Tim Haynes previews the forthcoming excess of loss renewals in the aviation market.

The vast majority of aviation re/insurers renew their annual excess of loss reinsurances at 1 January 2004. As this key date in the aviation calendar approaches, it is worth reviewing how the market has reacted and developed since the tragic events of September 11, 2001.It has been well documented that post-WTC, which was closely followed by the loss of an American Airlines plane on 12 November 2001, airline rates increased dramatically. These increases, together with the introduction of the war liability surcharge for third party, generated an overall gross airline premium figure of approximately $3.6bn for the 2001 underwriting year, against a figure of around $1.1bn for the 2000 underwriting year. Underwriters required this premium increase, not only because of the catastrophic size of the losses seen in 2001, but also against the backdrop of the preceding years, where rates had been sliding and had reached a point where the average annual loss amounts were exceeding the overall premiums received.One of the most important changes post-9/11 has been the further emphasis by capital providers on writing for gross profit, and making best use of capital allocation. As just about all lines of business saw increases in rates following WTC, capital providers' attention was focused on which classes of insurance required what level of capital to support the underwriting, and whether the potential returns of certain classes justified this capital allocation.With premium levels having reached their peak at the end of 2002, the levels of profit margin generated were significant. As a result, after an unparalleled period of two years during which there have been no significant losses combined with the continued overcapacity, it is no surprise to see that airline premiums and rates have fallen throughout 2003.While airline rates have been reducing, it is important to understand that the other classes within the aviation market, such as manufacturers' and airport liability, have, in fact, continued to see rate increases over the past two years. There is still a belief amongst the majority of the direct writers that there is currently enough premium within the aviation insurance market to sustain the necessary profitable returns, as witnessed by the fact that overcapacity remains.

Reinsurance securityExcess of loss reinsurers were clearly hit hard by WTC. Current reserves for the events of September 11 are in excess of $4bn, of which the overriding share - in excess of 90% - will fall upon the excess of loss market. Bearing this in mind, one issue that has become a central theme post-WTC is the financial security of aviation reinsurers. The major aviation losses over the last 20 years, in terms of liability claims, have historically not been settled until around seven years after the loss. That being the case, how does a reinsurance buyer know that each and every one of their reinsurers will be around to settle the claim when required to? Sadly they cannot, unless the outstanding loss can be collateralised through a letter of credit or some sort of outstanding claims advance. With the legal complexities surrounding WTC, there is a distinct possibility that these claims are not settled for an even longer period than seven years.As a result, reinsurance buyers became much more selective over which reinsurers were offered renewal, and the levels of aggregate that they were allowed to receive. This attitude has not changed, and remains an important facet for 2004 renewals.

Post-WTC reactionWith the most excess of loss reinsurance purchased from 1 January, excess of loss reinsurers were able to respond to the WTC and the American Airlines losses quickly. Prices went up dramatically, conditions were tightened and insurers had to buy more vertical coverage.Also, whereas insurers had previously purchased reinsurance on a `losses occurring on risks attaching' (LORA) basis, only isolated pockets of capacity existed for this for 2002, and most insurers were forced into buying `losses occurring during' (LOD) coverage. With the 2001 reinsurance having been placed on a LORA basis, there was some cover still in place, and this meant that the exposure under these renewed LOD reinsurances was extremely limited. Perhaps the biggest change to the market post-WTC was to retention levels. Whereas insurers' retentions prior to 9/11 were equivalent to around $75m-$100m original insured loss, after 1 January 2002 these rose to around $350m-$500m. With one exception, 2003 saw no significant withdrawals from the aviation excess of loss market and little change in capacity, pricing or coverage. However, where buyers were able to demonstrate reductions in exposure, some pricing flexibility was achieved.

Client differentiationAs reinsurance buyers increasingly seek to differentiate themselves from their peer group, both insurers and reinsurers are investing heavily in developing better systems to enable them to underwrite risks in a more technical manner, including loss scenario modeling and exposure analysis. One technique that has come to the fore in the last twelve months has been the introduction of exposure rating adjustment mechanisms. This involves insurers together with their reinsurers identifying a list of named original risks from which any change in line on each given risk is monitored from one year to the next. If the perceived exposure overall has increased then additional premium is due. Likewise if the exposure has fallen, then reinsurers give a return premium. This exposure can be calculated using a number of variables, whether original premium, average fleet value (AFV), revenue per km (RPK), or cycles.While this has its obvious attractions, it remains debatable as to whether on its own it meets insurers' requirements.On the back of a most extraordinary 24 months with no catastrophe losses and with excess of loss rates at an all-time high, it is no surprise that there is increased interest in aviation excess of loss globally. Capacity for excess of loss protecting original writers has increased through not only new players entering this arena, but also existing markets seeking to increase their portfolios. Recent renewals have seen rate reductions given, and lower retention levels achieved. The size of reductions achieved has been governed by the exposures, which so far have all been down. The real test will therefore come in the final stages of the renewals, with those insurers who have increased their exposures over the last twelve months. Another factor that will need to be addressed is in terms of coverage, and particularly the level of interest in switching from LOD to LORA at 1 January 2004. Price will, of course, determine whether this is adopted or not, and this will centre on the issue of the run-off cost.Excess of loss reinsurers have made significant profits in the last two years, although they will be required to pay substantial outstanding losses in the next few years. The nature of their business means that aviation insurers will continue to require reinsurance. However, we have reached a point at which reinsurers need to listen even more carefully to their clients in understanding their underwriting philosophy and long-term goals. The messages coming from the buyers are for the need for greater differentiation from their `peer group', more innovative products, and premiums that reflect market conditions.By Tim HaynesTim Haynes is Head of Reinsurance in the Aviation Practice at broker Marsh in London.