Once Upon a Time - The Aviation Market21st January, 2015
A Reinsurer’s View
Klaus ..., aviation executive manager at ..., recently presented a fairly gloomy picture of the aviation market at an address to the Insurance Institute of London. He charted the recent history of the market, and wondered why so many people remained so optimistic about its prospects for the immediate future. This is an extract from his speech.
“The airlines, the main customers of the aviation market, are possibly going through the most difficult period in their history. The 213 IATA airline members expect losses in the region of US$2.5bn for ----, which means the third devastating year in a row. Losses suffered since ---- will total in excess of US$9bn. The number of airlines that continue to operate profitably can be counted on one hand.
A clear indication of how serious the situation has become is seen in the large number of sometimes brand-new aircraft that have been removed from active service: up to 1000 aircraft have been grounded in recent months, well over 10% of the whole western fleet.
Similarly aircraft manufacturers have been forced to reduce production in the face of what is now a worldwide recession. The number of new orders is falling drastically and existing orders, concluded years ago in expectation of highly favourable trends, are now increasingly subject to negotiated delays in delivery.
Above all, these changes have been extremely serious for the aviation insurance industry.
Very substantial over-capacity has emerged since ----, the year when rating levels were extraordinarily high, many specialists seeing those levels as an unjustified overreaction by the market. It was the year when even the most inexperienced underwriter was “damned to success”.
The trend was greatly promoted by many underwriters being able to reduce their gross exposure, which was sometimes quite considerable, to insignificant net amounts, with the aid of extensive and favourably priced excess of loss reinsurance programmes. Such underwriters naturally concentrated their efforts on producing the cash flow necessary to finance the XL programmes. As a result, professional risk assessment and risk-oriented rating levels were forced into the background.
The scene was set for a drop in rates and, between ---- and ---- premium levels reached an all-time low, not only in the airline insurance sector, which suffered particularly badly, but also in other classes of aviation business.
The structure of the market also changed significantly during this period. Alternative markets were consciously opened up in various parts of the world – a trend which led to a severe weakening of the London market, whose established specialists had enjoyed a lead, if not monopoly, position for decades. What was once theory now became possible: fleet policies, even large ones, could be completed outside the London market, under conditions dictated by the original broker, before London’s lead underwriters had a chance to obtain a share. Of course this development has reduced London’s negotiating power.
Given this situation, it is truly remarkable that the four year long deterioration of rates was stopped at the end of ----, and that it was even possible to push through increases. Rates rose by as much as 300% in the airline sector – a percentage value which was clearly most impressive.
Unfortunately the subsequent euphoria quickly clouded the fact that a 300% increase in a premium level that had almost sunk to zero was just a first step in the right direction, and that additional and substantial rate increases would be necessary if the market, as a whole, was to become profitable again.
The euphoria of ---- has almost vanished completely and an assessment of the situation at the end of ---- reveals no grounds for optimism.
- The market’s excessive capacity remains unbroken;
- There are virtually no rate increases any more. Instead rate reductions are beginning to reappear in one or two cases;
- Prices are almost exclusively dictated by the holding broker, while the original underwriter usually decides on whether to accept a risk on a take it or leave it basis.
What are the reasons for such an unwelcome situation, one which has emerged as the airline market looks back on at least four consecutive years of loss?
- In spite of all the statements to the contrary, each underwriter still has the chance to reduce his gross acceptances to an insignificant net amount through extensive proportional and, in particular, non-proportional reinsurance. The practice still seems to pay off despite the recent increase in reinsurance costs.
- A relatively large number of market operators are exclusively aviation underwriting specialists. Their efforts often concentrate on defending market share. Consequently, selective and technically sound underwriting practices are normally not possible. Management teams operating in markets that behave in this way are forced to use every means at their disposal to secure their own survival for as long as possible.
- Underwriters who feel insecure, as a result of market trends, are often put under pressure by the vague threat that, if they should decide to opt out of a risk, they should not expect any new participation offers in the foreseeable future. This is one way of artificially preserving excess capacity.
In addition there is a trend whereby the insurance placements of several airlines are introduced onto the market within the framework of a single slip. The airlines are usually selected from a particular geographical area, according to more or less haphazard criteria and subject to highly imaginative categorization.
The individual underwriter is severely restricted in his freedom of choice. If he wants to write a single, interesting risk, he often has to accept between five and ten additional risks (or even more) when signing such a “line slip”. Moreover the slips are subject to extremely unsatisfactory conditions. Should this trend continue, it will not be too long before we reach a situation where just one mega broker remains in business – he will be able to place the four or five mega airlines left in the world with just two or three suitable underwriters and their reinsurers.
The most important motive for the market’s lethargic patience is the hope that profitable times will return. But most of the market participants apparently accept that they themselves can do nothing to help bring about this change. They assume that the often cited “market forces” regulate the market and they further naively assume that these market forces will get rid of their competitors while they themselves survive and make handsome profits.
A branch of the economy whose expectation for the future is based solely on passive hope surely cannot continue to be attractive for investors.
Where does the insurance market’s optimism come from, that business from new mega carriers will enable it to recoup the losses it has accumulated in the past – losses which, at least to a certain extent, come from airlines that will either no longer exist at all or at least not as individual insureds?
The more all composite insurers get used to the fact that horizontal subsidising in their companies is going to become even more difficult, the more attention they will have to pay to the classes of business which only play a minor role in terms of volume, particularly when these small classes of business involve a disproportionately large loss potential.
In a free market economy there are quite rightly great areas of freedom. Each person can invest his capital as he sees fit. This, of course, also applies to risk capital in the insurance industry. But what must concern us all is when the organisations criticised above dictate the pace of the entire market over a long period of time. This makes the situation all the more difficult for the true professionals as they have to recoup their higher costs, while those who simply cruise along in the market invariably have lower costs because they do not provide any professional input for the market whatsoever.
I can only hope that the future of the aviation market, as a whole, will no longer be influenced to such a devastating extent by those underwriters who adhere to the motto ‘we have doubled our efforts since we lost sight of our goal’.”
In 1993 I produced a report on Lloyd's entitled ‘Rowton’s Insurance Society for the Knowledgeable Investor (“Riski”) formerly known as Lloyd's of London – PROSPECTUS’. The report included the above appendix on the aviation market – A Reinsurer’s View.
How things haven’t changed!