There is a growing mismatch between in the primary and reinsurance aviation markets. Will the gap get wider still at the 1 January renewals? asks Mark Campe.

In contrast to the plummeting rates in the primary market, the aviation reinsurance market has so far maintained a firmer stance towards rate reductions. The primary market, meanwhile, has seen average reductions in hull and liability rates in excess of 20% (although the actual premium reductions are in the region of 12% as a result of higher exposures).

To a degree, one should expect a more conservative attitude from reinsurers. In the primary market, the available capacity adds to the pressure to apply a rational technical underwriting stance. Even in the hard market that followed the attacks of September 11, the premium-to-exposure ratios in aviation insurance were not for the fainthearted. Today, aviation insurers are facing the double whammy of falling rates and escalating exposures following a steady growth in air travel and the development of liability regimes.

Aviation reinsurers, on the other hand, are less likely to be driven by competitive pressures in their rating decisions. A number of market developments such as Solvency II and the growing influence of rating agencies ensure that aviation reinsurers stay focused on the strategic implications of their underwriting decisions. They analyse things from a portfolio perspective and appraise their decisions in terms of their impact on shareholders' value and return on risk-adjusted capital.

Growing divide

Throughout 2007 to date there has been a rating mismatch between the primary and reinsurance markets in the aviation sector. The situation bears a degree of similarity to the inconsistency between primary and reinsurance rates in the North American property sector. The mismatch has been present ever since the highly active 2005 hurricane season.

One of the side effects of this was the unprecedented growth in alternative reinsurance capacity through catastrophe bonds and sidecars. This has somewhat cushioned primary insurers from the impact of expensive reinsurance. However, investors have so far shown less enthusiasm for aviation-related capital market solutions.

Will the reinsurance market finally succumb to competition and reduce rates, or will the primary market be able to halt the downward rate movement? These are the questions being asked as the industry approaches the 1 January renewals.

One way to answer them would be to look at the available market capacity. Here the picture is far from clear. A combination of new capacity is entering the market of which CV Starr, Berkley Aviation and Mitsui are some notable examples. More recently there has been a small degree of capacity contraction, with Qatar Insurance Company announcing it would withdraw from aviation insurance from July 2007 and Korea's LIG suspending its aviation underwriting.

Another way to gauge the likely market behaviour would be to examine the loss activity in the aviation market during the past few years. Since 2002, the primary aviation market has remained relatively loss free in terms of major losses that fall on the reinsurance market. So the point at which attritional losses begin to influence the direction of primary rates is surely close?

When looking at the impact of losses on premium rates, a question that strikes many market observers is whether the absence of major losses over a five-year period is due to luck, or whether we are seeing a long-term trend. Are airlines now safer than they used to be five years ago? If insurers are optimistic in their sentiment, they will be more likely to accept lower premiums for aviation risks. This may partly explain the recent premium reductions.

In reality, there are likely to be a significant number of drivers for the downward pressure on rates - and how these combine to influence pricing is uncertain. Ahead of the January renewals, the only real certainty is that the market is waiting for news of further rate reductions with a growing sense of unease.

Mark Campe is a partner at JLT Re.