The True Value of Aviation Insurance - SwissRe

The true value of aviation insurance

Technical publishingAviation

The true value of aviation insurance

Table of contents

Foreword 5

1 Introduction 6

2 Exposure 8The global aircraft fleet and hull exposures – facts and figures 8The development of total and major partial losses 8Other hull exposures and natural perils 10The sky’s the limit – liability exposure in aviation 10The legal environment and framework 11Ever-widening exposure – the Montreal and Rome Conventions 13Frequency versus severity 13Air traffic control – runway incursions and mid-air collisions 14Third party legal liability – losses on the ground 15

3 Insurance 17Airline insurance 17What is insurance, actually? 17The value of insurance and the capital required 18The capital requirement for aviation insurance 18Pricing the insurance product 19

4 Capital 23Capital markets and development of equity in recent years 23Influences on the cost of capital 23Capital market solutions 25

5 Summary and conclusion 27

“The airline industry has historically prided itself on delivering a highly sophisticated product to passengers in terms of comfort, safety and speed.” Yet following a major accident, no other industryis subject to the same intense public scrutiny.

5 Swiss Re: The true value of aviation insurance

Foreword

On 17 December 1903, the Wright brothers managed to get their hand-built craftairborne for twelve seconds over sandy terrain at Kitty Hawk, North Carolina. Indoing so, they realised the first successful manned, powered and controlled flightand pioneered the first generation of aviation history. A little more than one hundredyears later, to speak of aviation’s “astounding development” would still be an under-statement. The last 25 years, in particular, have shown quantum leaps in aviationtechnology and the emergence of air traffic as an integral part of our daily lives. Regular intercity commutes to work have become part and parcel of the corporatedemand, while air travel for pleasure to points near and far is undertaken by hundredsof millions of tourists a year.

Society has accepted air travel as a commonplace and convenient means of trans-portation. The public demands a high degree of safety, performance and reliabilityfrom its airlines, not to mention a degree of comfort and service. For whatever pricethey pay to travel, most travellers take it for granted that their aircraft will operatesmoothly from push-back to standstill. Understandably, there are many prerequisitesto such smooth operation – from a reliable aircraft structure to sophisticated air traffic control, from experienced pilots to available fuel. Further, the competencies ofthe ground crew, emergency capabilities, contingencies and coping with inclementweather are but a few of the many factors which affect the airline’s performanceand either satisfy – or fall short of – passengers’ expectations.

Yet the critical public often overlooks one factor which absolutely must be securedbefore any aircraft flies – insurance. Despite the technical mastery of aviation in the 21st century, no aircraft, anywhere, will take off without its legally required insur-ance policy in place, that signed contract to abate the risk of an airline’s financialruin should unforeseen circumstances prevail.

By concrete example, this publication will demonstrate the superior value that insur-ance offers to the airline industry, an industry which, in turn, not only feeds – but to some extent drives – the world’s economy. Further, it will explore the risks thataviation harbours and examine the capital requirements for insuring this highly ex-posed line of business. Finally, as seen from the insurer’s perspective, the publicationaffirms that satisfying its stakeholders must be the primary goal of any risk carrier.Yet the argument that cost for capital genuinely contributes to the ultimate cost ofinsurance is not just a tactical exercise to increase the insurer’s capital base. On thecontrary, it is the only way for insurance and reinsurance companies to be sustainableproviders of a high quality product.

Andreas F. PeterGlobal Head Aviation & Space

1 Introduction


“Good afternoon, ladies and gentlemen. On behalf of the captain, I’d like to welcomeyou aboard….”

The flight announcement welcoming travellers, and wishing them a pleasant flight,is familiar to any of us who fly. Less well known is that once every second, through-out the day and night, similar announcements are being made on tarmacs aroundthe globe. It is with that frequency that an airliner takes off from a runway some-where in the world. Barring Acts of God, indisposition of the weather, terrorism andgroundings, there are few exceptions to this around-the-clock schedule. What’smore, the “once a second” rule applies to a worldwide fleet of some 21,400 West-ern built aircraft operated by about 400 commercial airlines.

On average, there are 65 passengers and a flight crew appropriate to the aircraftsize on board at take-off. Some of those men and women are top executives, someof them are single parents, one or the other might be carrying a priceless art treas-ure to a distant museum exhibition or humouring a babbling infant. But taken collec-tively – and again within the time frame of a single second – they represent millionsof dollars of potential passenger legal liability exposure at that one moment in time.In addition, the average aircraft hull value is approximately USD 27 million and hasthe potential to create millions of dollars more in third party losses should anaccident occur.

To illustrate, take a hypothetical example: a fully laden wide-bodied aircraft en routefrom New York to London just before a major holiday. The flight is well booked; its400 passengers – some two dozen short of full capacity – are joined by a crew of 19 to ensure travellers’ comfort on the overnight journey. The hull value of the air-craft may amount to some USD 150 million. In the event of a fatal accident, thepotential liability for the passenger awards could reach USD 1.5 billion, this withouttaking any third party losses on the ground into consideration.

Despite these substantial exposures, despite the figures which – to the layperson –approach mind-boggling levels, global airlines perform their normal course of oper-ations daily. In spite of the overwhelming value of these exposures, airlines can routinely go about their business knowing that the aviation insurance industry hasrelieved them of the burden of backing these enormous exposures financially.Understandably, substantial means are required to back those exposures and coverthe world’s collective fleets of aircraft valued at more than USD 570 billion. What,then, is the required capital insurers must provide to ease the minds of airline opera-tors and their respective shareholders?


In 2002, Swiss Re Aviation authored the publication Flight to quality – Financialsecurity in the aviation insurance market in response to the general downturn ofboth insurance and financial markets. It was a call to insurance buyers to be morevigilant and uncompromising in their approach to purchasing cover, particularly inlight of the pressures on some insurers’ financial security. Today’s market translatesinto a different set of requirements, yet the overriding message remains the same: in this highly-exposed risk industry, the value of insurance should never be under-estimated, nor should the considerable financial outlay such cover represents beshort-changed.

This Swiss Re publication will expand that focus, turning first to the various aviationexposures, examining a wide range of the potential risks more in detail and con-sidering the regulatory legal framework. Further, the work will address the technicalinsurance area: suitable handling, intelligent underwriting and insurance pricing.Finally, light will be thrown on the specific capital requirements which have evolvedas aviation’s technical innovations have rendered aircraft larger, faster, and capableof handling greater numbers of passengers. Swiss Re’s expertise on all three fronts – in-depth understanding of the expanded aviation risk, capital parametersand technical insurance factors – should underpin its record as a leading reinsurerfor long-term aviation clients whose individual requirements are highly demanding.


2 Exposure

On the tarmacs of the world’s major airports,the concentration of aircraft on any one daymay represent an insured hull value of USD billions.

The global aircraft fleet and hull exposures – facts and figuresAn airline operation is defined as the entity managing a fleet of several aircraft withscheduled or chartered passenger and/or cargo services. Today’s global fleetconsists of some four hundred commercial airlines. While small airlines might flyonly a few aircraft, the larger air carriers operate hundreds of planes whose typesrange from turbo-props to ultra-modern jets.

Currently, there are some 21,400 Western built airliners in service worldwide. Thisnumber represents close to five percent annual growth in terms of values and unitsover the past decade.

The current accumulated hull insured value for the operative global fleet of aircraftexceeds USD 570 billion. On an individual basis, values range from a “mere” USD 1 million per unit up to USD 200 million for aircraft newly built and commis-sioned. Cutting-edge technology – the so-called fourth generation aircraft – accountsfor approximately 7,700 units, and unquestionably takes a place at the higher endof this cost scale.

The development of total and major partial lossesThe insurance industry provides cover to the airlines and their lessors with opera-tional risk cover for total or partial loss occurring during take-off, in-flight and landingand for damages on the ground. As such, the airlines – and ultimately the insurancemarket – face hull total and partial operational losses of an average USD 900 millionannually.

The frequency of total losses has gradually decreased over recent years (see Figure 1,opposite). This is primarily attributable to two factors: greater engine and systemreliability in the newer generation aircraft and improved cockpit technology, whichprovides better situational awareness to flight crews. Aircraft manufacturers haveintegrated highly sophisticated state-of-the art collision avoidance systems such as TCAS (Traffic Collision Avoidance System), GPWS (Ground Proximity WarningSystem) and EGPWS (Enhanced Ground Proximity Warning System) in order torespond to a frightening development of a widespread cause of accident, namelyControlled Flight into Terrain (CFIT). Some 70% of today’s Western built jets areequipped with either GPWS or EGPWS and statistics indicate that technology andimproved manufacturing methods have had a positive impact on flight safety.


Yet while the statistics for total losses show an improvement, the consistent increasein the number of major partial losses over the past decade is reason for concern.Since 1998, major partial losses have begun to outnumber total losses.

In drawing any conclusion from those figures, we must take into account that thepoint at which a loss is classified as a major partial loss – namely a loss greater than10% of the hull value or a minimum USD 1 million – has not been changed to reflectinflation. Taking a higher trigger point of USD 5 million and applying inflationary cal-culations will reveal a narrowing of the gap to suggest that equal numbers of eachtype of loss can be expected every year. It is difficult to pinpoint the overriding causefor this increase, but it seems rational to attribute the rise in major partial losses tothe increasing complexity of aircraft structures, the use of composite materials andthe introduction of more sensitive and fragile equipment on board.

Figure 1:Total vs. major partial losses

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Hail can cause major damage to an aircraft,whether on the ground or in flight.

Other hull exposures and natural perilsIn addition, natural hazard and other “event” type perils also contribute to both totaland major partial losses. Hailstorm is a typical example. One such storm struck atKingsford Smith Airport in Sydney, Australia in mid-April 1999, damaging 45 aircraftand resulting in a loss of USD 61 million. This figure represents roughly 7% of theaverage expected annual hull losses of USD 900 million.

While earthquakes have failed to cause any substantial losses to aviation insurers to date, they do pose a serious potential, both from the perspective of total, majorpartial and partial loss. At Haneda Airport in Tokyo, for example, there is a concen-tration of more than one hundred aircraft on the ground on any one day, collectivelyrepresenting an insured hull value exceeding USD 7 billion. Since hull claims arepaid within weeks of the date of loss, these event type losses could pose liquidityproblems to some insurers.

One of the largest hull event losses resulting from a war-related peril is the July 2001attack at Colombo airport in Sri Lanka, where eleven aircraft were destroyed andthree others were severely damaged. The insured loss amounted to almost USD 400 million. In the same year, specialist hull war insurers faced four additionalhull losses in the wake of 11 September. For that one year alone, the hull war lossesamounted to nearly USD 700 million.

The sky’s the limit – liability exposure in aviationThe global airline industry transports just under two billion passengers a year toevery conceivable destination. As mentioned earlier, it is with a frequency of once a second that an airliner takes off from a runway somewhere in the world with an average passenger load of 65. Further, we have seen that depending on the passenger profile, domicile, age, earnings and dependency status, these passengersrepresent several hundred million dollars of liability exposure.

Therefore, to protect both their interests and balance sheets, the airlines buy insur-ance cover for passenger and third party legal liability. Depending on the size of aircraft, geographical area of operation and the relative legal requirements, suchlimits can range anywhere from USD 250 million to USD 2 billion. Insurers providethese liability limits to the airline for each aircraft, each take-off and hence eachoccurrence, and there is no limit to the number of occurrences covered in a givenpolicy period.


Logically, the extent of passenger legal liability losses which aviation insurers faceannually will depend on the number of accidents, fatalities and injuries. Yet whendetermining the size of a loss after an accident, the types and nationalities of thepassengers on board are more important than their actual number. The “type” ofpassenger refers to the status of the traveller. Does he or she have dependants?What is the victim’s earning power? Further, what is the country in which courtaction can be brought? That factor is central to insurers’ exposure calculation, ascompensatory damages can vary greatly from jurisdiction to jurisdiction.

Any discussion of increasing liability risks will touch on the new developments inwide-bodied aircraft. In keeping with tremendous developments to improve safety,increase comfort and enhance the economies of scale, new aircraft featuring recordseating capacity will become standard in fleets throughout the world. Initial serieswill offer a seating capacity of more than 550 seats in a three-class cabin configura-tion. Later variants will reputedly be configured to fit up to 800 passengers in a sin-gle class cabin, and clearly test the limit of risk capital providers’ appetite to coversuch immense and potentially volatile exposures. These developments clearly pose a new challenge for the airline and insurance industry alike.

The legal environment and frameworkThe airline industry has historically prided itself on delivering a highly sophisticatedproduct to passengers in terms of comfort, safety and speed. In the event an airlinefailed to live up to certain expectations, it would be protected by a legal regime orframework which significantly capped its liability – and consequently monetaryexposure – to its passengers.

Passengers flying domestically ticketed services in the United States have enjoyedthe benefits of unlimited liability on the part of their air carriers. Yet this has not beenthe case in other parts of the world. Historically, most airlines were still subject to the Warsaw Convention negotiated in 1929 – providing a legal framework that hasessentially survived into modern times. Liability of the airline was initially limited to125,000 gold francs, the equivalent of approximately USD 10,000. That figure was subsequently increased to 250,000 gold francs following the adoption of theHague Protocol in 1955 by most of the states which had signed the original Conven-tion. In 1966, airlines flying to, from or over the United States agreed to raise theirlimits of liability to USD 75,000 per passenger.

By the end of the 1980s, despite a number of gallant attempts to raise the limits tomore “realistic” levels, it became apparent that in certain respects, the legal frame-work was out of step with passenger expectations.

Bird and other wildlife strikes to aircraft causemillions of dollars in damage annually to civiland military aviation and put the lives of aircraftcrew members and their passengers at risk.


In August 1999, a wide-bodied aircraft with300 passengers on board crash-landed in highwinds of Typhoon Sam, which raged throughthe city of Hong Kong at 100 kph. The planeflipped over after its right wing hit the runway,and a fire on board spread quickly. There werethree fatalities and some 200 injuries.

Figure 2:Passenger awards by region

Indeed, as consumerism continued to gain momentum in the 1990s, a number ofairlines became increasingly conscious of the necessity for change in compensationawards. At the same time, the industry was becoming more and more aware thatthe enactment of potentially disparate national legislation would inevitably result inpiecemeal change. That threatened to complicate operations which, to date, hadbeen conducted in a legal environment which was universally harmonious, albeitdated.

The airlines did ultimately respond in 1995 in the form of the IATA Inter-CarrierAgreement, no doubt due to a combination of altruism, commercial necessity andresignation to the facts. This initiative lead to higher compensation awards beingpaid to passengers who suffered injury from an airline accident, or to their survivorsin the case of death.

A comprehensive market study of the passenger liability cost of airlines – mandatedby the International Union of Aviation Insurers – has examined more than 19,000cases since the 1980s. The study clearly points to substantial compensation awardincreases in all geographical areas. There is a marked increase in the period 1996 to 2002 following the implementation of the IATA Inter-Carrier Agreement.

Europe and North America clearly lead in the level of award stakes (see Figure 2).For the four years between 1991 and 1995, the average European and NorthAmerican awards amounted to USD 0.17 million and USD 1.6 million respectively.Yet between 1996 and 2002, the two continents’ awards stood at USD 1.1 million and USD 2.9 million respectively, representing nearly a seven-fold increase inEurope and a two-fold increase in North America. The US also operates the largestnumber of aircraft in the world, registering more than 40% of the world’s Westernbuilt jets and turbo-props.

Insurers observe with great concern that the trend for compensation is continuing togain momentum. Further increases in liability cost are expected, due to the recententry into force of the Montreal Convention and modernisation of the Rome Conven-tion.

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Ever-widening exposure – the Montreal and Rome ConventionsThe abolition of liability limits by the industry and ultimately formalised by states inthe Montreal Convention, did however – at least according to some of its critics –shift the pendulum too far, moving from a legal environment designed to protect theairline industry from financial ruin, to one intent upon promoting the interests of thepassengers at all costs.

The entry into force in 2003 of the Montreal Convention represents the culminationof a concerted effort by the airline industry, its trade association, consumer groups,governments and legal specialists intent upon modernising a legal regime that itsproponents considered outdated.

Apart from abolishing the limits of liability, the Montreal Convention changed twoother significant aspects of the legal framework that had survived from 1929 –namely, the legal defences available to an airline and the various jurisdictions avail-able to an aggrieved passenger.

The retention of the airline defences under the new Montreal Convention has beendescribed as legal fiction, essentially exposing, in practice, the airline and its insur-ers to unlimited strict liability. The passenger or their lawyers need only establishtheir economic loss and need not ascribe any fault or wrongdoing to the airlinewhatsoever. The new Convention also has the potential of providing easier accessfor passengers into plaintiff-friendlier jurisdictions. Not surprisingly, courts in theUnited States are the preferred venues, as awards there remain significantly higherthan those of non-US jurisdictions.

Airlines need to consider more than just the passengers in the context of legal expo-sure and compensation. New initiatives to modernise the Rome Convention – DraftConvention on Damage by Foreign Aircraft to Third Parties – may have significantrepercussions. Upfront payments to ground victims, for example, are now envisagedas an obligation under the Convention, placing considerable pressure on airline cov-erage limits and on their (re)insurers’ exposure, in turn. The spectrum of exposureappears to be ever widening.

Frequency versus severity Statistics show that individual passenger compensation and awards in case of deathor injury are steadily increasing. Interestingly, there has been a marked decrease inthe number of fatal airline accidents in the past ten years, however. The rolling three-year average indicates the average number of 50 fatal accidents per annum in 1994 had been reduced to a current average of 35. In a historical context, thecalendar year 2003 showed a record low, whereas the 72 fatal accidents and2,539 fatalities of 1972 left that year, by contrast, with the debatable distinction ofrecord highs on both counts.


Figure 3:Frequency vs. severity

The graph below illustrates that global airline traffic faces an annual average ofabout one thousand passenger fatalities. While the number of fatalities is relativelystable, the cost of any occurrence greatly varies from accident to accident. Air trans-portation seems to be getting safer. Is cutting-edge technology finally coming togrips with managing the risk of flight?

Air traffic control – runway incursions and mid-air collisionsAir traffic control’s primary task is to ensure safe airline operation. Further, it is theATC’s responsibility to prevent collisions between aircraft and obstructions on theground, as well as expediting and maintaining the orderly flow of air traffic. Thisbasic principle applies for all airline operations, the world over.

Typically, demand for passenger travel peaks during certain times of the day.Passengers to most international business centres expect regular services, sevendays a week. Inevitably, this leads to many flights being scheduled to depart from orarrive at airports almost simultaneously, invariably leading to congested airspace. Inboth Europe and the US, air traffic has increased dramatically in recent years. Therisk of either runway incursions or mid-air collisions is substantially greater. Someoperations, such as departures and arrivals, clearly involve more communicationand monitoring than others. Shortcomings in communication between ATC andflight crew or failure to follow standard procedure has led to some of the most tragicaccidents in aviation history, as the examples opposite illustrate.

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■ 27 March 1977; KLM Boeing 747-200/Pan Am Boeing 747-100; Tenerife,Canary Islands: Because of limited visibility and communications difficultiesbetween air traffic control and both aircraft, the KLM Boeing 747-200 started itstake-off roll while the Pan Am aircraft was still on the same runway. In the crashbetween the two aircraft, 555 passengers and 23 crew lost their lives.

■ 8 October 2001; SAS MD-87/private Cessna Citation; Milan, Italy: In dense fog,the SAS aircraft collided with the Cessna during take-off from Milan’s Linate airport. The SAS carrier then crashed into a nearby hangar and caught fire. All six crew members and 104 passengers on the airliner were killed, as were thefour occupants of the business jet and four airport workers on the ground.

■ 1 July 2002; Bashkirian Airlines Tupolev 154/DHL Boeing 757-200; nearUeberlingen, Germany: A mid-air collision occured at some 36,000 feet (ca 11,000 metres). Debris from both aircraft fell in an area near Lake Constanceon the German-Swiss border. Both crew members on the DHL Boeing 757 andthe 57 passengers and 12 crew members on the Tupolev 154 were killed.

Third party legal liability – losses on the groundPoor communication between ATC and flight crew was hardly the cause of thetragedy of the Pan Am Lockerbie loss on 21 December 1988, however. In that case,third party losses were caused by terrorism, the theme which, unfortunately, manybelieve has grown into the pre-eminent concern in air travel today. Third party lossamounts have been surprisingly negligible compared to those caused by passengerfatalities and injuries, but the potential for calamitous third party aviation claims hasalways loomed large.

The aviation industry has suffered major losses involving both freighter (Amsterdam,Holland, October 1992) and passenger aircraft (Queens, New York, US, November2001) affecting third parties on the ground. Had either of those tragedies occurredin the middle of the night, in even more densely populated cities or in areas withhigher concentration of values, the dimension of life and property loss on theground could have been far greater.

“The insurance industry provides cover to the airlines and their lessors with operational risk coverfor total or partial loss during take-off, in flight and landing and for damages on the ground.” Key is that the insurance policy replaces capital that the airline would otherwise have to have on its balance sheet.


3 Insurance

Airline insuranceAirline policies offer some of the broadest cover of any insurance line. In addition to the standard aircraft hull all risks, total loss only, aircraft spares, passenger legalliability, passenger baggage legal liability, third party and cargo legal liability, pas-senger and crew personal accident, they may extend to cover – primarily on anexcess basis at varying excess points – motor vehicles airside, employers and adver-tisers legal liability. In the case of charter operators, they can even cover their expo-sure as tour operators.

What is insurance, actually?Whether private or corporate, policyholders are most likely to identify insurance first as an “expense”. Airlines which regularly pay premium and have suffered nosignificant losses may have trouble accepting its inherent value. Insurance is, however, among the most vital and valuable of assets enabling an aircraft to fly. Of course, any airline will require financial means, aircraft, experienced staff and fuel – but without insurance, no aircraft will ever take off.

A case in point: in spring 2004, a low-budget airline had to ground a number of itsjets; owing to an administrative omission, the necessary insurance certificates werenot onboard the respective aircraft at the time of scheduled departure. The lack of asimple piece of paper had suddenly become a major obstacle to normal operations!

The textbook definition of insurance is as follows: “The individual can transfer therisk of a possibly large loss to the insurer by payment of a premium and so convertthe uncertainty of a possible large loss into the certainty of a smaller but fixed annu-al cost.” More than just that piece of paper, insurance is a promise by the insurers to reimburse the insureds for financial loss redeemable at some time in the future.Inasmuch, it guarantees a monetary compensation for losses which the insured mayincur and it replaces uncertainty by certainty for the payment of a premium.

In the case of aviation, insurance provides a financial guarantee for huge limits forhundreds of billions of US dollars at risk.

While insurance is an absolute prerequisite to an airline’s operation, its actual totalcost – on average at less than 2% of the operator’s overall budget – is relativelysmall. In fact, it is such an incidental cost factor that it is not even mentioned specifi-cally in most airlines’ financial reports. Of course, the airlines – like many other in-dustries – are under financial pressure. Yet the cost of commercial hull and liabilityinsurance for a single flight is modest compared to the huge exposure of the riskand the tremendous benefit the client derives.


The landing gear is emblematic of a highlysophisticated product in terms of strength andreliability.

The value of insurance and the capital requiredThis promise to meet financial obligations – the insurance policy – becomes a finan-cial guarantee and represents a form of capital for the airline industry. In the individ-ual case, it thus replaces a substantial amount of capital that the airline would other-wise be required to have on its own balance sheet.

To provide a watertight financial guarantee and to fulfil the terms of the policy, insur-ers require that the respective capital be secured in their balance sheets. The insur-ance industry has a clear and distinct capital requirement: a sound financial basis to cover the huge exposures and potential monetary obligations which they assumefrom the insured airlines.

The manner in which an insurance company manages its operation has substantialbearing and influence on the capital required. Operating as a life insurer or non-lifeinsurer – or specialising in motor or industrial property business – will affect theamount of capital needed to write business. As a rule, the more diversified the insur-ance company, the less relative capital is required. Diversification can include theline of business and the geographical spread.

The capital requirement for aviation insuranceWhat exposure of the aviation industry must be financially covered? Aviation insur-ance on a stand-alone basis implies some rather controversial considerations andelements for both underwriters and investors. Firstly, contrary to motor insurance,the law of large numbers has limited application in this line of business. Secondly,the business is highly exposed and offers potentially high volatility with an enor-mous financial downside. Despite that, aviation insurers give a promise to fulfil hugefinancial obligations emanating from losses the insured may sustain. Hence, insurersmust have adequate capital to meet realistically expected losses, cover worst-casescenarios and ultimately – with a strong security rating – remain solvent.

As mentioned previously, today’s global fleet consists of some 21,400 Western builtairlines, representing a hull insured value of some USD 570 billion. On average, aviation insurers grant liability policy limits of around USD 750 million for every single departure – of which there are roughly 31 million annually. Aviation insurerscover the combined aircraft hull and liability policy amounts on an each and everyloss basis and as such, the amount of exposure airline insurers assume is theoreticallyunlimited. The sums potentially at risk amount to hundreds of billions of US dollars.

Many of the individual policies fall considerably below the above average figure;numerous others exceed it by fifty or even one hundred percent. Fact is, it is themajor airlines that maintain the largest fleets of aircraft and purchase the highestavailable limits – up to, or in some cases even exceeding, USD 2 billion.

Given the exposures and potential loss scenarios we have considered, a lossexhausting the policy limit can hardly be taken as a flight of fancy.


While the total aggregated exposure of several hundred billion is purely theoretical,such figures are nonetheless utterly stunning in amount. Each aircraft represents anindividual risk, and naturally not every one is exposed to the full extent at the sametime. The global aircraft fleet is spread over five continents, many countries andthousands of different locations. Still, there are scenarios that point to losses forinsurers which exceed by a multiple the average expected USD 1.8 billion annualaggregated losses. Such claims could emanate from a series of losses, a frequencyof larger losses combined with some extraordinary, severe individual losses evenexhausting policy limits. Such a scenario might mean insured claims approachingmulti-billion dollar figures. Given the greater frequency of take-off and landings, aswell as congested airspace today, this is hardly a far-fetched scenario. What’s more,the aviation industry might also be hit with losses from natural catastrophe events,further exacerbating such a scenario.

Questions to risk managers and CFOsBear in mind the hull values of all airlines worldwide and the amounts exposed forliability for each individual aircraft, considering it is at risk at each and every take-off.Given the nature of the exposure and claims experience, how much capital wouldthe airline industry require on its own balance sheets to manage these risks?

Further, how much capital should your insurer have on his balance sheet for you tofeel “safe” and in financially good hands? How many billions of US dollars of capitalwould you require from your insurer to back your policy so that you could sleep comfortably?

Pricing the insurance productIn pricing the product, the following cost categories must be factored into the calculation.

Expected losses ClaimsStandard deviationCatastrophe marginAcquisition cost CostManaging costTaxesCapital cost Return on risk capitalProfit Margin

ClaimsInsurance underwriters use historical experience of attrition, major partial and totallosses to assess the expected losses in a year. In addition, they use exposure-orientedmodels and threat scenarios to project future losses for single accidents, collisionsof various aircraft on the ground or in the air and natural catastrophes which threatento damage a number of aircraft at risk in a certain location.


To reiterate, based on past experience, the expected average hull and liability claimsthat the insurance industry faces are in the range of around USD 1.8 to USD 2 billionin any given year. This amount represents the total of attrition, major partial and totallosses. Insurers must count on expected losses in this given range; the ten-year trendclearly shows an upwards development – even including the last two exceptionalyears (2002 and 2003).

On the loss side, various other components must be considered. Given their statisti-cal knowledge of the expected losses, insurers are well advised to calculate a mar-gin for volatility factors. In addition, the pricing calculation must include the catas-trophe element for the freak year – be it for man-made or natural catastrophe or acombination of the two. Liability losses tend to develop over time and the reportingand full assessment of such losses can sometimes take years. Thus, insurers set intheir reserves and pricing an adequate amount for the so-called IBNR – incurred but not reported – reserves. Some insurers will mitigate their risk of expected claimsand purchase reinsurance to reduce volatility and fluctuation of results. They, in turn,offset their expected claims by a cost element in the form of a premium.

CostTo acquire and underwrite the desired business, insurers incur external cost in theform of commissions. These must be paid to agents, brokers and intermediarieswho produce and service the business of their clients and are an element whichmust be factored into the premium calculation.

Insurers must have the necessary expertise, service, claims handling and policy-issuing capabilities to manage and underwrite a portfolio. They must also factortheir own management costs into the pricing of their products. Premium and incometax, for example, are pricing elements which must be considered when rating therisk. Taxes can vary greatly from country to country. A tax-friendly environment maygive an insurance company a certain, if modest, advantage.

Return on risk capitalFor an in-depth discussion, refer to section 4 of this publication.

MarginAny commercial enterprise with a corporate mission is intent on performance. If – after paying claims, cost and capital return – profit is not generated, an enter-prise has neither a sustainable position nor a viable future. A company must worktowards the goals of creating revenue and added value to be an attractive businesspartner to investors, capital providers and clients. Ultimately, those interest groupsseek reliable and long-term business partners to insure their own operations.


The graph above demonstrates clearly how premium income and losses haveproven to be highly erratic. Premium, at best, should be more regular, and all partiesconcerned would find smaller fluctuations far easier to budget. The insurance mar-ket has always tended to have had a reactive, rather than a proactive, approach.From 1988 to 2002, the deficit was USD 2.3 billion on an incurred loss basis. Lowclaims activity in 2002 and 2003 continued into the first half of 2004; should lossfrequency and severity continue in the current vein, underwriters are hopeful ofreaching a break-even or small credit surplus over ten years. It is still far from satis-factory since company overheads and returns to shareholders are not taken intoaccount in this case.

Figure 4:Airline net premium vs. incurred losses andcumulative result

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“While the total aggregated exposure is purely theoretical, it is nonetheless stunning in amount”.The aircraft engine in maintenance reflects the aviation industry’s many layers of complexity – andexposure.


4 Capital

Capital markets and development of equity in recent yearsWhile financial markets have undergone an unprecedented slow recovery since 11 September 2001, a key lesson has been learnt. Many insurance companies haverealised that they can no longer rely solely on investment returns to cover their finan-cial commitments. Further, subsequent rating downgrades have forced insurers tore-evaluate their respective underwriting methodologies, not purely from a risk man-agement perspective, but also from a financial standpoint.

Return on capital is clearly more than a ploy by insurance companies to maintain thecurrent premium level. Rather, it has become an integral part of the underwritingprocess. The days when a risk was priced exclusively on historical losses are longgone. In addition to actuarial pricing models which project future exposures, cost ofcapital has become a crucial element of pricing. And it does not stop there. Manage-ment is becoming increasingly aware of where capital should be deployed and isbetter able to identify where the prospect of returns is most promising.

Influences on the cost of capitalWhy price for capital? Including the cost of capital in the price of insurance is in the interest of four parties. The first three, investors, government bodies and ratingagencies, are readily recognised. The fourth, policyholders interested in the longterm viability of their insurers, may not be so obvious at first glance.

Investors provide the resources from which insurance companies draw their capital.The investors’ goal is to obtain a satisfactory return commensurate with the risk ofthe investment. All other things being equal, an insurance company that fails to in-clude a charge for its own cost of capital when pricing its products will consistentlyunderperform those that do. Investors can be expected to move their capital accord-ingly.

Secondly, government bodies legislate solvency requirements, the technical term for the minimum amount of capital to be reserved. Recent developments in regula-tion and accounting standards have increased the scrutiny to which insurers’ level of capital adequacy is subjected. While the financial markets’ perception of thecredit worthiness of an insurer determines its cost per unit of capital, the absoluteamount of capital required is also an integral part the insurer’s ultimate cost of capital. Increasingly stringent solvency requirements are constantly exerting moreinfluence over insurance companies which, in turn, can put pressure on the cost ofcapital.


Figure 5:The value chain of aviation insurance

Thirdly, rating agency assessments, although not a legal requirement, have becomeincreasingly important to insurers. A high quality rating is of vital importance for aninsurer seeking acceptance as a viable risk carrier by potential policyholders. To amajor corporate insured requiring large limits of coverage, such as an airline, a su-perior agency rating may be a crucial requirement to be an eligible insurer. Insurerswithout a satisfactory rating may find business opportunities severely impaired. Aninsurer’s capital adequacy as measured by the rating agencies has a direct relation-ship to the rating awarded to the insurer. The cost of maintaining sufficient capital toretain a higher rating as assigned by the agencies must be considered an integralpart of production costs.

Hopefully, by now, it should be obvious to the reader why the policyholder also hasan interest in his insurers’ charging for capital costs. Ultimately, policyholders willhave greater confidence in the long-term viability of their insurers if they enjoy stronginvestor backing, are well inside the solvency requirements and have a superior rat-ing from the rating agencies. In this case, bigger is better.

Obligation

D&O

Balancesheet

Insurance policy InvestmentBusinessstrategy

AirlineInsurance company

Investor

RegulatoryRating agencies

Competition Technical assessment

Equity

Interestrates

Expectedreturn

Return oninvestment

Premiums, claims


Volatility also greatly affects the cost of capital. In life or automobile insurance, forexample, individual policy limits are a minute fraction – some one percent – of thetotal premium generated by the line, therefore the volatility is naturally low. A com-pany that concentrates on such low volatility business can operate with a relativelysmall amount of capital. On the other hand, the aviation business, where a single liability policy limit can be more than half of the world wide premium, volatility is an irrefutable fact of life. Due to this extreme volatility, the degree of predictability in a given policy period can be very low. Put another way, there is a high margin for error. In regulators’ eyes, a high margin for error often means a higher level of solvency will be required. This leads to an aviation insurer requiring more capital tooperate than an auto insurer generating the same premium income.

Capital market solutionsCapital market solutions, such as insurance-linked securities, have recently drawnincreased attention. The value of catastrophe bonds is likely to exceed USD 3 billionin 2004. Price levels today are at their lowest since the first cat bond placement of aTaiwanese earthquake risk in the early 1990s. Investors are gaining confidence dueto more standardised structures and to more accurate modelling of loss calculations.

Given the level of transparency in risk evaluation for the aviation industry, substantialstart-up costs may be needed to achieve the prices offered by traditional insurancemarkets. Where time is fast becoming the most valuable commodity, the efficiencywith which traditional policies are being placed makes them the preferred option.Crucially, investors in this type of insurance vehicle will not cover losses on an unlim-ited basis as traditional insurance markets do.

While traditional insurance cannot provide the greater entrepreneurial indemnifica-tion that would entirely satisfy all airlines’ coverage needs, airline underwriters meetairlines’ insurance requirements successfully on the whole. Yet from the insurer’sperspective, satisfying stakeholders is also a primary goal. Considering the cost ofcapital is not simply a tactical exercise by insurance companies; it is the only way forinsurance companies to be sustainable in the future.


“In this highly-exposed risk industry, the value of insurance should never be underestimated, norshould the considerable financial outlay such cover represents be short-changed.”


5 Summary and conclusion

The authors hope they have managed to give insights into and better understandingof the huge airline exposure, the insurance required to cover the potential risks andthe financial means to secure a sustainable operation of the airline, insurance andreinsurance industry. A highly cost-effective vehicle, insurance is the mainstay ofone of the world’s most vital industries. It protects livelihoods and assets which arebecoming increasingly costly from year to year: aircraft values, spare parts, labourcosts and passenger awards. Aircraft are being pushed to larger and larger physicallimits and their capacities are set to swell. Cities and towns are more densely popu-lated and congested, raising the profile of third party damage, and the volume of airtraffic is only expected to grow.

Given these projections, the absolute number of total losses to Western built aircraftwill, optimistically, remain stable or, pessimistically, increase by three additional totallosses a year, which means about one loss a week!

Reading this aviation publication has probably taken about an hour. In that sametime:■ 3,600 aircraft took off all over the world;■ the hull values at risk of those aircraft at take-off approximated

USD 100 billion;■ more than 200,000 passengers travelled varying distances on numerous

airlines; and■ billions of dollars were at risk for passenger and third party legal liability

exposure.

We have seen how covering these risks and securing the insurable interests of thefinancially fragile airline industry, insurers and reinsurers provide billions of dollars of capital. Investors and capital providers analyse their investments carefully and target a return on their investments. If this is not forthcoming, capital will be with-drawn.

In conclusion, the insurance and reinsurance industry offers a prime product to air-line industry clients for a relatively small cost, replacing USD millions or billions ofcapital otherwise required on the insureds’ own balance sheets. In the interest of the ultimate consumer – the passenger – the airlines, their brokers, insurers andreinsurers must make a firm commitment to a financially viable and sustainableinsurance market.

Reference publication

Flight to quality – Financial security in theaviation insurance marketThe complex interactions of the volatile aviationre/insurance industry which coincide with ageneral downturn in financial markets world-wide could cause serious financial difficultiesfor many industry players. Decision-makers inthe airlines and other major aviation clientsmust collaborate closely with their brokers andthe global re/insurance community to createfinancially sound insurance programmes.Order no.: 1492369_02_en

The brochure entitled Swiss Re Publicationsincludes a complete overview of all availableSwiss Re publications. Order no.: 1492220_04_en

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© 2004Swiss Reinsurance Company,Zurich

Title:The true value of aviation insurance

Authors: Philip ChrystalMarcel FokFerdinando MartinoAndreas PeterShinji Shirai

Editing and production:Technical CommunicationsChief Underwriting Office

Graphic Design: Logistics/Media Production

Photographs: Cover: Dietmar PlathPage 4: Adrian RathsPage 8: Erik FrikkePage 10: Kenji SatohPage 11: Adam SamuPage 12: Keystone/AP Photo/Vincent YuPage 18: Dietmar PlathPage 22: Dietmar PlathPage 26: Dietmar Plath

The material and conclusions contained in this publi-cation are for information purposes only, and theauthor(s) offers no guarantee for the accuracy andcompleteness of its contents. All liability for the inte-grity, confidentiality or timeliness of this publication orfor any damages resulting from the use of informationherein is expressly excluded. Under no circumstancesshall Swiss Re Group or its entities be liable for anyfinancial or consequential loss relating to this product.

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The True Value of Aviation Insurance - SwissRe

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