The current climate of financial uncertainty is highlighting the importance of a key aviation insurance feature, known as the cut-through clause, which is often ignored by certain members of the aircraft financing community.
The cut-through clause is designed to protect aircraft owners when confronted by a major loss. Most local insurance companies are unable to foot the full aircraft insurance risk themselves, so they turn to re-insurance companies. When correctly implemented, the cut-through clause allows financiers to receive any loss payment directly from the re-insurers of local insurance companies, rather than risk the money being diverted via the insurance companies.
Aviation financiers failing to understand the full implications of the cut-through clause are sitting on a ticking time bomb, according to Glen Brighton, executive director at Willis Aerospace Advisory Services. "The likelihood of an insurance company being insolvent at the same time as a major aircraft loss is increasing in today's perilous financial landscape," argued Brighton, warning that the threat to the aircraft financing community should be taken more seriously.
Further complicating matters, it has been difficult to obtain cut-through clauses in countries such as China, Japan and France owing to national legislation. However, some countries have begun to address this complicated issue, Brighton remarked. "Brazil, for, example, has recently changed legislation so that a cut through clause is enforceable as long as the primary insurer is insolvent, which avoids domestic insurance firms missing out on investment," he said.
Yet many banks and smaller leasing outfits are ignoring the risk inherent in failing to properly investigate a clause preventing re-insurers from making loss payments to an insurance company that is in financial distress or unwilling to transfer the payment to the correct party, Brighton noted.
"It's not that high on our order of priority of concerns when putting a lease together," admitted one European lessor. "It probably should be, but we tend to focus on other counterparty credit risk such as the lessee, guarantor, LC providers and other immediate risks such as jurisdictional risks."
The big leasing companies that have their own insurance departments tend to understand the risk, but some financiers can't appreciate how wrong it could go, Brighton said. Part of the lack of awareness can be attributed to the fact that there has yet to be a major case brought to court, where administrators have taken the money instead of the rightful loss payee. "Until there is a high profile failure to pay out due to insurer insolvency, cut-through clauses are not going to get the attention that maybe they should," the European lessor said.