Credibility theory is a set of quantitative tools that allows an insurer to perform prospective experience rating (adjust future premiums 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.
The policyholder’s argument is as follows: The manual rate is designed to reflect the expected experience (past and future) of the entire rating class and implicitly assumes that the risks are homogeneous. However, no rating system is perfect, and there always remains some heterogeneity in the risk levels after all the underwriting criteria are accounted for. Consequently, some policyholders will be better risks than that assumed in the underlying manual rate. Of course, the same logic dictates that a rate increase should be applied to a poor risk, but the policyholder in this situation is certainly not going to ask for a rate increase! Nevertheless, an increase may be necessary, due to considerations of equity and the economics of the situation.
The insurer is then forced to answer the following question: 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? In other words, how credible is the policyholder’s ...