Cyber Risk in Reinsurance
February 12, 2025
One of the most widely used frameworks for analyzing cultural differences is the model developed by the eminent cultural theorist, Geert Hofstede. In this model, the differences in culture between countries have been plotted along five dimensions, which can be used as the basis for predicting the cultural differences between different countries. The model was […]
Negotiation is a technique employed to avoid conflicts and decide something which would benefit all. Individuals negotiate with each other and try to reach to a solution satisfying all. Negotiation is not possible unless and until individuals learn to compromise to some extent and stop finding faults in each other. Professionals must know how to […]
Confidence and attitude play an essential role in public speaking. One needs to be confident in front of his/her audience to create an everlasting impression. Remember, your audience would not take you seriously unless and until you believe in yourself. Nervousness only indicates either you are lying or not sure of what you intend to […]
Dealing with Radical Change We live in times when change is the only constant. Indeed, organizations now compete in an external market landscape where the time to market is in the months and not years, as earlier, and where each new technology or trend that emerges leads to another round and wave of disruption. Just […]
The insurance industry is a large and diversified industry. It has several different types of products and operates in multiple geographies. This means that the risks on the balance sheet of the insurance company can be quite diversified. This means that a reinsurance company is also exposed to a lot of variety when it comes […]
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.
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.
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.
The main advantages of the burning cost approach are as follows:
The disadvantages of the burning cost approach have also been mentioned below:
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.
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.
Your email address will not be published. Required fields are marked *