Burning-Cost Ratio: What it is and How It Works

Burning Cost Ratio

Investopedia / Matthew Collins

What Is the Burning-Cost Ratio?

In the insurance sector, the term “burning-cost ratio” refers to a metric that can be calculated by dividing excess losses by the total subject premium. This figure is chiefly used to ascertain the rates for excess of loss reinsurance, which is the insurance that insurance companies themselves procure, to ensure that they remain solvent, should they fail to collect the adequate premiums needed to cover total claims. 

How the Burning-Cost Ratio Works

Calculation of the burning-cost ratio is one of several, widely-used rating methods, but it requires a large amount of claims data to be accurate. This calculation is strongly related to a type of statistics called ratio estimation.

The burning-cost ratio is arguably the simplest and most intuitive approach to figuring out costs. It works by estimating the expected losses to a policy based on average losses in past years, after allowing for claims inflation, exposure changes, incurred but not reported (IBNR) claims, and any other amendments that need to be made to make the past claims data relevant to today's situation.

In its simplest form, the burning-cost ratio is based on aggregate losses. It should be noted that this approach easily falls apart in the presence of deductibles and limits, as the policy might have had different levels of deductibles over the years. Furthermore, the effect of inflation is non-linear in the presence of a deductible. So, the ratio ignores trends of claims inflation. Moreover, by taking current exposure (often premiums) and comparing it with current undeveloped claims, the ratio leads to understating the ultimate position.

Burning-Cost Workers' Compensation

More large companies are taking out burning-cost policies, especially for their workers' compensation insurance. These policies set final amounts for premiums, according to an organization’s actual claims experience for the relevant period.

Enterprise companies that choose a policy with burning-cost pricing rather than a conventionally priced premium can reap significant financial benefits, but they can also be impacted negatively by unforeseen claims costs. For example, employers can potentially pay lower premiums for their workers' compensation insurance. Although it also carries the risk of ultimately being higher than a conventional rate. 

CFOs and brokers should be aware of the risks when choosing a workers' compensation policy. Workers' compensation is typically the single highest insurance expense a business will face, so examining the options and the potential impact is a worthwhile exercise.

Benefits of the Burning-Cost Ratio

The chief advantage of burning-cost pricing is that it provides a direct financial incentive for companies to operate efficiently and prioritize worker safety and rehabilitation. Incurred but not reported (IBNR) costs should also be considered, such as ongoing medical costs from problematic injuries. Company officials should also have comprehensive risk management and best-practice return-to-work programs in place to maximize the benefit of using the burning-cost ratio for workers' compensation insurance.