It is a popular notion that the reinsurance market bears considerable responsibility for over-capacity in the aviation market. It seems to me that this is usually an excuse for lack of underwriting decisions by direct underwriters, or an excuse given from underwriting units with high expense ratios which need income to survive.
Considerable imbalance is inherent in the aviation account because of the very high policy limits required. As a result, partnership between the direct and reinsurance markets is absolutely vital in order that the market can continue to satisfy the future needs of its clients.
It may be considered that the need for reinsurance by the direct underwriter falls into four categories:
With the first two categories, there can be the legitimate use of both proportional and non-proportional reinsurance in what could be termed a traditional way. The first two categories also require long-term relationships with major reinsurance markets, in order that capacity can be consistent through the various market cycles.
Pricing will vary, certainly from the excess of loss point of view. However, if the right relationship has been struck with the major reinsurance markets then the pricing will be affected by not just the aviation result, but by the world catastrophe results.
If the reinsurance is being used legitimately, and at the higher end of the exposure spectrum, then changes in pricing are unlikely to affect dramatically the direct market's pricing. The main effect on the pricing would be lack of capacity to complete programmes, thus causing difficulty in completion of original policies requiring high liability limits. The same consideration can be given to the correct partnership with proportional reinsurers who one would expect to support through the various market cycles.
Perhaps the third category referred to, minimising retention in soft market conditions, is the area that affects the market most dramatically and most rapidly. The problem with this category of reinsurance is that historically someone gets hurt.
When that happens, the effect is dramatic. Prices may rise to a non-commercial level, causing the direct underwriter to be forced to increase his retention, perhaps in an underwriting unit that does not necessarily have the financial resources to retain substantial amounts. Alternatively, or maybe in addition, when someone gets hurt we usually end up with a non-responding reinsurer, causing the direct underwriter to have to create reserves against that position.
Recent history shows that, not necessarily non-responding reinsurers, but certainly reinsurers who have been involved in the bottom end of the aviation market, withdraw - if not terminally ill, then certainly badly injured.
The fourth reason for needing reinsurance - which may be unique to the aviation market - is that very high limits of indemnity have been required and given by the direct market. Therefore, this market has become very highly geared Consequently, catastrophe excess of loss reinsurance is essential for this to continue.
Currently, it appears that the reinsurance market is finally looking to price capacity at correct levels. In addition, it is not only looking at aviation catastrophes, but more at the results in the world catastrophe market. The structure of reinsurance programmes during this year and for the next two or three years is going to have to be reviewed. Indeed, this process has begun.
There may be greater use of alternative risk transfer (ART) products, although whether these are really viable within the aviation market remains to be proved at this time. The big underwriting units will be able to accept increased retentions whilst some smaller or less well-financed units will be in some difficulty. At the same time, the aviation market is faced with the continual increased value of new aircraft equipment and the prospect of needing to supply ever-increasing liability limits.
What of the future relationship between direct underwriters and reinsurers? As higher liability limits are required, clients may well become aware that there is very little point in asking a direct underwriter to take those limits if he is merely passing them straight on to the reinsurance market. It may be that, in the future, clients will make greater use of the reinsurance catastrophe market, with direct discussion taking place between them.
In the long term, it has been proved time and again that responsibility for underwriting cannot be passed off to the reinsurance market. Aviation is a class of business with a long tail, and old underwriting years have a nasty habit of needing reserve increases at a later stage. The bottom end of reinsurance does not solve this problem, it merely postpones the inevitable.
Of course, there will always be opportunists, both within the direct and the reinsurance markets. But, at the end of the day, with the increasing emergence of merged groups or group insurance programmes, combined with the growing consolidation taking place in the aviation industry, thus reducing the number of major clients, the exposures will increase significantly.
The same is happening with insurers. I believe there will be greater moves of cooperation between major clients, major insurers and major reinsurers. This could even be to the extent that major aviation risks may start to emerge with a completely different market structure, in terms of the relationship with their direct and reinsurers' underwriters, from the medium-sized risks.