Alternatives to Burning Cost Rated Contracts

Burning-Paper

In one of my previous blogs I explained that certain types of contracts may be rated on a burning cost basis, where the final contract premium can only be calculated when the contract has expired and the losses to it are known.

Why are Some Contracts Rated in This Way?

Sometimes an insurer needs a layer of protection that is almost certain to produce losses for the reinsurers on a regular basis. Reinsurers will want to charge a premium that will cover the expected losses, plus their own margins. One way they can achieve this is by charging a variable rate that is calculated by loading the eventual losses to the contract by (typically) 100/70ths.

This “Loaded Burning Cost” is then capped by expressing it as a maximum rate on the declared premium income. The idea of the cap is that once the losses reach a certain level (an abnormal result for the year), the reinsured starts to benefit from the cover. The contract premium may be expressed something like this:

Minimum and Deposit Premium $1,000,000 adjustable on expiry at 100/70ths of the incurred losses to this agreement, subject to a minimum rate of 2.5% and a maximum rate of 12.5% of the reinsured’s Gross Net Premium Income (GNPI). Let’s assume that the GNPI is estimated to be $40,000,000.

This form of rating a contract has been widely used on low layers of motor excess of loss programmes, amongst others, especially in situations where the portfolio is relatively new and no reliable statistics exist. However, there is an obvious problem. Once the incurred losses to the contract, multiplied by 100/70 exceed 2.5% of the GNPI, the reinsured must pay an extra $100 premium for every $70 of claims recoverable, until the loaded rate exceeds 12.5% of the GNPI. This is clearly illustrated in the following graph:

Cost/Benefit of burning cost contract

Remember that the purpose of this layer is to protect the reinsured against an abnormal year of losses, rather than one or more unusually large claims. The minimum rate of 2.5% would produce a premium equal to the Minimum and Deposit (M & D) of $1,000,000. The rate would start to increase when the losses to the contract exceed $700,000. If the losses reach $1,400,000 the contract premium becomes $2,000,000 or 5% of the GNPI, meaning that the additional $700,000 of claims recovered have cost the reinsured an extra $1,000,000 in premium.
The maximum premium (based on the GNPI, which is currently only an estimate) is 12.5% of $40,000,000 or $5,000,000 which becomes payable when claims to the contract reach $3,500,000. From that point, any further claims to the contract have no effect on the premium calculation. The profit to the reinsurers will fall until the claims reach $5,000,000 and only after that point will the reinsured actually start to benefit from the contract.

Wouldn’t it be easier if the reinsured simply didn’t claim until after the maximum rate has been reached?

Contractually, if the premium is calculated as a factor of the incurred losses, the reinsured may not simply choose not to claim until the maximum contract rate is exceeded. That would be a breach of the contract and a breach of good faith.

But there is another way to structure the contract that can keep the initial premium low and avoid the cash-swapping of the burning cost rate.

Our alternative method involves setting an annual aggregate deductible (AAD) in addition to the each and every loss (EEL) deductible and charging a fixed rate on the GNPI, rather than a floating rate. To illustrate this, let’s suppose that the burning cost contract had a limit expressed as:

$1,000,000 each and every loss, excess of $1,000,000 each and every loss.

In our revised contract, we could amend this to read:

$1,000,000 each and every loss, excess of $1,000,000 each and every loss, excess of $4,000,000 of losses otherwise recoverable hereunder.

Each time the reinsured suffers a loss of more than $1,000,000 the amount in excess of that figure, up to a further $1,000,000 would count towards the annual aggregate losses to the contract.  The reinsured would only claim from the contract any amount of its aggregate loss that exceeds $4,000,000.  If reinsurers charge a fixed premium rate of 2.5% of GNPI, the contract premium would be $1,000,000 irrespective of the losses to the contract.  As we can see from the next graph, the AAD basis should produce exactly the same result as the burning cost basis when the losses exceed the $5,000,000 break-even point.

burningcost

This contract may be more attractive to both the reinsured and the reinsurers, as it eliminates the administrative burden of collecting many claims and adjusting the burning cost rate.

The AAD solution can be tweaked in order to reduce the premium while still maintaining the same break-even and downside risk to reinsurers.  For example, if the AAD is increased by $500,000 to $4,500,000, the premium could be reduced by the same amount (by reducing the rate from 2.5% to 1.25%).  Whether or not the reinsurers would accept this reduced rate is simply a matter for negotiation.

About Keith Riley

Keith Riley is Divisional Director in Willis Re's Asia Pacific, Middle East, Turkey and Africa team. Keith’s rein…
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4 Responses to Alternatives to Burning Cost Rated Contracts

  1. artjd says:

    Hi Keith,

    That’s one good way of accommodating reinsured’s usual request for lower premium and at the same time amply protecting the reinsurer. How about reinstatement premium?

    • Keith Riley says:

      A Burning Cost rated contract does not require reinstatement premiums because the cost of reinstatement is catered for by the loading factor (e.g. 100/70 x the incurred claims to the layer). The higher layers of Motor and Liability XL contracts (usually priced at a fixed rate on GNPI) generally gave unlimited free reinstatements, especially the unlimited layer, where calculating reinstatement premium in the traditional way (pro-rata to the amount of limit reinstated) clearly cannot be applied. In recent times, reinstatements have been creeping into Motor/Liability XL covers. I have even seen reinstatement premiums charged on some unlimited layers using a formula based on a notional limit, but without of course attempting to limit recoveries under the layer. I personally would not advocate reinstatement premiums on the aggregate deductible Casualty covers, but there may be a case for applying an aggregate annual limit.

  2. Please kindly provide us updated regarding reinsurance
    How to analysis the submitted risk profiles and portflios .
    How to arrange profitable reinsurance program .

    • Keith Riley says:

      Hello Mohamed. I have several blogs on WillisWire on the pricing of property XL contracts. For a fuller description please take a look at “Reinsurance: The Nuts and Bolts”. There are also some low-priced e-books on Amazon. The links can be found at http://www.kemmatraining.com Reinsurance programmes should emphasise capital efficiency, adequacy of protection, capacity augmentation etc

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