Flight to quality

Flight to quality – Financial security in the aviation insurance market

Technical publishing Aviation

Flight to quality – Financial security in the aviation insurance market

Contents Preface

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Breaking news: An aircraft with 362 passengers and a crew of 19 aboard has crashed...

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A closer inspection of the aviation re/insurance market Historically poor technical underwriting results Highly cyclical and volatile market Inadequate premium base and cross-subsidisation Concentration of insureds Small sample size – a barrier to effective pricing Dependency on reinsurance and retrocessional coverage The controversial practices of the fringe markets and cash flow underwriting Concentration within the distribution chain and its implications Overabundance of capital and capacity

7 7 7 8 8 8 9 10 10 11

Quality not quantity Premium components

13 13

Volatility of the airline industry – understanding the dynamics The adequacy of re/insurance?

What causes insolvency?

Correlation between underwriting risks and insolvencies Correlation between premium and insolvencies Correlation between cash flow underwriting and insolvencies Correlation between catastrophic loss and insolvencies Impact of interest rates Spread and insolvencies

15 15 18 18 18 19 20 20 21

Turbulence ahead Assuming the worst – the impact of insolvency on an airline insurance programme Importance of financial security for an airline in a world of stakeholder value Passengers: ultimate beneficiaries, ultimate casualties Alliance and code-sharing partners The financial community – awareness and aversion to insolvency risk Governments Employees The community at large

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Conclusion Safety culture Financial safety culture Responsibility and due diligence

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24 24 24 25 25 25 25

Preface In the aftermath of Exxon Valdez, Piper Alpha and Hurricane Andrew, it became clear that an extended period of rate inadequacy followed by a catastrophic loss creates a precarious financial situation for many insurers. In the current environment, at least one additional critical factor has emerged: massive reduction of shareholder capital following the steady erosion of re/insurers’ investment portfolios. Further, the consolidation and concentration which has occurred in the aviation reinsurance market during the past decade has reduced the number of reinsurers available to aviation insurers.

Risk managers, responsible for placing billions of dollars of insurance on behalf of airlines and aviation products manufacturers, may feel confident that they still have a financially sound panel of insurers, but do they know how strong their insurers’ reinsurers are? Do they realise how much of their insurers’ obligations are reinsured with the same few reinsurers? Do they know that many of their insurers have reinsurance with an aggregate limit that could be exhausted by just two catastrophic losses during the same contract period?

Flight to quality highlights the complex interactions of the volatile aviation re/insurance market and how they are coinciding with a general downturn in financial markets worldwide, creating a situation in which many re/insurers could experience serious financial difficulties. This brochure is addressed to all participants in the aviation insurance and reinsurance market and emphasises the need for vigilance and an uncompromising approach when selecting the quality of the security offered by insurers and reinsurers.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

Breaking news: An aircraft with 362 passengers and a crew of 19 aboard has crashed . . .

We all stop and listen. Probably no other business sector suffers such high profile losses as the airline industry. Even in remote regions of the world, aircraft accidents involving unknown carriers capture our attention. Why? Could it be the number of casualties, the magnitude of property damage occurring so suddenly and concentrated in one specific place? Our fascination with flight and the subconscious realisation that accidents happen despite favourable statistics and a strong safety culture?

Long after news of the tragic accident fades, various aspects continue to affect the involved parties for years – the families of the victims, the airlines, government agencies, manufacturers, lawyers and the insurance community.

Years may pass without reaching resolution as evidence is meticulously gathered and examined, possible causes investigated. Legal liability and damage issues are assessed, debated, settled by the parties or ultimately decided by the courts.

During this lengthy process, it has always been taken for granted that the airlines would compensate passengers and their families for any loss. Likewise, the insured airlines have also expected that costs incurred by and compensation paid to the victims would be indemnified by their insurers. This was not an unreasonable expectation on the part of the affected parties; passengers entered into a contract of carriage with the airlines to transport them safely to their destination. The airlines paid a premium to their insurers, thereby enabling them to compensate passengers in the event of failing to fulfil contractual obligations.

In the current financial and political environment, these expectations may well be tested. The very structure of the re/insurance markets upon which these expectations have been based in the past is now showing signs of vulnerability. Factors such as the lack of technical focus, complacency and short-term thinking – which converge during a period of greater financial uncertainty – are now shaking the very foundations of the aviation re/insurance market which offers financial security to its airline insureds.

While passengers are generally oblivious to the arrangements between airlines and their insurers, an airline’s risk/insurance manager is expected to be well-versed in the intricacies of the re/insurance market. Nevertheless, the structure and inherent idiosyncrasies of the market must first be examined to fully comprehend the impact of recent change on the market’s future direction.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

A closer inspection of the aviation re/insurance market When underwriters analyse an airline policy submission, numerous factors affect their decision to accept or decline the risk. Some of them require detailed analysis, others are evaluated according to experience.

From the underwriting perspective, one technical factor used in evaluating the individual risk dominates, namely: the historical loss ratio of the insured airline.

Has the insured historically generated more premium for the insurer than incurred losses? From the airlines’ standpoint, this factor alone would be a valid criterion for assessing the risk.

Viewed in its proper context, however, underwriting an individual airline risk only follows the decision that a specific line of business on the whole is an attractive financial proposition for the insurer.

Precisely what makes a line of business attractive depends on a variety of other factors collectively referred to as the commercial realities of the market.

All these elements and the manner in which they interact play a decisive role in the ultimate decision to underwrite the individual risk. What exactly are some of these factors in the aviation insurance market?

Historically poor technical underwriting results The technical underwriting results for the market as a whole are evaluated in the same manner as an individual risk. In this context, the aviation insurance market has performed poorly, its losses outpacing premiums in ten of the past 13 underwriting years. Although gross premiums totalled some USD 17 billion in the same period, the insured airlines collectively posted claims for hull and liability losses of roughly USD 21 billion, resulting in an approximate technical loss of USD 4 billion.

Highly cyclical and volatile market The aviation insurance market is also highly cyclical, with the 1990s representing a period of extremes for both aviation insurers and their clients.

Despite the increasing quantum per claim, world airline premiums were roughly USD 1.9 billion in 1995 and continued to decline to approximately USD 1 billion in 1998. Premium then exceeded USD 1.8 billion in 2001.

Airline market net premium (Underwriting year basis)

Net premium in USD m

2000

1600

1200

800

400

0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

In the first quarter 2002, one prominent broker reported an average premium movement of 46% on renewals placed after 11 September, estimating that aviation premium income would be in the range of USD 4–5 billion for 2002.

Such a market does not create a stable environment which would permit the airlines to budget their insurance costs beyond the next renewal, and re/insurers to develop a solid premium base for paying anticipated and extraordinary losses.

Inadequate premium base and cross-subsidisation The premium base of the airline industry has been historically low in relation to the sums insured. Analyses of airline hull and liability programmes collated by a major broker revealed that of 323 programmes, some 160 had legal liability limit provisions in excess of USD 1 billion, while 80 insureds had limits of USD 1.5 billion and more. Currently, the total worldwide insured fleet value exceeds USD 550 billion. With average annual premium during the past 10 years of USD 1.4 billion, this is a disproportionate premium-to-exposure ratio for any line of business.

In view of such poor technical results, some degree of cross-subsidisation has developed in this specialised market. This means that premiums generated from other lines of business are used to indemnify aviation-specific losses.

Not all re/insurers can benefit from this practice since the aviation insurance market is also characterised by a relatively large proportion of monoliners, ie re/insurers who underwrite aviation business exclusively. Market vulnerability is heightened without the additional financial security of other lines.

Concentration of insureds Among the approximately 345,000 policyholders who insure against hull and/or liability risks, some 200 are key airlines and an additional 260 are major ancillary aviation-related clients. These 460 insureds account for roughly 50% of the total direct aviation insurance premium. With additional cross-border mergers anticipated in the future, the concentration of insureds and their average exposure level will increase commensurately. Therefore, larger amounts of capacity will have to be allocated by re/insurers to a proportionally smaller number of insureds.

Small sample size – a barrier to effective pricing Currently, there are some 15,000 western built jet aircraft and 8,000 turboprops in operation. The exposure for re/insurers represents USD 550 billion for hulls alone. In terms of units, the number of aircraft insured worldwide roughly equals the number of vehicles registered in a medium-sized European or North American city. This reinforces the point that a small number of aircraft constitutes large single exposures. In short, a participation of 1% in a medium-sized European airline’s hull programme of USD 5 billion represents an exposure of USD 50 million for a single insurer.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

Despite high insured values, the relatively small number of aircraft also creates problems for insurers attempting to technically rate or calculate the optimal or acceptable premium they should charge for hulls.

To arrive at an actuarially based evaluation or rating, insurers generally categorise insureds or clients collectively. The criterion for this allocation is that each member of the group is exposed to the same type of risk. The larger the group or sample size, the closer the average loss will approach a statistically valid number. Known as the Law of Large Numbers, this application is employed by actuaries for rating risks. It is effective in lines of business such as motor vehicle or life insurance markets with large sample sizes. Conversely, its use is far less effective for small sample sizes, and the low number of aircraft hulls worldwide is such a case. Consequently, the aviation industry falls outside the scope of the Law of Large Numbers.

The inability to obtain a statistically acceptable margin of error because of the small sample size means that a more technically accurate rating is difficult to ascertain – even if the technical rate is only to be employed initially as a benchmark by underwriters.

Dependency on reinsurance and retrocessional coverage If a 1% participation in an aircraft hull policy with an agreed value of USD 220 million represents a potential exposure of USD 2.2 million for a single insurer, the same participation in the average airline’s liability policy translates into an extremely large exposure for the individual insurer. It can range anywhere between USD 10 and 15 million for each aircraft in the airline’s fleet.

Few insurers have the financial strength to sustain losses of such magnitude if they occur and are covered. Therefore, insurers attempt to spread the risk.

Traditionally, one of the most effective techniques of spreading the risk has been through purchasing reinsurance, thereby transferring the risk to the balance sheet of the reinsurer. This chain continues when the reinsurer acquires large amounts of retrocessional coverage, and, in the process, creates a complex web of insurers, reinsurers and retrocessionaires of broad geographical diversity. They are all underwriting and participating in the same risk but, in some cases, are unknown to each other and even to the airline itself.

Another aspect of the reinsurance/retrocessional market is that direct and reinsurance coverage can be improperly matched. Strictly speaking, direct policies are written on an each aircraft basis, thereby providing unlimited sideways cover. This is in contrast to reinsurance/retrocessional policies which frequently offer coverage on an occurrence or event basis. Generally, reinsurance programmes include an aggregate limit. Hence, insurers granting unlimited sideways cover are protected by reinsurance programmes with limited sideways cover, which results in coverage gaps.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

The controversial practices of the fringe markets and cash flow underwriting Some of the re/insurance and retrocessional capacity provided to the aviation insurance market originates from the fringe markets, so called since capacity migrates from non-aviation lines of business where surplus capacity may exist.

The perception of more favourable conditions in the aviation insurance market triggers an influx of capacity. While this market may hold the promise of additional premium income for the fringe player, the economic reality – which is fully consistent with the principal of supply and demand – is that this additional capacity may lead to a capacity surplus, ultimately driving the premium rate price downward for all re/insurers in the market. It must be remembered that if a mere 0.1% of all non-life underwriting capacity flows into the aviation market, this may correspond to a 25% increase in capacity dedicated to this specialised market.

Compounding the problem, fringe market players often have little or no experience in aviation underwriting, and are unlikely to acquire it since they have no explicit long-term commitment to the market. Instead, they base their participation on minimal underwriting information, and are often indifferent to the scope of coverage to which they commit themselves. In addition, they focus almost entirely on the premium they receive for underwriting the risk and whether or not it is sufficient to cover the cost of reinsuring that risk with the next reinsurer or retrocessionaire. This practice will continue as long as the quantum of incoming premium exceeds the outgoing premium to the reinsurer and/or retrocessionaire and the difference is employed to gainfully generate investment income. This is a rather opportunistic and technically unsophisticated approach to underwriting.

Although not necessarily confined to fringe market players, the practice described above is referred to as cash flow underwriting, or underwriting to obtain sufficient premium volume as seed money for investment opportunities.

Concentration within the distribution chain and its implications The mid to late 1990s were characterised by a wave of mergers and acquisitions within the broker community which dramatically reduced the number of major aviation brokers worldwide. While distribution channels have become more concentrated, the number of re/insurers willing to underwrite aviation risks has not reduced as dramatically. Given such an imbalance, brokers have emerged as possibly the driving force in placing aviation risks. Intense competition among the remaining brokers to retain business and acquire new clients has forced them to focus on attaining the most competitive rates for their client airline. For a price-conscious airline insurance manager who is under intense pressure to cut costs, the possibility of cost reduction is a convincing argument to either retain or change brokers. Brokers have also been successful in broadening the coverage scope afforded under the policy, again to the benefit of their airline clients.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

From such a strengthened bargaining position, brokers also initiated and refined the practice of so-called vertically marketing an airline policy. This means placing the same risk with various re/insurers, but at different terms. Endeavouring to obtain the most competitive premium price for their airline clients, brokers may initially approach those insurers whom they consider responsive in terms of offering competitive rates. Thus, capacity is committed at the lower end of the market from bottom up. This places pressure on the leader and upper-end markets to match, or at least lower, their quoted rates in order to participate in the programme. Traditionally, the leader who is responsible for drafting the policy and handling claims commands the highest rates in view of the additional services provided. Reversing this practice in the 1990s, it was the competitive end of the market that ultimately drove the cost of the insurance purchased by the airline.

Overabundance of capital and capacity The reversal in rating procedures exemplified by vertical marketing is attributable to one single factor – an oversupply of capacity. This was certainly a predominant factor of the aviation re/insurance market throughout much of the 1990s. Irrespective of the quality of capacity in terms of the financial security backing the commitment to indemnify claims, the overabundance of capacity was so great that it inhibited a technically sound assessment of the re/insurance product. This factor was brought to light when the commitment of the re/insurance industry to underwrite a single risk was 2.5 times greater than the limits required for a single policy. In short, when the market peaked in 1997, there was 250% capacity.

The overabundance of capacity fostered the soft market cycle, or the scenario of supply exceeding demand and its attendant effect on pricing. But what, in fact, was driving the influx of capacity? Was it additional capacity from longstanding and specialised aviation re/insurers or new capacity from the fringe markets? The answer was to be found in the buoyant financial and capital markets. New capital created during the financial boom of the 1990s spurred a capacity surplus to be deployed.

A factor of significant importance was that returns in the equity markets meant that premiums – as underrated as they were – could still be invested profitably. Pending the indemnification of any losses, their return on investment more than compensated for all losses which may have to be paid.

Today, the dependency on investment income to bolster profitability in a soft market no longer appears to be a reliable and sound formula. Not only is it difficult to rate the re/insurance product, but challenges are also expected in obtaining a decent return on premium invested.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

Quality not quantity The aviation industry has, for many years, experienced a surplus of capacity from competitive providers, leading to depressed pricing and unsatisfactory results. Soft market conditions have prompted re/insurers to exit this business or reduce their line size. This substantially reduced capacity available to the airlines. As with any cyclical business, the fear prevailed that improving prices and prospects in a firming market would attract additional capacity, thereby triggering another downturn.

While a healthy balance of supply and demand is a key factor in a functioning market, reduced capacity volume alone is not a panacea for the ills of the aviation insurance market. The quality of the capacity and how it is employed is an equally important factor. Historically, many insurers have been affected more by market forces than by technical considerations, and, in this context, cash flow underwriting has been practised in the aviation insurance market for several years.

To successfully and profitably employ capacity, the underwriter must have sound technical skills and comprehensive understanding of client requirements. A technical approach requires that underwriters know how the premium rate is calculated.

Premium components In simple terms, premium is the cost of a promise on the part of the insurer to pay the insured in the event of claims covered under a policy. Numerous factors – which include the frequency and severity of the potential claims – will determine the price of that commitment. As premium flows from an airline into complex re/insurance layers, all programme participants make a commitment to the airline – either directly or indirectly – to pay claims in proportion to their share.

Risk and premium distribution within the airline re/insurance market

Airline Original insured

Broker

Lead insurer/reinsured

Co-insurer/reinsured

Co-insurer/reinsured

Reinsurance broker

Reinsurer

Reinsurer

Reinsurer

Reinsurance/retro broker

Reinsurer Retrocessionaire

Reinsurer Retrocessionaire

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Reinsurer Retrocessionaire

Reinsurer Retrocessionaire

Reinsurer Retrocessionaire

Reinsurer Retrocessionaire

Swiss Re: Flight to quality – Financial security in the aviation insurance market

Reinsurer Retrocessionaire

This commitment is backed by reserves the re/insurer allocates from premium income and/or capital. Reviewing each of the premium components is crucial for understanding how premium affects an insurer’s ability to pay in the future, thereby underscoring the importance of precise risk assessment. Premium consists of the following expense and income components: Expense components: J loss experience over a number of years, accounting for paid and outstanding losses, including those losses incurred but not reported, as well as claims adjustment costs J standard deviation margin J catastrophe margin J socio-economic changes reflected in progressively larger claim amounts or settlements J cost of capital J reinsurance cost J original commission and brokerage J business administration costs J business acquisition costs (both direct and indirect) J required profit margin Income components: J effect of technical interest on reserves or positive cash flow J commission or overrider from reinsurance Statistics show that ever-increasing loss amounts combined with market forces have resulted in the volume of claims outpacing premiums written.

Recent market pricing also indicates that underwriters have been prepared to sacrifice standard deviation and catastrophe loss margins to retain the business and thereby the premium volume.

Despite the lag between a series of losses and a corresponding hardening of the market, it is clear that a market-oriented – rather than a technical – approach has been the prime force behind pricing in recent years. The end result is that the premium cannot fulfil what it is intended to do, namely indemnify the client in the event of a loss.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

Volatility of the airline industry – understanding the dynamics Another factor destined to affect insurers’ risk assessments in the future lies in the changing nature of the aviation industry itself. As a highly cyclical industry, aviation is particularly vulnerable to general economic trends and, in view of soaring costs, it must remain agile to survive. To understand the risks, underwriters must comprehend the changing dynamics of an industry which both appears to defy economic logic and poses a challenge to rating since it is continually in flux. The International Civil Aviation Organisation (ICAO), a UN agency dedicated to commercial aviation matters, estimates that airlines worldwide will incur an operating loss of USD 10.9 billion in 2001 as opposed to an operating profit of USD 11.0 billion in 2000.

After the euphoria of privatisation and intermittent periods of robust economic growth, the industry has been forced to face the harsh realities of a global economic downturn. Shareholder expectations have increased. In an effort to adapt to the economic environment, the industry has seen a spate of consolidation, bankruptcies and a continually changing network of partnerships and alliances.

Whether these structural changes will be sufficient or the industry needs to radically rethink its business model remains to be seen. What is certain is that the aviation industry’s insurers will need to factor all these changes into an overall evaluation of a company’s risk and consider the price that risk commands.

The adequacy of re/insurance?

Beyond the internal policy renewal procedure involving an airline insurance/risk manager – and possibly the CFO – with their placing broker, insurance is not a subject which historically initiates broad discussion in the corridors of an airline’s head office or company boardroom. Insurance has been regarded traditionally as a relatively minor operating expense, contributing on average less than 1% of the overall operating costs of an airline. Costs such as fuel, maintenance and labour are understandably of far greater concern for airline management.

While a strong safety culture within an airline has been established as a risk deterrent, it has its limits, and, hence, the fundamental need for insurance. In the event of a major accident, insurance assumes a much more significant role, becoming the financial safety net whose very existence and adequacy can determine whether or not the airline survives. Consequently, insurance becomes the key hedge airlines employ against financial ruin.

This pronounced safety consciousness which characterises the airline industry has resulted mostly from technical initiatives engineered by the airlines themselves during the past 80 years of commercial aviation. It can also be attributed to direct government regulation and intervention at the domestic and international levels.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

The work of the ICAO has been legendary in raising the safety standard of commercial aviation throughout the world. At various times, the agency has also been instrumental in addressing the liability issues which have been the centre of intense activity particularly during the last decade. Throughout the liability debate, insurance per se was never a crucial topic; the primary concern was whether or not any increase or abolition of passenger liability limits would raise insurance premiums.

The Montreal Convention1 intends to formalise the removal of these limits.

Apart from one minor exception, this is the first time the role of insurance has been acknowledged in an international aviation convention or amending protocol. Article 50 places an obligation on the contracting states/signatories, whereby their carriers (ie airlines) are obliged to maintain adequate insurance covering their liability under the Convention. Further, a carrier may be required by the signatory state to furnish evidence that it maintains adequate insurance cover for its liability.

For whatever reason, the term “adequate” is not defined in the Convention. It can be safely assumed that the intent was to ensure that carriers maintained adequate insurance in terms of the sufficiency or amount of insurance coverage they purchased. It may also be reasonable to assume the required scope of coverage is adequate.

What about the inherent financial ability of the re/insurer to pay in the event of a loss? The inability – as opposed to the unwillingness – to honour this promise to indemnify a claim arises in the event of the insolvency of a re/insurer. In such an event, the airline will be forced to absorb the loss itself, in whole or in part.

A daunting prospect for an airline, given the existing demands placed on its capital and the potential extent of a loss. This prospect obliges even professional risk assessors to seek reinsurance and retrocessional coverage when engaged in this line of business.

Ultimately, the quality of re/insurance is the only criterion by which adequate cover can be measured. If that is the final determinant, then identifying the factors contributing to the possibility of a re/insurer’s inability to indemnify a claim or loss does indeed merit examination.

1

Essential Documents on International Air Carrier Liability June 1999. International Air Transport Association (IATA), Montreal & Geneva.

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What causes insolvency?

The re/insurer’s core activity is the assumption of risks. The underwriting process transfers a risk to the books of the re/insurers. This raises significant issues about their capability to fulfil claims payment obligations – or even continue business operations – in the event that they are unable to acquire the funds to indemnify the insured for a loss. It also raises major issues about the consequences for the insured in the event of insolvency.

Correlation between underwriting risks and insolvencies According to a sigma study in 1995, the underwritten risk itself represents the largest single cause of insolvency. However, insolvency is also attributable to insufficient reserving practices on the part of the re/insurer and an inadequate premium base being developed as a result of inadequately rating those risks.

It also results from a rapid and unforeseen escalation in the number of claims presented, and the occurrence of a catastrophic loss during the policy term. The sum of these factors naturally represents an increase in liabilities for a re/insurer.

The 1995 sigma study outlined the high correlation between re/insurers’ underwriting results and default. In 1985 and 1992, the two years with the largest number of insolvencies considered in the study, underwriting performance was at its lowest point following a period of decline in results. Among those UK-based insolvencies examined, there was an approximate lag of one year between the peak of insolvencies and the valley of underwriting results.

Correlation between premium and insolvencies This graph illustrates how the frequency of insolvencies is inversely proportional to the premium cycle in a cyclical non-life market.

Insolvencies in a cyclical market

2000

80

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70

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60

1400

50

1200 40

1000 30

800 20

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400 200

0

1986

1987

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Premium cycle (in USD m)

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1993

1994

1995 Number of insolvencies

Worldwide rise in insurance company insolvencies; sigma no. 7/1995, page 6

90 80 70 60 50 40 30 20 10 0 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

USA UK Europe excluding UK Rest of world

Although data is not restricted solely to the aviation market, the graph above shows how the 1980s and 1990s were periods of high frequency of insolvencies among non-life insurers, particularly in the US following Hurricane Andrew in 1992.

Correlation between cash flow underwriting and insolvencies Cash flow underwriting involves acquiring reinsurance at favourable terms or terms more favourable than the premium received from underwriting the risk.

Any delay in recovery under a reinsurance programme can seriously undermine the financial soundness of the underwriter and expose the insureds’ programme to shortfall risk. Therefore, in a market environment dominated by depressed premiums, poor investment returns and high loss frequencies, those players who practice cash flow underwriting are more susceptible to insolvency.

An A.M. Best study in 1991 concluded that in the three years prior to their insolvency, 80% of the insurers recorded either stagnant premium growth (less than 5% per annum) or exceptional growth (greater than 25% per annum). The significant number of insurers experiencing strong growth during this period prior to their insolvency substantiates the hypothesis that cash flow underwriting was a key factor in these defaults. Opportunistic insurers who participate on the fringes of the aviation market and rely on cash flow underwriting may be rendered insolvent if they are confronted with a large number of claims in terms of frequency and severity before additional premium income can shore up their cash flow requirements.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

Correlation between catastrophic loss and insolvencies Empirical data suggests that increases in catastrophic losses are directly related to a greater number of insolvencies. The number of insurance company bankruptcies in the aftermath of Hurricane Andrew provides the most notable example. There is concern that this experience could be repeated following a catastrophic aviation loss.

While there were relatively few insolvencies in the mid to late 1990s, specialists predict that more insolvencies will be triggered by the combined effects of low premiums, low interest rates, stagnant growth and excess capital against a backdrop of higher losses.

Following 11 September, lawyers, brokers and insurers reported the increased concern of corporate risk managers over the prospect of catastrophic losses exceeding the market’s capability to pay. With escalating values of airline fleets, one possibility is that a series of multiple hull losses within a relatively short period would put re/insurers under pressure to pay for the losses in an expedient and prompt manner.

Impact of interest rates On the assets side, interest rate developments in particular are influential in determining the financial results of re/insurers and ultimately any possibility of insolvency. Traditionally, when interest rates increase, asset value declines, thereby reducing solvency. In such a situation, an insurer may experience payment difficulties if forced to divest assets for claims payment. High interest rates also mean greater current investment income. When the policy incepts during a period of high interest rates, premium prices become competitive. Satisfactory investment returns are achieved in the short term, following a decline in interest rates through the realisation of capital gains. However, sustained periods of falling interest rates produce a negative effect on investment results and cannot be sustained indefinitely by a re/insurer when risks are continually underrated.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

Spread and insolvencies One concern of aviation re/insurers has been the breadth of the rating spread between programme leaders and the following markets. In a broker’s recent report2 on airline programmes which were renewed following 11 September, the spread was shown to have decreased dramatically from 29% in 1997 to 5% in 2002. This is consistent with the decline in capacity from a level of 220% – 250% to 150%. Not only has capacity decreased from 1997 to 2002, but the number of market participants has also dropped correspondingly during the same period: from 31 in 1997 to only 20 underwriting a single airline policy at present.

This may encourage major financial players to return to the market. According to one senior executive of a major airline this would be a positive step. In an environment still reacting to the repercussions of a soft market and 11 September, this observation is an acknowledgement that large, financially sound risk takers are needed to lend their support to the aviation insurance industry. The following graph shows default rates according to Standard & Poor’s ratings. It illustrates that the probability of a default is greater for those risk takers which are less financially secure.

Average cumulative defaults rates

Default rates in percent

70

60

50

40

30

20

10

0 1

3

5

7

8

9

Year

CCC B BB BBB A AA AAA

2

Heath Lambert report on airline insurance: Issue 11, 2002 page 10; published by Heath Lambert Group Aerospace, London, 2002.

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11

13

15

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

Turbulence ahead There is justifiable and growing concern that a wave of insolvencies may be triggered if losses continue to outpace premiums and the market continues to operate as it has in the past. Factors contributing to this situation include: J

J J

J J

J J

depressed premiums in the aviation market during the last soft cycle which resulted in an inadequate premium base; an increase in the average amount per claim; the ever-present potential for a catastrophic loss and the failure to adequately reserve for such an eventuality; a severely eroded capital base; the prevalence and dependency upon cash flow underwriting among capacity providers and an attendant decline in investment earnings; the current economic downtrend and general lack of confidence; and the dramatic decrease in returns on the underwriter’s investment portfolio.

Assuming the worst – the impact of insolvency on an airline insurance programme The enormous limits of liability coverage that an airline acquires and the exposures these create for re/insurers has already been discussed. The complex and intricate web of co-insurers, reinsurers and retrocessionaires which became necessary to provide the required capacity has also been examined.

Constant change, together with financial uncertainty, continues to undermine confidence in general. This combined with the vulnerability of the aviation re/insurance market creates the heightened possibility of insolvency for any re/insurers in the aviation market. Wherever the insolvency occurs in the complex market network will determine the magnitude of the impact on the original insured, ie the airline.

Assuming the possibility of such an insolvency, what consequences could result?

The worst case scenario would be the bankruptcy of the insured airline itself.

This is conceivable given the financial tightrope upon which the airline industry itself is balanced so precariously.

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Importance of financial security for an airline in a world of stakeholder value The decade of the 1990s was characterised by the then fashionable phrase, shareholder value. Today, the term is stakeholder value, which is actually more relevant and accurate in the context of the airline industry. Given the complex and comprehensive nature of airline operations, there are actually many more associated interests affected by the fortunes and failures of an airline than just those of the shareholders. An airline’s stakeholders include its passengers, its employees and management, suppliers of everything from engine spare parts to paper napkins, aircraft manufacturers, alliance partners, airport authorities and adjacent communities, as well as government agencies.

Passengers: ultimate beneficiaries, ultimate casualties For passengers, the existence and adequacy of insurance is consistent with their expectations concerning the airline’s commitment to safety. It would be a shock for passengers if an airline’s insurance programme failed to respond to their legitimate demands for compensation. In such an image-conscious industry, the effects on the airline’s reputation would be incalculable, if indeed the airline survives financially.

Alliance and code-sharing partners In an era of alliances and code-sharing arrangements, it is not only one airline’s insurance programme which requires scrutiny but also the programmes of the alliance and code-sharing partners.

Whether it is incumbent upon the insurance policy of either the marketing or the operating airlines to respond to a loss has been the object of intense activity of the insurance industry and their airlines’ trade association (IATA). This is particularly relevant when the shortfall of one partner’s programme may – in accordance with the legal doctrine of vicarious liability – oblige the other partner to indemnify the loss in whole or in part. Additional due diligence on the part of airline management which has code-sharing arrangements and alliance memberships is required to ensure that the financial security behind all partners’ insurance programmes complies with the respective airline’s standards. Failure to do so – aside from the reputational damage it incurs – leaves the individual airline financially exposed.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

The financial community – awareness and aversion to insolvency risk Members of the financial community are stakeholders directly affected by the airlines’ insurance programme. Unlike liability claims which take many years to resolve, hull losses are generally paid within weeks of a loss. Aircraft are highly mortgaged and leveraged assets and various institutions with financial involvement are greatly interested in the insurance proceeds following the loss. In their concerns over the potential insolvency of a direct insurer, many risk-averse lessors/financiers have insisted on cut-through clauses in reinsurance policies.

This enables them to obtain the benefit of the proceeds directly from the reinsurer, thereby bypassing the direct insurer. It also prevents delay in payment of policy proceeds, as well as partial or even nonpayment by a direct insurer or its administrator.

Cut-through clauses are a contentious issue in some jurisdictions, raising the possibility that a lessor/financier may be unable to rely on these clauses for recovery. This may impede their ability to replace the aircraft, particularly on short notice if recovery is blocked by bankruptcy proceedings. The loss of an aircraft and the inability to replace it also have obvious implications for the airline.

Governments Governments are major stakeholders in airline companies. The partial or full privatisation of flag carriers during the 1980s and 1990s does not divest them of their entire responsibility. Indeed, in the aftermath of 11 September, governments have assumed the role of insurers of last resort for third party war and terrorism coverage. This commitment will certainly revive their interest in the insurance industry in general, and demand greater scrutiny of the solvency of the underlying global aviation insurance market in particular.

Employees Depending on the magnitude of the shortfall from insurers, employees will be affected as a result of severe financial difficulties created for the airline. To remedy gaps in insurance coverage, cost-cutting measures may be necessary.

With the airlines’ thin margins, even a 5% shortfall in insurance proceeds following a USD 1.5 billion loss could render the airline insolvent and have obvious ramifications on employment.

The community at large The demise of a major airline can have a devastating impact on stakeholder interests above and beyond those of employees and shareholders. Many airports have massive capital commitments in improvement and expansion projects; these are often dependent on the expectations of their home base airline. The loss of a such an airline can severely disrupt and threaten the financial viability of the airport itself and the attendant aviation-dependent economy.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

Conclusion Safety culture We do not live in a risk-free world. Ever aware of this fact, the airlines have developed a strong and responsive safety culture. The responsibility of maintaining stringent safety standards has always been a pointed issue for airline management. This commitment logically extends to an airline’s financial operations, particularly in the current economic and political environment, where the meaning of accountability in commercial life is being fundamentally reassessed.

Financial safety culture Despite the fact that insurance represents a relatively small part of overall operating costs, it is a core element of an airline’s financial safety culture. It may be argued that airlines have been purchasing cover from a market characterised by high exposures and a complex and fragmented structure. The market is also highly cyclical in terms of profitability and is fundamentally imbalanced in view of its premium-to-exposure ratio.

Responsibility and due diligence In an era of greater emphasis on sound corporate governance, airline management must recognise the imbalanced nature of this situation and the potential repercussions for all stakeholders.

Assessing the financial health of the insurance market must be based on facts and not supposition. This must be confirmed by due diligence on the part of management, examining not only the direct insurance contracting partners, but also the reinsurers and retrocessionaires forming the network of capacity providers. Brokers also have a key role to play in this area.

The factors which airline management must examine when performing this due diligence of their capacity providers extend beyond the strength of the re/insurers’ balance sheet to include their sense of corporate responsibility.

This is shown in their commitment to stability and in the expertise they possess, their innovation in terms of overall risk management and their strong desire to see their clients prosper.

Decision-makers in airlines and other major aviation clients must collaborate closely with their brokers and the worldwide re/insurance community to create financially sound insurance programmes – employing either traditional risk transfer or non-traditional products, or a combination of both. A sound and healthy insurance industry is in the best interests of both the re/insurers who accept these volatile risks and the airlines and their stakeholders. The financial gain of airline stakeholders depends on the ability of airlines to endure catastrophes. The selection of established, experienced and financially sound re/insurers provides protection for all whose future rests on the wings of the airline industry.

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Swiss Re: Flight to quality – Financial security in the aviation insurance market

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©2002 Swiss Reinsurance Company, Zurich Title: Flight to quality – Financial security in the aviation insurance market Authors: Philip Chrystal Suzanne LeBlanc Editing and production: Chief Underwriting Office Technical Communications Graphic design: Galizinski Gestaltung, Zurich Photographs: Cover: International Stock/Blue Planet Page 6: Dale Sanders/Blue Planet Page 12: XL Digital Images Page 16: Tim Bieber/The Image Bank Page 18: Stockmarket/Blue Planet Page 20: Zefa/Blue Planet Page 22: Color Day Production/The Image Bank Page 26: Daryl Benson/Blue Planet The material and conclusions contained in this publication are for information purposes only, and the author(s) offers no guarantee for the accuracy and completeness of its contents. All liability for the integrity, confidentiality or timeliness of this publication or for any damages resulting from the use of information herein is expressly excluded. Under no circumstances shall Swiss Re Group or its entities be liable for any financial or consequential loss relating to this product.

Order no.: 1492369_02_en BGFS 9/02, 2500 en

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