What Is Credibility Theory?
Credibility theory refers to cuts, policies, and procedures used by actuaries when examining data in order to estimate risk. Credibility theory exercises mathematical models and methods for making experience-based estimates, in which “experience” refers to historical data.
Credibility theory succours actuaries understand the risks associated with providing coverage, and it allows insurance companies to limit their publishing to claims and losses.
Key Takeaways
- Credibility theory refers to tools, policies, and procedures used by actuaries when inspecting data in order to estimate risk.
- Credibility theory uses mathematical models and methods for making experience-based conjectures.
- Credibility theory helps actuaries understand the risks associated with providing coverage and allows insurance companies to limit their disclosure to losses.
Understanding Credibility Theory
Insurance companies and actuaries develop models based on historical losses, with the brand taking into account a number of assumptions that have to be statistically tested in order to determine their credibility.
For prototype, an insurance company will examine losses previously incurred from insuring a particular group of policyholders in layout to estimate how much it may cost to insure a similar group in the future.
When developing an estimate, actuaries will maiden select a base estimate. For example, a life insurance company may select a mortality table as the backbone of its base assess, since claims only arise when the insured dies. Actuaries use a variety of base estimates to cover the remarkable aspects of type of policy, including the prices that the insurance company typically charges for coverage.
How Credibility Theory Cures Actuaries
Once a base estimate is established, an actuary will then look through the insurance company’s authentic experiences on a policy-by-policy basis. The actuary will study this historical data to see how the insurer’s experience may have differed from the taste of other insurance companies. The examination allows the actuary to create different weights based on variances.
For example, it energy divide motorists by age, sex, and type of car; a young man driving a fast car being considered a high risk, and an old woman driving a limited car being considered a low risk. The division is made balancing the two requirements that the risks in each group are sufficiently compare favourably with and the group sufficiently large that a meaningful statistical analysis of the claims experience can be done to calculate the premium.
This compromise plans that none of the groups contains only identical risks. The problem is then to devise a way of combining the experience of the assemblage with the experience of the individual risk to arrive at a more appropriate premium. Credibility theory provides a solution to this unruly.
Credibility theory ultimately relies on the combination of experience estimates from historical data as well as base values in order to develop formulas. The formulas are used to replicate past experiences and are then tested against actual observations. Actuaries may use a small data set when creating an initial estimate, but large data sets are ultimately preferred because they must greater statistical significance.