as a whole rather than to each group separately?

What are some ways a seller of labor (that is, someone looking for a job) might reassure a possible employer who is faced with imperfect information?
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