0 INTRODUCTION

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Chapter 8 Credibility theory
0 Introduction

• In this chapter we will look at credibility theory, which is a technique that can be used to determine premiums or claim frequencies in general insurance. • We will look only at the Bayesian approach to credibility.

0 INTRODUCTION

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• The contents of this chapter are: – Credibility ∗ The credibility premium formula ∗ The credibility factor – Bayesian credibility ∗ Introduction ∗ The Poisson/gamma model ∗ Numerical illustrations of the Poisson/gamma model ∗ The normal/normal model ∗ Further remarks on the normal/normal model ∗ Discussion of the Bayesian approach to credibility

there is data relating to a large number of local authority bus fleets from all over the United Kingdom which show that the average cost of claims .600. i. the expected cost of claims in the coming year.e. in addition to this information. The pure premium for this insurance needs to be calculated.1 Credibility The credibility premium formula • The basic idea underlying the credibility premium formula is intuitively very simple and very appealing. The local authority wishes to insure this fleet for the coming year against claims arising from accidents involving these buses. The data for the past five years for this particular fleet of buses show that the average cost of claims per annum (for the ten buses) has been £1. Suppose that. • Consider an extremely simple example: Suppose a local authority in a small town has run a fleet of ten buses for a number of years.1 CREDIBILITY 3 1 1.

1 CREDIBILITY 4 per annum per bus is £250. some of the fleets of buses included in this large data set operate under very different conditions (which are thought to affect the number and/or size of claims.500 is based on many more fleets of buses than the figure of £1.g. in large cities or in rural areas) from the particular fleet which is of concern here.500. so that the average cost of claims per annum for a fleet of ten buses is £2. However.600. e. . while this figure of £2.

• The credibility approach to this problem is to take a weighted average of these two extreme answers. whereas the estimate of £2. 2. • Z is known as the credibility factor. 600 + (1 − Z ) × 2.500 is based on less relevant data. i. a more reliable figure. 500 where Z is some number between zero and one. £2.1 CREDIBILITY 5 • There are two extreme choices for the pure premium for the coming year: 1.500 could be chosen on the grounds that this is based on more data and so is. or. £1.e. . in some sense. to calculate the pure premium as: Z × 1.600 could be chosen on the grounds that this estimate is based on the most appropriate data.

. typically. but not necessarily identical to. data for risks similar to. for convenience. i.e. possibly. the term of the policies will be taken to be one year. short term policies and. • The following information is available: – X is an estimate of the expected aggregate claims (number of claims) for the coming year based solely on data from the risk itself – µ is an estimate of the expected aggregate claims (number of claims) for the coming year based on collateral data. or. just the expected number of claims. the particular risk under consideration. although it could equally well be any other short period. in the coming year from a risk. • These policies are.1 CREDIBILITY 6 • We express this example a little more formally. • The problem is to estimate the expected aggregate claims.

1 CREDIBILITY 7 • The credibility premium formula (or credibility estimate of the aggregate claims/number of claims) for this risk is: ZX + (1 − Z )µ where Z is a number between zero and one and is known as the credibility factor. .

• Its value reflects how much “trust” is placed in the data from the risk itself (X ) compared with the data from the larger group (µ).2 The credibility factor • The credibility factor Z is just a weighting factor. the higher the value of Z . the lower should be the value of the credibility factor. – The more relevant the collateral data. . • It can be seen that.1 CREDIBILITY 8 1. the higher should be the value of the credibility factor. in general terms. the more trust is placed in X compared with µ and vice versa. the credibility factor would be expected to behave as follows: – The more data there are from the risk itself. • As an estimate of next year’s expected aggregate claims or number of claims.

its value should not depend on the actual data from the risk itself. could be written in the form of ZX + (1 − Z )µ by choosing Z to be equal to (φ − µ)/(X − µ). say φ. • Because ZX + (1 − Z )µ = = φ−µ X+ X −µ φ−µ X+ X −µ φ−µ 1− µ X −µ X −µ µ X −µ φX − φµ = X −µ = φ . while its value should reflect the amount of data available from the risk itself. • If Z were allowed to depend on X then any estimate of the aggregate claims/number of claims. i.1 CREDIBILITY 9 • One final point to be made about the credibility factor is that. on the value of X .e.

1 CREDIBILITY 10 • The problems remain of how to measure the relevance of collateral data and how to calculate the credibility factor Z . . • There are two approaches to these problems: – Bayesian credibility – empirical Bayes credibility theory • In this chapter we will only study Bayesian credibility.

2 BAYESIAN CREDIBILITY 11 2 2. – the normal/normal model which looks at claim amounts.1 Bayesian credibility Introduction • The Bayesian approach to credibility involves the following steps: – Prior parameter distribution – Likelihood function – Posterior parameter distribution – Loss function – Parameter estimate • This study of the Bayesian approach to credibility theory is illustrated by considering two models: – the Poisson/gamma model which looks at claim frequencies. .

λ • The conditional distribution of X given λ is P oisson(λ). and the estimate wanted is the Bayes estimate with respect to quadratic loss. • The random variable X represents the number of claims in the coming year from a risk.2 BAYESIAN CREDIBILITY 12 2. • The prior distribution of λ is gamma(α. . • x1. Recall from Chapter 2 that the estimate with respect to a quadratic loss function is the mean of the posterior distribution. which will be denoted x. E (λ|x). . the expected number of claims in the coming year. . . xn are past observed values of X . β ).e. value of a parameter.2 The Poisson/gamma model • Suppose the claim frequency for a risk. i. i. • The problem is to estimate λ given the data x. x2. but unknown. • The distribution of X depends on the fixed.e. . needs to be estimated.

• Suppose n = 0 → Z = 0 → E (λ|x) = α β . α/β .2 BAYESIAN CREDIBILITY 13 • The posterior distribution of λ given x is gamma(α+ n i=1 xi . • The mean number based on prior beliefs is the mean of the prior gamma distribution. β + n). • and α+ n i=1 xi E (λ|x) = β+n α + = β+n β+n n = × β+n n = β+n = Z where Z= n β+n n i=1 xi n i=1 xi n i=1 xi n n i=1 xi + β α × β+n β n n i=1 xi n α + 1− β+n β + (1 − Z ) α β n • The observed mean number of claims is n .

and the collateral information. n. n i=1 xi n as an • β reflects the variance of the prior distribution for λ.2 BAYESIAN CREDIBILITY 14 n i=1 xi • Z = 1 → E (λ|x) = n • The value of Z depends on the amount of data available for the risk. • As n increases the sampling error of estimate for λ decreases. . through β . • Thus Z reflects the relative reliability of the two alternative estimates of λ.

9/10. 7/8. 5/6. • λ ∼ gamma(100. 10/11 • Figure 2 on page 15 shows the credibility estimate of the number of claims in successive years for the gamma(100. 4/5. .3 Numerical illustrations of the Poisson/gamma model • In this section some simple numerical examples relating to the Poisson/gamma model will be considered which will help to make some further points about this model.2 BAYESIAN CREDIBILITY 15 2. 8/9. 1/2. 1). (Note that this distribution has mean 100 and standard deviation 10. • Figure 1 on page 14 shows the credibility factor in successive years. 2/3.) • The actual number of claims arising each year from this risk are given. 3/4. 0. 1) prior distribution for λ. 6/7.

5) prior than it does for the gamma(100. – The estimated number of claims increasing with time until it reaches the level the actual claim numbers after eight years. 1) prior. • This feature can be explained in terms of credibility theory. 1) prior. . • Suppose the prior distribution of λ is gamma(500. 5) prior have the same general features as for the gamma(100. 1) • Figures 3 and 4 on page 16 show that the credibility factor and the estimated number of claims for the gamma(500. 5) rather than gamma(100. • The most obvious difference between these two cases is that the credibility factor increases more slowly for the gamma(500. – The credibility factor increases with time.2 BAYESIAN CREDIBILITY 16 • The following simple observations can be made about Figures 1 and 2.

E (X |X ) .2 BAYESIAN CREDIBILITY 17 • E (X ) = E [E (X |λ)] = E (λ) v.s.

– The uncertainty about the value of θ is modelled in the usual Bayesian way by regarding it as a random variable.4 The normal/normal model • In this section we will estimate the pure premium. for a risk. 2 2 – The values of µ . but unknown. θ – The conditional distribution of X given θ is 2 N (θ. i. • If the value of θ were known.2 BAYESIAN CREDIBILITY 18 2. • Let X be a random variable representing the aggregate claims in the coming year for this risk and the following assumptions are made: – The distribution of X depends on the fixed.σ1 and σ2 are known. the correct pure premium for this risk would be E (X |θ) = θ . – n past values of X have been observed. value of a parameter. σ1 ). σ2 ). which will be denoted x.e. the expected aggregate claims. 2 – The prior distribution of θ is N (µ.

E [E (X |θ)|x] = E (θ|x) 2 2 ¯ x µσ1 + nσ2 = 2 + nσ 2 σ1 2 2 2 σ1 nσ2 ¯ = 2 x µ+ 2 2 2 σ1 + nσ2 σ1 + nσ2 = Zx ¯ + (1 − Z )µ where: Z= n 2 /σ 2 n + σ1 2 • This is a credibility estimate of E (θ|x). – It is an increasing function of n. • These features are all exactly what would be expected for a credibility factor. – It is always between zero and one. . the amount of data available. • There are some further points to be made about the credibility factor Z . – It is an increasing function of σ2.2 BAYESIAN CREDIBILITY 19 • The problem then is to estimate E (X |θ) given x. the standard deviation of the prior distribution.

xn] need to be estimated. . value of a parameter. be random variables representing the aggregate claims in successive years. X2. . . X2. – The distribution of Xj depends on the fixed. . but unknown. . – Given θ. . σ2 ). Xn have already been observed and the expected aggregate claims in the coming year. the random variables {Xj } are independent. without making any different assumptions. θ – The conditional distribution of Xj given θ is 2 N (θ. Xn. • The assumptions are: – Let X1. . . but in a slightly different way.2 BAYESIAN CREDIBILITY 20 2.e. . . x2.5 Further remarks on the normal/normal model • In this section the model discussed in last section will be considered. . Xn+1. . – The value of X1. . (*) 2 – The prior distribution of θ is N (µ. i. . E [Xn+1|x1. σ1 ). . .

– The random variables {Xj } are (unconditionally) identically distributed.2 BAYESIAN CREDIBILITY 21 • Some important consequences are: – Given θ. Because ∞ P (Xj ≤ y ) = −∞ ∞ fθ (θ)FX |θ (y )dθ = −∞ σ2 1 √ y−θ −(θ − µ)2 Φ dθ exp 2 2 σ σ 2π 1 2 f (x|θ)f (θ)dθ f (x ) = . the random variables {Xj } are i.d.i.

2 BAYESIAN CREDIBILITY 22 – The random variables {Xj } are not (unconditionally) independent. θ is known. E [X1X2] = = = = E (X1) = = = E (X2) = = = E (X1X2) = E [E (X1X2|θ)] E [E (X1|θ)E (X2|θ)] E (θ 2 ) 2 µ2 + σ2 E [E (X1|θ)] E (θ ) µ E [E (X2|θ)] E (θ ) µ E (X1)E (X2) • The relationship between X1 and X2 is that their means are chosen from a common distribution. If this mean. . then this relationship is broken and there exists conditional independence.

g. In each case the aim is to estimate some quantity which characterizes this distribution. • This approach can be summarized as follows: – The problem is stated.g. e. to determine a claim size or claim number distribution. e.g. . e. the mean number of claims or the mean claim size. – This estimate is then shown to be in the form of a credibility estimate. it is assumed that the claim number distribution is Poisson and that the unknown parameter of the Poisson distribution has a gamma distribution with specified parameters. – A (Bayesian) estimate of the particular quantity is derived.2 BAYESIAN CREDIBILITY 23 2. – Some model assumptions are then made within a Bayesian framework.6 Discussion of the Bayesian approach to credibility • The approach used in the Poisson/gamma and normal/normal models was essentially the same.

the Bayesian approach may not work in the sense that it may not produce an estimate which can readily be rearranged to be in the form of a credibility estimate. • The two drawbacks of this approach are: – The first difficulty is whether a Bayesian approach to the problem is acceptable. . – The second difficulty is that even if the problem fits into a Bayesian framework. what values to assign to the parameters of the prior distribution.2 BAYESIAN CREDIBILITY 24 • This approach has been very successful in these two cases. and. if so. It has made the notion of collateral data very precise (by interpreting it in terms of a prior distribution) and has given formulae for the calculation of the credibility factor.

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