Overcapacity is continuing to reduce aviation insurance rates at a time when they are already badly out of kilter with operating costs and claims. So far the reinsurance markets have borne the brunt. Gordon Mackenzie reports.Aviation underwriters with a superstitious bent saw it as an ill omen when, at the start of the renewal season for 1994, a China Airlines Boeing 747-400 overshot the runway on its approach to Hong Kong's Kai Tak airport and came to rest in the sea, leaving the industry with a record hull damage bill of US$145 million.

Last year turned out to be the aviation insurance industry's worst ever: the $2.2 billion airline hull and liability losses for 1994 exceeded the industry's last record loss in 1985. Premium income again fell far short of the level needed to cover claims, with the shortfall estimated at around $900 million, three times the amount for 1993. Airclaims, the London/Heathrow-based consultant and statistics group, estimates that premium rates may have to more than double to meet operating costs and produce a reasonable return. In 1988-92, the latest five-year period for which data is available, the deficit was some $2.82 billion, consisting of $3.11 billion in premiums minus $5.93 billion in claims.

Claims poured in during 1994 at a time when the positions of insurers were already unsteady. Reinsurers in particular were struggling to make business pay, hindered by the growing number of small players from emerging markets who keep capacity artificially high and prices low by writing business at cheap rates to get a foot in the door.

The availability of such surplus reinsurance capacity is initially good for the direct writers as it reduces the cost of spreading risk. But in the longer term overcapacity has a destabilising effect on rates. The long-term players remain unprofitable, while the short-term participants can pull out when the claims situation deteriorates.

This year looks likely to do little to redress the imbalance between premiums and claims as foreign underwriters from continental Europe and Bermuda compete for London renewals at aggressively low rates. Meanwhile, in the constant battle to reduce their costs, airlines continue to exert pressure on rates despite criticisms that in seeking the best priced deals they risk exposing themselves to less certain underwriting credits.

Gary Cooke, underwriter at the RJ Maylam syndicate at Lloyd's, summarises: 'Since 1986, the only profits generated have been on a net basis, with the burden of underwriting losses being passed on to the reinsurance markets and beyond. This has been likened unto the game of pass the parcel, but in this game you certainly didn't want to be left holding the parcel when the music stops.'

To make matters worse, rates for hull and liability insurance have been in turmoil and the values of hulls have spiralled. In 1985 a top of the range Boeing 747-300 was worth around $100 million. By 1994 that had risen to $150 million for a 747-400F, a rise of 50 per cent. And if the proposed very large aircraft ever get off the drawing board, they could be valued at as much as $300 million. When 747s were first built they were rated at only $18 million and there were doubts then that insurers would provide sufficient capacity.

Lack of capacity is not a problem now and for the good risks there is too much capacity. Cheap reinsurance, written using new capital attracted by relatively firm rates over the past few years, has forced prices down. Many pundits believe the financial state of the insurers is connected to that of the aviation industry in general and the airlines in particular. Fred Elsberry, director of consumer affairs for Delta Airlines, recently said the airline has been very successful in setting the correct premium levels after sound risk assessment. With IATA projecting a 1994 net profit of only $1 billion on international scheduled services - approximately 1 per cent of revenue - airlines are likely to continue to seek savings where they can by putting pressure on premiums.

The worldwide premium income for 1994 is estimated at around $1,775 million for airlines, $590 million for product liability, $170 million for airports/refuellers, and $750 million for general aviation. With 10 hull losses over $50 million, 1994 produced claims of more than $2.25 billion to the aviation insurance market, a figure that will inevitably exceed $3 billion when unsettled secondary claims are added in.

As if that wasn't bad enough, the year's highest single loss - USAir at Pittsburgh, currently reserved at $410 million - carries the largest initial liability reserve ever set (an average of $3 million for each individual). Reserves on other well known losses were of little help to the market:

1 An increase in reserves for KE 007 in 1983.

2 An increase of reserves for PA 103 first to $450 million, then to $750 million.

3 A $57 million increase in reserves for United at Sioux City in 1989.

So was 1994 just an exceptionally bad year or does it provide valuable indicators for the future? Airclaims notes that the number of hull losses was far from exceptional. In 1994 the number of western built jet losses was 22, fractionally less than the annual average so far for the 1990s and only slightly worse than the 1980s average figure of 20.6. However the estimated cost of major hull losses, including jets and turboprops, was $969 million in 1994, about 20 per cent above the trend line. In 1985 the cost of losses was more than 60 per cent above the trend, however. If 1985's experience had been repeated in 1994, the cost of major hull losses would have been around $1.3 billion.

The number of passenger fatalities during 1994 was also unexceptional - indeed the figure of 870 passengers who died on revenue passenger services is almost identical to the 1980s' annual average of 876. However, in 1994, around 500 of the fatalities were on US or Japanese flights which carry greater liability, and accounted for the majority of the year's liability reserves. In 1985 more than 1,000 US and Japanese passengers were killed. If this had been repeated in 1994 liability reserves might have exceeded $2.0 billion. Altogether if the 1985 loss experience of just 20 jet aircraft was repeated at today's rates, the cost could come to $3.7 billion. Aviation insurers should therefore be steeling themselves to cope with potential losses in excess of $4 billion.

'Airline insurers should look at 1994 as a benchmark for the future,' says Cooke. 'The average loss over the past ten years has been $1.07 billion, but the trend line is going in one direction, upwards. We must also be aware of the potential implications of a repeat of the losses seen in 1985.' Cooke predicts that the market is approaching the time when it will require in excess of $3 billon in premiums per annum.

In terms of financial security, direct insurers and their reinsurers are best served by sustained gross profitability, making it important for reinsurers to price their product properly. The rates war cannot go on forever, and many believe the increase in exposure that would accompany the introduction of very large aircraft would make corrective action unavoidable.

Cooke spells out the problem underwriters face. 'I need to be able to satisfy the expectations of my capital providers. So I need premium income of sufficient size to fund all my operating costs, reinsurance, fund contingency reserves for bad debts and claim deterioration, and provide for the claims arising from the business written. The ultimate dividend then being proportionate to the level of risk associated with the initial investment.' Given the inherent catastrophe potential of aviation, this should be close to 15 per cent of the level of risk, says Cooke.

Some optimism

So far 1995 has seen differing levels of increases, coupled with rationalisation, but Cooke believes aviation underwriters in pursuit of gross profitability will need to look elsewhere. 'I have seen some optimism that the market is addressing the inadequate rating levels of the prime carriers, and showing reason in the rating of the others.'

In general it has become something of a battle of nerves, with insurers having to decide how committed they are to the aviation market and for how long. But it will take a series of major withdrawals to force significant change. Meanwhile underwriters will continue to feel that airlines are getting away with paying less than an economic rate for their cover and that those with poor safety standards do not get sufficiently penalised.

Underwriters will also have to respond to other developments. One problem causing growing concern is the liabilities issue from possible environmental pollution claims. Insurance cover for pollution from sudden and accidental causes is being interpreted by the US courts to include gradual and deliberate pollution. Claims from manufacturers, aircraft operators, refuellers, and airport owners could be affected.

Captive businesses

The instability in hull and liability rates has also spawned the growth of captive underwriting businesses. There are around 40 captives now, where there were only 20 in 1985. Any business spending more than £500 000 ($800,000) on insurance a year is now being tempted to set up a business to underwrite a portion of its own insurance and reinsure the rest, and the rise in their use is expected to continue. This adds to the underwriters' dilemma of trying to get sufficient rates while remaining competitive.

Insurance brokers also have to ensure their position is not undermined. Ralph Oelssner, director of corporate insurance at Lufthansa, believes mergers and acquisitions in the world of broking, forced by globalisation, cost pressures and the need for economies of scale, may have an effect on the aviation insurance market. 'The cost-awareness of these bigger units may make many an airline doubt whether they will still get the best price out of a broker,' says Oelssner. He points to the increase in broker swapping or 'zapping,' and forecasts that brokers will have to prove their worth. The role of brokers probably won't change, but their approach and the importance of the added value they claim to bring probably will.

In addition, they will have to respond to new concerns. Increasingly sophisticated communications procedures have made it easier for clients to talk directly with their insurers. And, as has happened in the motor market, several insurers are gunning to remove the middleman altogether. Of course aviation insurance is more complex than the cover afforded in the mass market approach taken to motor insurance. But airlines are better informed, and several in the US have close links with their insurers.

As Martyn Hedley, deputy managing director of Willis Faber & Dumas, told an aviation insurance conference in March: 'Brokers will have to reemphasise the benefits of their role, their negotiating services, and their ability to secure better cover, lower prices, greater risk management and speedier claims handling.' Other areas they can assist in include filling the gaps in cover in leasing programmes, and the mutually beneficial avoidance of minor claims. Brokers can also help identify the hidden costs of incidents and advise on awareness raising programmes, banking, accounting and legal matters.

The area of passenger liability compensation presents further challenges to insurers and the priority should be to clear the legal thickets hindering the award of passenger compensation in a timely manner following an aircraft incident.

As new capacity continues to swamp the London aviation insurance market, forcing prices down further, the traditional insurers will continue to suffer. Meanwhile airlines seeking the best deals should beware of the risk of a deterioration in the quality of underwriters. Those major carriers that do not already possess their own captive operation would do well to consider such a move which enables a company to keep control of its underwriting risks and exert more clout in the market place.

As new capacity continues to swamp the London aviation insurance market, forcing prices down further, the traditional insurers will continue to suffer. Meanwhile airlines seeking the best deals should beware of the risk of a deterioration in the quality of underwriters. Those major carriers that do not already possess their own captive operation would do well to consider such a move which enables a company to keep control of its underwriting risks and exert more clout in the market place.

Source: Airline Business