The Burning Cost Approach

In the previous article, we have already seen how reinsurance policies are generally priced and what factors are taken into account while pricing them. There are certain specific methods and approaches which have been used by reinsurance companies across the globe for many years. These methods or approaches have now become a standard that is followed worldwide. The burning cost approach is one such approach. In this article, we will have a closer look at what the burning cost approach is and how it is used by reinsurers across the globe.

What is the Burning Cost Approach?

The burning cost approach is probably the most widely used approach in reinsurance pricing. The popularity of this approach stems from the fact that this is one of the simplest and yet most effective approaches to calculating reinsurance premiums.

The burning cost approach relies extensively on the use of past data in order to determine the premiums which will be payable in the future. In this method, the reinsurer asks the ceding insurer to share past data with them. This past data can be related to a larger timeframe of five years or more. Once this data is available with the reinsurer, they begin to compare the claims which were paid in each of these years with the premium which was taken in. If the data is taken for a large number of years, the year-to-year fluctuations can be negated and a trend can be seen.

Once, the data has been analyzed, the reinsurer divided the total losses (both paid out and under process) by the gross net premium income. This helps the reinsurer find the pure burning cost. For example, if a ceding insurer has paid a premium worth $20 million in the last five years and they have charged losses worth $1 million to the reinsurer, then the pure burning cost is 5%

The pure burn cost is the amount that the reinsurance company expects to pay out in the form of claims in the long run. However, the reinsurance company will have certain administrative costs which it will have to bear if it wants to stay in business. Also, there is a cost of capital. Hence, the reinsurer would also want to make a reasonable rate of profit. All these calculations are done while coming up with the loading factor. The loading factor is then multiplied by the pure burn cost.

For example, let’s say that the loading factor is 100/80. In such a case the pure burning cost of 5% will be multiplied by the loading factor of 100/80. This multiplication will give a result of 6.25%. This is the rate that the reinsurer will end up charging the ceding insurer if they use the burning cost approach in order to calculate their premium.

There are many more complicated approaches that can be used on top of this simple approach. For instance, some reinsurance companies use the sliding scale approach. This means that instead of coming up with a single premium, they come up with a minimum and a maximum range. The reinsurer is paid a minimum rate at the beginning of the year. Adjustments are then made to this premium as the losses increase. However, finally, the premium adjustments stop once the maximum amount has been reached.

Different Base for Calculation

It is important to note that the base used to calculate reinsurance premiums is different as compared to the base which is used for calculating the insurance premium. When it comes to insurance premiums, ceding insurance companies decide the premium based on the coverage being offered by the policy. However, when it comes to reinsurance policies, coverage is not the key factor.

Instead, as mentioned above, premiums are calculated based on gross net premium income (GNPI) which is the total amount of premiums that have been collected by the ceding insurer. Hence, the reinsurance premium is linked to the premium of the original policy. As a result, it automatically fluctuates up and down with a change in the premium for the original policy.

Advantages Of the Burning Cost Approach

The main advantages of the burning cost approach are as follows:

1. Pro-Rata Distribution of Premiums: The burning cost approach uses past claim data in order to determine the amount of money that will be paid to the reinsurers. This ensures that ceding insurers who have made fewer claims in the past are incentivized by giving them a lower premium rate.

2. Less Stochastic Approach: Another advantage of the burning cost method is that the approach is less stochastic. This means that this approach does not involve statistically tracking hundreds of different variables and making a complex formula. The simplicity which is inbuilt into the approach makes it highly effective.

Disadvantages of the Burning Cost Approach

The disadvantages of the burning cost approach have also been mentioned below:

1. Based on Past Data: The burning cost approach is based completely on past data. This means that there is an inherent assumption that the future will be like the past. If that is not the case, then the approach will lead to incorrect measurements and distribution of risks. Given the impact of climate change and the unpredictability of claims, this assumption is being challenged and hence the effectiveness of this model is being challenged.

2. Data Skewed Towards Recent Events: Also, there is excessive emphasis on events that have taken place in the recent past. Hence, if a ceding insurer faces one adverse event, their premiums are likely to spike up for the next few years. This makes the burning costs approach somewhat inconvenient and unfair.

The fact of the matter is that the burning costs approach is one of the simplest approaches used for calculating reinsurance premiums. There are many reinsurers who reinvent this approach by adding additional variables and creating their own customized approach.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.