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The major additional costs to insurance companies, other than the payment of claims, are the costs of running a business: the administrative costs of hiring workers, administering accounts, and processing insurance claims. For most insurance companies, the insurance premiums coming in and the claims payments going out are much larger than the amounts earned by investing money or the administrative costs.

Thus, while factors like investment income earned on reserves, administrative costs, and groups with different risks complicate the overall picture, a fundamental law of insurance must hold true: The average person’s payments into insurance over time must cover 1) the average person’s claims, 2) the costs of running the company, and 3) leave room for the firm’s profits. This law can be boiled down to the idea that average premiums and average insurance payouts must be approximately equal.

Risk groups and actuarial fairness

Not all of those who purchase insurance face the same risks. Some people may be more likely, because of genetics or personal habits, to fall sick with certain diseases. Some people may live in an area where car theft or home robbery is more likely than others. Some drivers are safer than others. A risk group    can be defined as a group that shares roughly the same risks of an adverse event occurring.

Insurance companies often classify people into risk groups, and charge lower premiums to those with lower risks. If people are not separated into risk groups, then those with low-risk must pay for those with high risks. In the simple example of how car insurance works, given earlier, 60 drivers had very low damage of $100 each, 30 drivers had medium-sized accidents that cost $1,000 each, and 10 of the drivers had large accidents that cost $15,000. If all 100 of these drivers pay the same $1,860, then those with low damages are in effect paying for those with high damages.

If it is possible to classify drivers according to risk group, then each group can be charged according to its expected losses. For example, the insurance company might charge the 60 drivers who seem safest of all $100 apiece, which is the average value of the damages they cause. Then the intermediate group could pay $1,000 apiece and the high-cost group $15,000 each. When the level of insurance premiums that someone pays is equal to the amount that an average person in that risk group would collect in insurance payments, the level of insurance is said to be “actuarially fair.”

Classifying people into risk groups can be controversial. For example, if someone had a major automobile accident last year, should that person be classified as a high-risk driver who is likely to have similar accidents in the future, or as a low-risk driver who was just extremely unlucky? The driver is likely to claim to be low-risk, and thus someone who should be in a risk group with those who pay low insurance premiums in the future. The insurance company is likely to believe that, on average, having a major accident is a signal of being a high-risk driver, and thus try to charge this driver higher insurance premiums. The next two sections discuss the two major problems of imperfect information in insurance markets—called moral hazard and adverse selection. Both problems arise from attempts to categorize those purchasing insurance into risk groups.

Questions & Answers

What is a monopsony?
Allan Reply
economic is tha process of banking
hashmat Reply
Pls can u explain it into details
Praise
Cause I don't understand what you are saying
Praise
brownies price is 5$ quantity demand is 5000$ supplied is 3000 if brownies are not taxed how many are consumed?
Fel Reply
what is unemployment
Rita Reply
ok so what would u say is supply in your own terms
Odessa Reply
Ok
fedaa
ya
Lal
why the demand curve is downwards sloping and supply upward sloping
Odessa Reply
the dd curve is downward sloping because consumers dd less when price is high and vice versa the ss curve is upward sloping suppliers are willing to produce more when prices are high
Clifford
what is dead weight loss
jeremy
when the prices of supplies slop upward then the prices of demand curve will increases downward
Kerubino
Why scarsity is considered to be very important in the study of economics
Sesay Reply
How can you solve the problem of scarcity
Sesay
If there is a enough quantitative the problem of scarcity would be solved.
Kerubino
what is demand
aliyu Reply
Demand refers to the quantities of a commodity which consumers are willing and are able to buy at given prices.
Okonji
demand is the number units of goods or services that buyers are willing and able to buy at verous prices
muhiyadiin
what is a full form of GDPCP?
Sadhna Reply
if the price of a commodity is at 6$, is the magnitude of the excess supply
Emma Reply
The quantity supplied at a price above or higher than $6 would be the excess supply
Elisha
2003, and $12,700 in Korea. Assume the growth rates for each country remain the same. 1. Compute the doubling time for
busywork
6$ the quantity remained the same
Sekou
write shirt note of the following terms normal goods
Adamu Reply
what is normal goods
Adamu
what is a full form of GDPCP?
Sadhna
evaluate measures to remove the deflationary gap?
Tinotenda Reply
State four importance of economics
School Reply
1) Economics help us to know how gouvernement,society, individuals and house holds allocate scarce resources 2)Economics help give us valable knowldge on daily decisions 3)Economics also help us to better understand economy 4)Economics help us better our daily life
Blessing
thank you dr
BLESSED
what is scarcity?
MCclean Reply
what is economics
MCclean
why is economics not consider as pure science?
Stanly
Economics is defined as science that studies human behaviour as a relation between ends and scarce means
School
Economics is not considered as pure science because it only deals with currency and human behaviour...
School
Scarcity refers to a limited supply of goods and services
School
What is Stock exchange?
Rock Reply
An exchange where security trading is conducted by professional stockbrokers
Bnysn
A place where scurity trading is conducted on an organised system
Blessing

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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