Credibility Theory

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Credibility Theory is a branch of actuarial science. It was developed originally as a method to calculate the risk premium by combining the individual risk experience with the class risk experience.

When an insurance company calculates the premium it will charge policy holders it divides the policy holders into groups. For example it might 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 small car being considered a low risk. The division is made balancing the two requirements that the risks in each group are sufficiently similar and the group sufficiently large that a meaningful statistical analysis of the claims experience can be done to calculate the premium. This compromise means that none of the groups contains only identical risks. The problem is then to devise a way of combining the experience of the group with the experience of the individual risk the better to calculate the premium. Credibility Theory provides a solution to this problem.