The burning cost method is a commonly used approach in
reinsurance to calculate the premium for excess of loss (XOL) treaties. This
method estimates the cost of future claims based on the historical loss
experience of the cedant (the insurance company purchasing reinsurance). Here’s
an in-depth look at how the burning cost method works:
Overview of the Burning Cost Method
- Historical
Data Collection:
- Gather
historical loss data over a specified period, typically 5-10 years. This
data includes all losses that fall within the layers covered by the XOL
treaty.
- Adjust
the losses for inflation and any changes in exposure or underwriting
practices to ensure consistency and relevance.
- Calculating
the Burning Cost:
- Sum
of Losses: Calculate the total incurred losses that fall within the
reinsurance layer for each year.
- Average
Annual Losses: Determine the average annual losses by summing the
total losses over the period and dividing by the number of years.
- Exposure
Adjustment: Adjust the average annual losses to reflect any changes
in exposure (e.g., changes in premium volume, policy count, or sums
insured).
- Loading
for Expenses and Profit:
- Add
a loading factor to the burning cost to cover the reinsurer’s
administrative expenses, profit margin, and any contingencies. This is
typically expressed as a percentage of the burning cost.
- Final
Premium Calculation:
- The
final premium for the XOL treaty is the sum of the burning cost and the
loading factor.
Burning Cost
= Total Losses in the reinsurance Layer / Number of Years
Reinsurance Premium = Burning Cost + (Burning Cost *Loading Factor)
Example
Suppose an insurance company has
the following historical loss data for a reinsurance layer of Kes 1 million in excess of Kes 1 million over a five-year period;
|
Year |
Loss
in Layer |
|
2019 |
200,000.00 |
|
2020 |
500,000.00 |
|
2021 |
300,000.00 |
|
2022 |
100,000.00 |
|
2023 |
400,000.00 |
- · Sum of Losses: 200,000 + 500,000 + 300,000 + 100,000 + 400,000 = 1,500,000
- · Average Annual Losses (Burning Cost): 1,500,000 / 5 = 300,000
- · Loading Factor: Suppose the loading factor for expenses and profit is 20%.
Therefore, reinsurance premiums
will be calculated as follows;
Reinsurance premium = 300,000 + (300,000 * 0.20) = (300,0000 + 60,000)
Key Considerations
- Accuracy
of Historical Data: The reliability of the burning cost method heavily
depends on the accuracy and relevance of historical loss data.
- Adjustment
for Inflation and Exposure: Proper adjustments for inflation and
changes in exposure ensure that the calculated burning cost accurately
reflects the current risk environment.
- Catastrophic
Events: This method may need adjustments for catastrophic events, as
they can skew historical loss data and may not be fully indicative of
future risk.
Advantages and Disadvantages
Advantages:
- Data-Driven:
Relies on actual historical loss data, making it a realistic basis for
premium calculation.
- Simplicity:
Relatively straightforward and easy to understand.
- Transparency:
Clear and transparent process for both ceda nts and reinsurers.
Disadvantages:
- Historical
Limitations: May not accurately predict future losses if the
historical period is not representative of future risk.
- Sensitivity
to Outliers: Significant losses in the historical period can
disproportionately affect the burning cost.
- Exposure
Changes: Requires accurate adjustments for changes in exposure and
inflation.
In conclusion, the burning cost
method provides a structured approach to pricing XOL reinsurance treaties,
leveraging historical loss data to predict future losses and determine
appropriate premiums. Its effectiveness depends on the quality of historical
data and appropriate adjustments for current risk factors.
