ACTL3003 Assignment: Credibility Theory

Selina Li

Part 1 Assumption 1 Units of Volume

Contract/ Time

1 2 3 4 Losses
Contract/ Time

1 2 0 0 0

2 2 0 0 0

3 3 0 0 0

4 4 0 0 3

5 6 0 0 3

6 6 0 3 2

7 8 0 4 2

8 5 0 2 2

9 6 9 3 2

10 6 11 2 3

1 2 3 4

1 0 0 0 0

2 1345 0 0 0

3 1846 0 0 0

4 10159 0 0 15016

5 7364 0 0 0

6 5972 0 5854 526

7 23524 0 6008 750

8 14976 0 1390 2436

9 10824 6344 1393 362

10 17601 10556 0 552

Intermediary Results
Contract (j)

48 20 14 17 1950.23 845.00 1046.07 1155.41 0.77 0.58 0.49 0.54

per unit of volume

1 2 3 4

1,803.65 1,040.65 1,181.35 1,227.70

4 10 99 1462.61

3014701.03 210085.74 2.39 1313.34

Assumption 2 Units of Volume

Contract/ Time

1 2 3 4 Losses
Contract/ Time

1 0 0 0 0

2 2 0 0 0

3 3 0 0 0

4 4 0 0 5

5 7 0 0 0

6 4 0 4 2

7 9 0 4 1

8 8 0 1 3

9 5 7 1 1

10 5 9 0 2

1 2 3 4

1 0 0 0 0

2 1345 0 0 0

3 1846 0 0 0

4 10159 0 0 15016

5 7364 0 0 0

6 5972 0 5854 526

7 23524 0 6008 750

8 14976 0 1390 2436

9 10824 6344 1393 362

10 17601 10556 0 552

Intermediary Results
Contract (j)

47 16 10 14 1991.72 1056.25 1464.50 1403.00 4 10 87 1664.34 0.82 0.60 0.49 0.57

per unit of volume

1 2 3 4

1,906.18 1,242.38 1,495.47 1,455.34 1493522.44 141660.96 2.48 1524.84

Part 2 Question 1 The underlying rationale of credibility theory is that the risk premium can be derived as a combination of the individual risk experience and the group risk experience. In the context of insurance, the premium can be expressed as a weighted average of the individual experience and the collective experience: ( ) The credibility level zj reflects how credible or trustworthy the experience of contract j is compared to that of the collective experience . A credibility level of one is suitable when there is large variation between contracts or the risk experience for contract j is sufficiently vast. In contrast, a credibility level of zero is suitable when contracts are homogenous. Under Approach 1, the zj values for each group were computed using the total exposure of each contract (wjsum), the average variance within each contract (s^2) and the variance between contracts (a). For all groups, s^2 and remain constant whereas total exposure changes. Higher total exposure results in higher zj values which is consistent with credibility theory since the credibility level approaches to one when the risk experience increases. Question 2: Compare results between Approaches 1 and 2 above. The difference between the intermediate results and credibility premiums of Approach 1 and 2 can be explained by the change in assumption for volume. In general, total units of exposure were greater than the total claims across all groups, resulting in higher wjt for Approach 1. The decline in volume also contributed to the higher lower weighted mean of outcomes (Xjt) for Approach 2. The variance within contracts and variance between contracts was also significantly different between both Approaches. This can be attributed to the increased dispersion of data in Approach 1 compared to that of Approach 2. In particular, contract 1 and 4 have units of exposure but not number of claims in certain time periods. The increased volume data and hence increased variability in Approach 1 contribute to s^2 and a, resulting in s^2 values and a values significantly greater than that of Approach 2. The changes in the intermediate results can all be linked to the changes to the credibility premiums. The higher the higher credibility level, higher collective mean and higher individual mean across all contracts for Assumption 2 has resulted in a greater Pcred for Approach 2 compared to the Pcred of Approach 1. Apart from the resulting data, the differences in the assumptions can also be examined. An implicit assumption of approach 1 is that it has a constant claims experience across all contracts. Hence, there is no incentive for individuals to manage their claims experience in Approach 1 than that of Approach 1. With Approach 1, there is no incentive to act in a more risk-adverse manner since the premium is just a measure of exposure (which could be number of contracts). Question 3 Contract 2 has credibility factors of 0.58 and 0.60 for Approach 1 and Approach 2 respectively. Despite the limited data, this suggests an emphasis on the risk experience of the contract rather than that of the collective mean. It can be argued that results of this model is not suitably appropriate since limited experience should have credibility weighting factors emphasized on the collective mean. On the other hand, the credibility model improves with time and hence should be used. A flaw to the model designed is that the time period used for all contracts is constant when only one contract had exposure in all ten time periods. This assumption could have contributed to the higher credibility levels determined. Nonetheless, even if the model was changed there is still considerable uncertainty with the group due to the limited risk experience. However, over time, this model will be able to become more accurate with greater input of data. The two approaches were also tested for homogeneity (using the F-test) and it was found that there was considerable heterogeneity in the data given. This gives more confidence that the credibility method used is suitable for both approaches. Hence, using credibility is justified and these unfavourable results should be only be used with considerable reasoning. However, there is confidence that the credibility model will improve with time.