07 July 2022
Reinsurance Dynamics & the Impact on the Direct Market
A high level of uncertainty currently exists around the future of direct aviation pricing levels, with the Russia-Ukraine conflict potentially representing a major market claims event. With a substantial portion of any major aviation claim feeding through to reinsurance protections purchased by direct insurers, the cost and availability of such protection will be subject to the same uncertainties seen in the direct market. In this article, we explore the potential impact of the conflict on the reinsurance market, how this affects insurers and subsequently how this may influence pricing trends for aviation insurance buyers.
Reinsurance
The reinsurance market is a well-known but often misunderstood element within the insurance ecosystem. The reinsurance world mirrors the direct market in many ways, with reinsurers having specialist divisions to underwrite individual classes. However, this is contained within fewer companies, who aggregate risk in ever larger pools as the original risk moves through the (re)insurance capital chain. As a rough guide, around 30% of direct aviation premiums are transferred to the reinsurance market – 75% of this on a proportional basis (quota share or QS) whereby reinsurance premiums are directly related to original premiums and a commission is paid to cover the insured’s expenses, 25% of this on a non-proportional basis (excess of loss or XOL), whereby markets determine premium based off a loss exceeding the insured’s retention. The implication of this is while the QS reinsurers’ results will approximate the direct insurers, the XOL market generally responds above the low level, attritional claims, whilst paying the lion’s share of the large catastrophe losses. Given this inherent volatility, many reinsurers also look to reinsure their portfolio with retrocession (retro) reinsurers – where a premium is paid to transfer reinsurance risk after taking their own retention, with these retro reinsurers being at the top of the (re)insurance capital chain.
Reinsurance acts as a hedge for insurers to protect their balance sheet. As insurers aggregate risk and mutualise losses from all aerospace sub-classes, reinsurers in turn mutualise losses from a portfolio of insurers, and aggregate risks from other lines of business such as Marine, War, Terrorism, and Political Violence. At every stage, the objective for (re)insurers is to aggregate non-correlating risk and to dampen volatility, reducing capital requirements thereby supporting a higher return on their capital.
Excess of Loss (XOL)
For aviation specific programmes, average retention levels mean that market losses below USD250m are retained by direct insurers, with XOL programmes typically responding to losses above this level. XOL cover is placed in layers, each with its own ‘leader’ responsible for quoting and basic administration, with between four and six layers on a programme, allowing reinsurers to vary their involvement at different loss levels, depending on risk appetite. The amount of cover (vertical limit) purchased by an insurer will depend on their own risk appetite and/or market conditions but it's often purchased up to an equivalent market loss of USD4.5bn, or 2x their maximum line deployed on any one risk. Each layer has its own event limit, and should a loss to the layer occur, will have its own terms for additional premium to be paid to reinstate the limit (reinstatement premium). These reinstatements (or sideways cover) are also limited in number (typically 1-3 times), and if exhausted would require new terms and conditions to be negotiated, meaning that insurers buying XOL can never truly protect against worst-case multiple loss scenarios. With the aviation All Risks insurance product offering unlimited sideways cover (i.e., insurers are exposed to the full policy limit for each aircraft irrespective of how many aircraft are involved in a loss), insurers in this class are therefore forced to run the threat of tail risk (events modelled in the tail of a probability distribution) on their balance sheet, with multiple sideways losses exhausting their reinstatements. This is in addition to the more obvious threat of insufficient vertical cover (i.e., the limit of the reinsurance is exhausted by the size of an individual loss event).
Composite Layers
With reinsurers aggregating risks across many different classes, the natural progression is for these to be grouped where there is appetite to do so. Whilst aviation All Risks XOL has typically remained a stand-alone product, we have seen insurers in the aviation Hull War class protect these portfolios within composite layers i.e., where many lines of business are covered under a single limit. The aim for these layers is to group non-correlated classes and reduce the total limit purchased by insurers (and therefore cost), whilst keeping capital requirements low. Meanwhile, from a reinsurers perspective, they will receive a higher premium rate for their capacity and reduced capital charge compared to individual ‘pillars’ of capacity being deployed for each class. These layers have recently come under scrutiny due to the specific circumstances of the Russian invasion of Ukraine, with ‘non-correlating’ classes now potentially correlating, and questions over the level of detail known by reinsurers pricing these covers.
“History doesn’t repeat itself, but it often rhymes”
- Mark Twain
What happens next?
Given the scale of the potential contingent airline exposure in Russia, there are no comparable loss examples for us to explore. If we want to look for parallels, however, we might explore the precedent from the WTC attacks in 2001, which represented a seismic change for the insurance industry. The backdrop to this event was the aftermath of the Dot-com bubble bursting, with large investment losses followed by a period of interest rate cuts to boost the economy, and rapid reversal once inflationary pressure started to build. This uncertain macro environment was coupled with poor underwriting results, which led to consecutive unprofitable years in aviation from 1998 to 2000. The shocking nature of the attacks led to an instantaneous reaction, with systemic insurance product change, dramatic price increases in all classes, and consequently a new excess AVN52 third-party liability war coverage emerging. Capacity, which had been falling prior to 2001, bottomed out, leading to hard market conditions. Within the reinsurance market, coverage restrictions meant retentions for insurers increased by more than 2x, and cover was amended to be ‘Losses Occurring During’ the policy period (compared to the more generous Risks Attaching cover previously available). Minimum premium rates charged by reinsurers at the top of programmes move from c.2% to 4%, which then exerted more pressure on the insurers to raise prices.
As we move into the second half of 2022, we can see many of the same conditions that existed in the build-up to WTC; a period of loose monetary policy, followed by increasingly hawkish central bankers attempting to control inflation in the face of sluggish growth, and now an aviation (re)insurance market faced with the potential of a significant unmodelled loss event. The wide range of outcomes for the (re)insurance market from the Russia-Ukraine war mean we have not seen the speed of reaction that WTC precipitated, but that does not preclude similar drastic responses if pessimistic scenarios are realised.
Russia-Ukraine Conflict
There’s approximately USD1.1tn of airline aircraft value at risk globally, and Russia makes up around 3% of this value at USD32bn of exposure.
Russian airlines also lease a disproportionately high percentage of the aircraft they operate. Globally, 51% of aircraft are leased, whereas Russia leases 86% of their total (US 27%, China 63%, Major European 61%, India/Brazil both 85%).
Aircraft leasing companies purchase contingent cover for their potential exposure if an airline policy fails to respond to a loss. In 2021, the contingent market was estimated to generate roughly USD150m for Hull and Liability cover, and about USD25m for Hull War cover.
Raw numbers:
- 750 aircraft operating in Russia, of which 388 are western-leased aircraft, totalling USD14.7bn
- 53 lessors, of which 20 are Russian or Chinese
- Average western-leased hull sum insured of USD40m
- Estimated Hull War aggregate limits for the western-leased aircraft covered under contingent policies of USD12.5bn*
For perspective, Lloyd’s of London standard modelling for severe losses envisages a five aircraft event for Hull War, and two maximum Hull & Liability lines for All Risks Losses.
Whilst significant uncertainty exists surrounding the likelihood and size of any loss materializing, put in the context of the World Trade Center attacks (WTC), Russia-Ukraine could be up to 4x the initial WTC reserve, and 7x the final loss amount to the aviation market.
*Based on Cirium data, Gallagher Re estimated hull agreed values and hull war aggregate limits (where known).
The Domino Effect
Whilst the questions over the coverage and size of the Russia-Ukraine loss event are answered, insurers are in the unenviable position of underwriting a portfolio, whilst speculating on the availability and price of reinsurance coverage when their respective reinsurance programmes renew. Meanwhile, reinsurers making these decisions are equally forced to price business now based on considerable uncertainty around the availability of retro capacity. Once these terms and conditions solidify in the retro market, each participant down the capital chain will be able to reassess their individual economics and amend terms and conditions accordingly. The nuances of this potential loss event mean that it could yet fall to aviation (All Risks) (re) insurers, or to marine composite (Hull War) (re)insurers, or in some degree to both, which will create vastly differing pressures in either of those markets. In the short term, the lack of clarity is likely to see a focus on Hull War coverage and an increase in aviation retro costs, plus renewed focus on other potential systemic risks in the class. Whilst not all reinsurers are reliant on retro cover, this squeeze on capacity and coverage will be felt to varying degrees by reinsurers.
Consequently, reinsurance costs for insurers are likely to rise, which will be felt differently in the market; larger insurers with economies of scale can dilute these increases more easily than smaller players. Although in a verticalised market (where the premiums are quoted by a leader and negotiated with each following insurer, often at a discount to the lead price), the larger the cost squeeze, the more likely for reverse verticals appearing (i.e. following markets achieving prices above the leader). This chain of action and reaction is influenced by a multitude of decision-makers, each with their own circumstances and objectives, creating a domino effect down the capital chain.
As we enter a new phase for the world economy, with elevated inflation, rising interest rates, all under the looming threat of recession, it is helpful to understand how the existing insurance ecosystem has developed and risen to all previous challenges and threats. The extremely competitive and unique product that insurers offer aviation clients has evolved with support from a willing reinsurance community, who collectively have remained committed through extremely difficult periods. Until the true impact of the Russia-Ukraine conflict reveals itself, we can benefit from understanding the inter-dependency that exists in the (re)insurance world, but also that within these complex and varied links, the true resilience of the market remains.
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Joe Davidson-Merritt
Senior Associate, Aerospace, Gallagher Re
Joseph_DavidsonMerritt@gallagherre.com
Arthur J. Gallagher (UK) Limited is authorised and regulated by the Financial Conduct Authority. Registered Office: The Walbrook Building, 25 Walbrook, London EC4N 8AW. Registered in England and Wales. Company Number: 119013.