Credibility Theory

Credibility theory is a statistical approach used in insurance and risk management to predict future risks based on both historical data and external information. The theory helps insurers set premiums by balancing the insured entity's past claims experience with broader industry data, providing a more accurate risk assessment. It’s particularly useful for estimating risks when the insured has limited historical data.

Example

An insurance company uses credibility theory to set premiums for a new business by combining its limited claims history with industry-wide loss data for similar businesses.