Technical Report: Aviation - Flying High

This September will mark the fifth anniversary of the events of 11 September 2001. Take a moment to think about that: it has been five years since the day that scorched its way across the minds - and balance sheets - of the (re)insurance industry.

The aviation market could be forgiven for wanting to forget that day, along with the days after it where it came very close to hitting a fiscal wall and dying. Flights were grounded as aviation insurance became horribly difficult to find in the wake of the hijackings, and security concerns became fixed in people's minds.

Last-minute TRIA

Five years later, many of the clouds have rolled away - but others remain on the horizon. Surprisingly enough, the terrorism risk issues almost returned last year. The Terrorism Risk Insurance Act (TRIA), which required property and casualty insurers in the US to offer coverage for acts of international terrorism and effectively saved many airline companies that were unable to fly because they could not get affordable insurance - or even any insurance - for their planes, was only renewed at the metaphorical last minute at the end of 2005.

The act was described as being "indispensable" for US airlines by the Air Transport Association of America (ATA), which claimed that no TRIA would mean a return to the commercial market for war-risk aviation insurance and higher prices. According to the ATA, without TRIA, US airlines currently facing $150m in annual premiums would see their potential bill rise to $500m.

However, Congress took an awfully long time to pass the extension last year. True, it was trying to deal with the hearings for the appointments of two Supreme Court justices plus other legislation, but the absence of activity - as well as some active opposition to the bill - was surprising. According to the Consumer Federation of America, TRIA was no longer needed for the general (re)insurance market as a whole. It argued in 2005 that most of the US had no significant terrorist risk under TRIA, and that the private sector could cover virtually the entire risk.

Finally, Congress at last concentrated its mind on the topic and passed the extension in the middle of December 2005, leaving the subject to bubble under the surface until the next time TRIA needs to be extended (December 2007). We can only imagine how many sweaty brows were wiped when the news of the extension finally came through.

Rising fuel costs

For airlines, the past five years have been something of a curate's egg - good in parts, bad in others. One negative element has been the steady rise in costs over the past few years. Although aviation has been a growth industry for some time, with passenger traffic climbing year on year, other costs have been making their presence felt. The rising price of oil, which went from $50 a barrel in June 2005 to $74 at the start of May 2006, has meant that jet fuel has also leapt in price.

According to the ATA, the aviation industry's total fuel expense more than doubled from 2003 to 2005 and increased by $10.3bn from 2004 to 2005 alone. Further increases will make it increasingly uneconomical to run cheap flights without getting more income in from somewhere or cutting costs elsewhere.

The rising price of oil has taken its toll on the balance sheets of a number of US air carriers, with several being forced into Chapter 11 proceedings in order to sort their finances out and attempt to make a comeback.

Air travel boom

These increasing costs come at a boom time for the aviation industry as a whole. the ATA claims that US airline traffic and capacity reached record levels in 2005, with 738.6m passengers taking to the skies, along with a $28bn revenue per ton miles (a way of measuring cargo).

Global air travel, which was briefly affected in the Middle East by the 2003 invasion of Iraq and in the Far East by the impact of the restrictions caused by the SARS virus the same year, also saw substantial rises in traffic as people took to the skies again once the crises were over.

In order to cope with rising demand, Cathay Pacific is to expand its fleet by 31% to 126 aircraft by 2010, and Air Emirates are following suit as they plan to grow their fleet by 36% to 120 planes by the same year. At the same time, India and China are both now full members of the World Trade Organisation and are opening their doors for more trade, which should fuel a substantial demand for aircraft in both countries.

There is a downside to this growth, however: in the US, there have been concerns that the air traffic-management system is starting to creak under the weight of traffic and needs to be updated, but apart from this it has been a good period for the aviation industry.

Claims benefits

For one thing, it has been an excellent few years for claims, largely due to a lack of large insured losses. The events of 11 September aside, with the hijacking and subsequent total loss of four planes, over the past five years there have been few major crashes that have been covered by the industry. Those crashes that have taken place have been over areas of the world like Africa, Columbia and Asia, where insurance coverage has been minimal and the planes involved have been relatively elderly.

According to Steve Blakey, president and chief executive of CV Starr-offshoot Starr Aviation, the main reason for the fall in covered losses over the past few years has been down to the fact that planes are currently a lot safer. He said: "Losses have been significantly lower after 11 September. One reason has been better equipment. There are large fleets out there with more safety equipment, and a lot of older equipment has been retired. Although there have still been accidents, the level of severity of losses over the past five years is lower.

"As for the safety equipment that is now being fitted to planes, like proximity alarm systems and so on, these had previously not been widely available. Most of the planes built in the West now have them."

Another plus for the industry is the fact that there have been few losses to terrorism since the attacks on the World Trade Center, with the only two incidents occurring when two small Russian airliners were blown up in mid-flight by Chechen suicide bombers.

Terrorism is not a new threat for the aviation industry, and security measures have been steadily increased since the first hijacking incidents in the 1970s that captured the world's horrified attention. Ironically, the events of 11 September showed up a number of key weaknesses for airline security, which have been remedied to make flying extremely safe, although it is too soon for airlines to be too complacent about the threat from terrorism.

However, according to Swiss Re, there is a caveat to be inserted here. The company pointed out in one of its latest aviation reports, The True Value of Aviation Insurance, that although the frequency of total losses has decreased due to better safety equipment as mentioned above, the number of major partial losses is increasing (see Figure 1 below).

Major partial losses are basically damage to a plane that is greater than 10% of the hull value or a minimum $1m, such as damage to a fuselage from hail or even a bird strike. This increase is logical as planes are now able to take more punishment and keep flying.

Swiss Re also points out that when it comes to liability exposure, the sky is literally the limit. In the report it says: "Logically, the extent of passenger legal liability losses that aviation insurers face annually will depend on the number of accidents, fatalities and injuries. Yet when determining the size of a loss after an accident, the types and nationalities of the passengers on board are more important than their actual number.

"The 'type' of passenger refers to the status of the traveller. Does he or she have dependants? What is the victim's earning power? Further, which is the country where court action will be bought? That factor is central to insurers' exposure calculation, as compensatory damages varies greatly from jurisdiction to jurisdiction."

Falling rates

The lack of losses is one of the reasons why rates in the airline aviation market have generally been falling in recent years - by 15% a year over the past three years, according to Mr Blakey. Other lines, like general aviation (small planes with no more than 50 passengers) and aerospace have remained stable, again with no major losses but also no major growth.

Nick Redgrove, head of aviation at Cooper Gay, is positive about the state of the market at the moment, pointing out that underwriters in particular are more sophisticated than 12 years ago, when some unwise risks were written on the back of reinsurance. However, he also points out that with new capacity coming into the market, this may put pressure on rates on certain lines of aviation business. The new capacity is primarily from CV Starr, as well as the new Limit Aviation Syndicate that starts operating around 1 September this year.

Steven Doyle, manager of Aon's aviation and aerospace global practice group, is less optimistic about the state of affairs: "The level of exposure growth, combined with falling premium levels, has taken the market to the point it potentially views as the lowest possible. With premiums fast approaching pre-11 September levels and exposure significantly higher, it could be suggested that the market is in a worse situation than it was five years ago. The changes that have taken place in the industry over the past five years, however, meant that the premium is covering differing exposure levels both geographically and by sector. How the insurance market responds to these changes will define its activity during 2006."

Aon's market review of 2005 makes it clear that the company is keeping a careful eye on the market. One of its conclusions is that: "The airline insurance market is driven by capacity and claims - should the low level of losses continue and the market continue to look profitable, then there may be the temptation to continue to participate. If this happens, there may be little to halt the slide in premium.

"The discussion about a hardening in the market has been taking place since the devastating hurricane season that battered the southern states of the US mid-way through 2005. While aviation interests were relatively undamaged by the storms, they did lead to massive insurance claims in other sectors, which are likely to have a knock-on effect as global insurers look to recoup their losses. While profitable, aviation needs to remain as profitable as other markets to ensure capital providers' continued participation."

A newly identified flying object

In the meantime, the market is coming to terms with a new risk. Anyone loitering near Heathrow airport in the middle of May this year might have seen an unfamiliar shape in the sky above them. Insurers are also pondering this new flying object: the Airbus A380.

The latest Airbus model has already been dubbed the 'super-jumbo' due to its size and passenger complement, making it the world's biggest passenger aircraft. Built with two decks and capable of carrying up to 850 passengers (in economy class seats, or 555 in the more traditional three-class seating arrangement) the plane will mark a major step up in the aviation market. A total of 160 firm orders for planes have already been announced and mass-production of the plane has already started, with the first delivery due to Singapore Airlines in the last quarter of 2006. The A380 is already looking like a major commercial success for Airbus, and will boost the company in its long-standing battle with Boeing for leadership of the aviation industry.

It will also impact the aviation insurance market, not to mention airports all over the world. The size of the plane means that runways will have to be strengthened, taxiways widened and airbridges built to cope with the new double-door arrangement on the plane. In Heathrow alone, the cost of all these alterations has come to $450m so far.

The cost for (re)insurance will be harder to work out. GE Insurance Solutions (GEIS), before it disappears into Swiss Re, has recently published its latest Exposure - Property and Engineering report. In it, GEIS points out a few important facts: "Because of the size of the A380 and its new design, there are still many unknowns that could affect potential losses. For example, the aircraft incorporates new composite materials, but it is unclear at this time whether this will speed up or slow down repairs. Also, the additional ground-handling complexity of double-decker passenger entry and limited space at airports could increase the frequency of partial hull losses."

Moreover, the GEIS report looks at the way the arrival of the A380 affects potential passenger-liability loss and has come up with a potential shock for aviation insurers. By using two critical parameters, average award and seating configuration, GEIS estimates (see Figure 2) that for an A380 loss the average passenger-liability loss amount would be "significantly higher than for a loss within the existing large aircraft fleet. The median-liability loss increases by 4.8% from $262m to $275m. On the other hand, the average liability loss actually increases by 9.2%, from $329m to $359m.

"The impact of the A380 fleet on the combined fleet of large aircraft does not seem too extreme at first sight, but gets quite dramatic when looking at higher loss levels. One can observe that the probability of a passenger-liability loss exceeding $500m would increase by about 25% compared to the existing worldwide fleet. Further, the probability of a passenger-liability loss between $750m and $1bn would increase by roughly 40%."

GEIS points out that over the past 15 years there has been a trend to increase hull and liability limits and with the arrival of the A380, this trend will push these limits up further.

Airbus is also planning a 'stretch' version of the A380, called the A380-900. At the moment this exists only on paper, and there is no confirmed information for insurers to estimate this version's capabilities. (Just to put things into perspective, though, the A380 is the third-largest plane in the world. The second-largest is the Antonov AN225, which was designed to carry freight such as rocket boosters; only one of these planes is still flying.

** NOTE: This story has been truncated from its original size in order to facilitate transmission. If you need more information about this story, please contact NewsEdge Corporation at 1-800-766-4224. **