The old saying "information is power" applies to anyone involved in aviation insurance, be they insurers, customers or reinsurers, says Richard Rodriguez of EMB.
Any buyer hoping for a sudden rush of capacity into the global aviation insurance market is likely to be disappointed. Certainly, I have seen very little evidence of it to date and capital providers are understandably wary of such a volatile line of business, which has caused so much pain in recent years.
It is true that rates have come down significantly from their post-9/11 highs, but this owes more to sentiment than the laws of supply and demand. To understand the drivers behind aviation insurance and reinsurance you need to accept that market behaviour is very difficult to rationalise, and practically impossible to justify in terms of the rules of technical underwriting.
In the late 90s rates fell to levels that could not be sustained. When a Swiss Air passenger jet crashed in the Atlantic – the kind of dreadful event that was bound to happen sooner or later – the resulting claim was equivalent to global aviation premium income for the entire year. Prices remained very low, however, and losses continued to mount.
Even this horrendous result paled into insignificance alongside the World Trade Centre, which sparked an overnight quadrupling of aviation rates. Aviation underwriting suddenly became highly profitable. The reaction may have been understandable, but neither this correction nor the depressed rates that preceded it can be explained purely in terms of finding the correct technical prices to match the known exposures.
In the aviation market, the cost of any risk is not really determined by technical factors. It is whatever the underwriter is able to negotiate: nothing more and nothing less. This is not to deny the importance of relationships between suppliers and buyers of aviation re/insurance or to suggest that the process need be confrontational. Nonetheless, the reality is that the prices and terms are just about as far removed from the tariff-based regimes that we find in some other lines as it is possible to be.
In this scenario there is much you can do to strengthen your negotiating hand through the use of data. True, this could be said of all types of commercial insurance and reinsurance, but it is especially the case in aviation where the pricing guidelines are so ill-defined. Many buyers and sellers alike of both insurance and reinsurance could be doing more to exploit this tool.
If you go to the underwriter with insufficient data, he will not be able to model the risk in a satisfactory way. He is likely to play safe by upping your rates and restricting your terms, especially in a hard market. Yet one of the difficulties that buyers of both aviation insurance and reinsurance often face is the patchiness of their own data.
For this reason it is important to supplement your own statistics with publicly available market information. Some of this is freely available, the rest can be purchased and it is normally a very good investment. If a broker is involved, they should be able to assist. Indeed, intermediaries often play a leading role in evaluating risks on behalf of all partiers. Many actuaries also have their own databases.
Underwriters, especially those committed to long-term relationships, should welcome this type of information. By giving them more to go on, they can arrive at a more sensible solution that is better matched to your needs.
The exercise that follows, if you are a buyer, may well lead you to ask fundamental questions about your risk management. Although the dynamics of the market have changed fundamentally over the past five or so years, many of the participants have yet to adapt their mindsets. You may well find that your existing insurance or reinsurance programme is no longer the most effective use of capital; increased retentions often become an attractive option.
Whatever the direction of aviation rates – and they are likely to continue moving downwards assuming no major loss – there is much you can do to improve your competitive position within the marketplace.
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 US$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 US$5 billion represents an exposure of US$50 million for a single insurer.
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.
This article appeared in Asia Insurance Review in February 2006
