What is credibility theory?

Credibility theory uses mathematical modelling to make decisions based on historical data. It examines similar situations that have occurred in the past, and their outcomes, to assess financial risk.

Where have you heard about credibility theory?

Credibility theory is widely used in the insurance industry to determine the cost of premiums. To calculate car insurance premiums, for example, an insurer will typically group motorists by age, gender and car type. A common outcome is that an older woman driving an ordinary car is deemed to be a lower risk than a young man driving a fast car, and therefore the woman’s premium is lower.

What you need to know about credibility theory.

There are two types of credibility used by actuaries to calculate risk; Bayesian and Bühlmann.

The Bayesian approach separates each data group and assigns it a probability before examining how likely an experience is to occur within each data group. The Bühlmann approach looks at the variance across the population.

Both approaches can be used to assess an uncertain or volatile market, helping investors limit risk and exposure to losses.