Burning cost (and burning cost ratio)

Burning cost is an empirical pricing method widely used in non-proportional reinsurance, which consists in estimating the cost of a layer from the historical losses actually observed on that layer. Over several past years, one reconstructs the losses that would have hit the layer in question, then relates them to a premium base to obtain the burning cost ratio, expressed as a percentage. This ratio, once loaded for expenses, margin and inflation, serves as the basis for the premium charged. The method has the advantage of simplicity and of being anchored in real data, but its limits are significant and well known. It is purely retrospective and poorly captures rare events not observed in the history, which makes it unreliable on high layers rarely hit or on perils with strong catastrophic potential. It also assumes a degree of portfolio stability and requires adjustments to account for claims inflation and changing exposure. In cyber, the brevity of the available history particularly weakens the burning cost approach, which leads reinsurers to supplement it with scenario models.

Over five years, the losses that hit a layer average 12 percent of the premium base; this burning cost ratio, loaded for expenses and inflation, gives a starting point for pricing the layer.

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