Introduction to Credibility Theory

A.Ronnie E.
UGM

November 17, 2014

A.Ronnie E. (UGM)

Introduction to Credibility TheoryNovember 17, 2014

1 / 20

Credibility: Introduction

Introduction

Credibility theory is a set of quantitative tools which allows an insurer to

perform prospective experience rating (adjust future premium based on
past experience) on a risk or group of risks. If the experience of a policyholder is consistently better than that assumed in the underlying manual
rate (sometimes called the pure premium), then the policyholder may
demand a rate reduction

A.Ronnie E. (UGM)

Introduction to Credibility TheoryNovember 17, 2014

2 / 20

Credibility: Introduction

No rating system is perfect

The manual rate is designed to reflect the expected experience of the

entire rating class and implicitly assumes thet the risks are homogeneous.
However, no rating system is perfect !!!
There always remains some heterogeneity in the risk levels after all underwriting criteria are accounted for. Consequently, some policyholders
will be better risks than that assumed in the underlying manual rate

A.Ronnie E. (UGM)

Introduction to Credibility TheoryNovember 17, 2014

3 / 20

Credibility: Introduction

The Questions

How much of the difference in experience of a given policyholder is due

to random variation in the underlying claims experience and how much
is due to the fact that the policyholder really is a better or worse risk
than average for the given rating class?
In other words, how credible is the policyholders own experience?

A.Ronnie E. (UGM)

Introduction to Credibility TheoryNovember 17, 2014

4 / 20

Credibility: Introduction

Two facts

Two facts must considered:

The more past information the insurer has on a given policyholder,
the more credible the policyholders own experience, all else
being equal. In group insurance the experience of larger groups is
more credible than that of smaller groups
Competitive consideration may force the insurer to give full (using
the past experience of the policyholder only and not the manual
rate) or nearly full credibility to a given policyholder in order to
retain the bussiness

A.Ronnie E. (UGM)

Introduction to Credibility TheoryNovember 17, 2014

5 / 20

Credibility: Introduction

Setting of rates for classification systems

Another use for Credibility is in the setting for classification system.

For example, in workers compensation insurance there may be hundreds
of occupational classes, some of which may provide very little data. In
order to accurately estimate the expected cost for insuring these classes it
may be appropriate to combine the limited actual experience with some
other information, such as past rates, or the experience of occupation
that are closely related

A.Ronnie E. (UGM)

Introduction to Credibility TheoryNovember 17, 2014

6 / 20

Credibility: Introduction

Balancing information weight

Credibility theory tells us that it is optimal to give only partial weight

to experience information (from insured or group of insured) and give
the remaining weight to an estimator produced from other information

A.Ronnie E. (UGM)

Introduction to Credibility TheoryNovember 17, 2014

7 / 20

Credibility: Limited Fluctuation

Limited Fluctuation Credibility Theory

This subject was developed in the early part of the twentieth century.
This provides a mechanism for assigning full or partial credibility to a
policyholders experience. The difficullty with this approach is the lack
of a sound underlying mathematical theory justifying the use of this
methods. Nevertheless, this approach provided the original treatment of
the subject and still in use today.

A.Ronnie E. (UGM)

Introduction to Credibility TheoryNovember 17, 2014

8 / 20

Credibility: Limited Fluctuation

Limited Fluctuation Credibility Theory

Suppose that Xj is the experience from the jth policy in a group or from
the jth member of a particular class in a rating scheme. Suppose that
E(Xj ) = and V ar(Xj ) = 2 , the mean and the variance of a particular
class, respectively. The is the premium to charge if only we knew its
value.
= n1 (X1 +
The past experience may be summarized by the average X
= , and if the Xj are independent,
... + Xn ). We know that E(X)
2

V ar(X) = /n.

A.Ronnie E. (UGM)

Introduction to Credibility TheoryNovember 17, 2014

9 / 20

Credibility: Limited Fluctuation

The Goal

The Insurer goal is to decide on the value of . But How?

A.Ronnie E. (UGM)

Introduction to Credibility Theory

November 17, 2014

10 / 20

Credibility: Limited Fluctuation

The Three Possibilities

Ignore the past data (no credibility) and simply charge M a value
obtained from experience on other similar but not identical
policyholders. This quantity is often called manual premium
because it would come from a book (manual) of premiums.
(full credibility)
Ignore M and charge X
(partial credibility)
Choose some combination of M and X

A.Ronnie E. (UGM)

Introduction to Credibility Theory

November 17, 2014

11 / 20

Credibility: Limited Fluctuation

Full Credibility

how can we sure that X

is stable? One
If we ignore M and charge X,
is to infer that X
is stable if the
method of quantifying the stability of X

difference between X and is small relative to with high probability,

or



X 


Pr   yp = p
/ n

A.Ronnie E. (UGM)

Introduction to Credibility Theory

November 17, 2014

12 / 20

Credibility: Limited Fluctuation

Partial Credibility

If it is decided that full credibility is inappropriate, then for competi in the

tive reason it may be desirable to reflect the past experience X
net premium as well as the externally obtained mean, M . An intuitively appealing method for doing this is through a weighted average,
the credibility premium:
+ (1 Z)M
Pc = Z X
where the credibility factor Z [0, 1] needs to be chosen. There are many
formulas for Z which have been suggested in the actuarial literature,
usually justified on intuitive rather than theoretical grounds.

A.Ronnie E. (UGM)

Introduction to Credibility Theory

November 17, 2014

13 / 20

Credibility: Greatest Accuracy

Greatest Accuracy

We return to the basic problem. Suppose that we have manual rate

which is applicable to a particular policyholder, but the past experi could be quite
ence indicates that this may not be appropriate (The X
different from M ). This raises the question of whether next years net
or combination
premium (per exposure unit) should be based on M , X
of the two.

A.Ronnie E. (UGM)

Introduction to Credibility Theory

November 17, 2014

14 / 20

Credibility: Greatest Accuracy

The Question

Is the policyholder really different from what has been assumed in the
calculation of M or has it just been random chance wich has been re and M ?
sponsible for the differences between X

A.Ronnie E. (UGM)

Introduction to Credibility Theory

November 17, 2014

15 / 20

Credibility: Greatest Accuracy

The Bayesian Methodology

In this methodology, we assume that the risk level of each policyholder

in the rating class may be characterized by a risk parameter , but the
value of varies by policyholder. In Statistical term, we have is a
random variable with distribution function () = Pr( ) and with
probability function ().
Let Xj have conditional pf
fXj | (xj |),

j = 1, ..., n, n + 1

Thus we are interested in the conditional distribution of Xn+1 given =

in order to predict the claims experience Xn+1 of the same policyholder.

A.Ronnie E. (UGM)

Introduction to Credibility Theory

November 17, 2014

16 / 20

Credibility: Greatest Accuracy

The Bayesian Premium

To accomplish the mision we have to calculate the distribution called

predictive distribution, which is a conditonal distribution of Xn+1
given X = (X1 , ..., Xn )T = X. This distribution is the relevant distribution for risk analysis, managemant and decision making. It combines the
uncertainty about the claim losses with that of the parameters associated
with the risk process.
After several Bayesian calculation we can determined E(Xn+1 |X = X),
the Bayesian premium (the mean of the predictive distribution)

A.Ronnie E. (UGM)

Introduction to Credibility Theory

November 17, 2014

17 / 20

Credibility: Greatest Accuracy

The Credibility premium

The major chalange with Bayesian approach is that it may be difficult
to evaluate the premium, E(Xn+1 |X = X). Often numerical integration
may be required.
An alternative was suggested by B
uhlmann in 1967. Recall the basic
problem: We wish to use the conditional distribution fXn+1| (xn+1 |) or
hypothetical mean n+1 () for estimation next years claims. Because
we have observed data X, one suggestion is to approximate n+1 ()
by a linear function of the past data. B
uhlmann suggests credibility
premium as:
n
X

0 +

j Xj
j=1

A.Ronnie E. (UGM)

Introduction to Credibility Theory

November 17, 2014

18 / 20

Credibility: Greatest Accuracy

The B
uhlmann model
Next, we generalize previous model and define:
() = E(Xj | = )
and
v() = V ar(Xj | = )
Also
= E[()]
v = E[v()]
and
a = V ar[()]

A.Ronnie E. (UGM)

Introduction to Credibility Theory

November 17, 2014

19 / 20

Credibility: Greatest Accuracy

The B
uhlmann Credibility Premium

Thus The B
uhlmann Credibility Premium is:

0 +

n
X

+ (1 Z)

j Xj = Z X

j=1

where
Z=
and
k=

A.Ronnie E. (UGM)

n
n+k

E[V ar(Xj |)]

v
=
a
V ar[E(Xj |)]

Introduction to Credibility Theory

November 17, 2014

20 / 20