Keeping the World’s Runways Open

By now it is clear that a global failure to confront international terrorism, combined with a soft market in aviation insurance is going to result in substantially higher insurance premiums for an already cash-strapped airline industry. Still, it is unlikely that even a 400%-plus increase in third-party damage on its own will be enough to ground aircraft in Canada, or shutdown major airports.

Industry sources suggest, however, that some premiums could increase ten-fold over the next 12 months (some U.S. regional airlines are already reporting 1000% increases) – that is if airlines can find insurance at all. Already national governments, including Canada, have agreed to step in and “bridge the gap”. The question, however, is “for how long”?

Immediately after the attacks in the U.S., cover against terrorist acts became a risk too hot to handle. Within days of two commercial airliners slicing through the twin towers of New York’s World Trade Center (two other aircraft ploughed into the Pentagon and a field in Pennsylvania), insurers were hurrying notices of cancellation of third-party war risk cover as of midnight September 24th. Commercial aircraft have traditionally been covered by two types of insurance: standard maritime protection for the loss or damage of the aircraft’s cabin (or hull), and AV52 aviation insurance which covers damage to third-parties. While it is likely that all premiums are going to face heavy increases as a result of industry losses prior to September 11, it was the cancellation of AV52 cover that threatened to silence the world’s runways.

Rate & term adjustments

AV52 aviation insurance has a seven-day escape clause that enables insurers to withdraw war risk if the threat of war or terrorist act heightens. This is precisely what happened, causing airlines like Air Canada to scramble for cover. It is estimated that third-party coverage for the entire Canadian airline industry was Cdn$3 billion prior to September 11, at an annual cost of approximately Cdn$1 million per year. Airports, and Nav Canada, the country’s private sector air navigation service are also insured for third-party liability.

Most aviation insurers have softened their position since abruptly canceling AV52 coverage outright. But this change of heart did not arrive without a price. Where liability has traditionally been capped at US$1.5 billion per aircraft, insurers – headed by the London market which underwrites approximately 30% of the world’s aviation activity – wanted to ratchet down maximum exposure to war risk and hijacking liability to US$50 million per aircraft – and at substantially higher premiums (airlines were already hit with 30%-70% increases in war risk cover at the time of renewal).

For the airline industry, even this gesture was not enough to keep flying. Major airports such as Toronto/Pearson International Airport require up to US$1 billion in ground cover and US$120 million in war insurance coverage to land. Many airports were demanding proof of coverage before aircraft could land.

Aircraft leasing companies expect similar levels of coverage or the airline is in breach of its operating contract. An indication of how high the stakes had become, London’s Financial Times reported that two of Japan’s largest airlines admitted to flying without adequate third-party cover, exposing both companies to billions of dollars in potential liability.

In Canada, the situation never got so desperate. On September 22, Transport Minister David Collenette announced that Ottawa would step in as insurer of last resort. The federal government would provide indemnity for third-party war and terrorism liabilities to a maximum of 90 days. This indemnity will apply to airlines that already carry such coverage, and is limited to the portion of existing coverage that will not be offered in commercially available insurance policies.

Ottawa used to self-insure Canada’s air transport infrastructure until the government privatized the air navigation system and loosened its grip on airport operations in the 1990s. It’s also not the first time that governments have agreed to backstop liability in cases of terrorism. In 1992, the U.K. created Pool Re to reinsure terrorism risk after the IRA bombing of London caused commercial insurers to withdraw cover. Large insurers run Pool Re, but the UK Treasury acts as the ultimate guarantor of claims. Similarly, governments provided cover during the Gulf War ten years ago, although industry analysts suggest today’s situation is more serious. The U.S. is promising to compensate American airlines for added insurance costs for the next six months.

Canadian difference

The U.S. notwithstanding, what distinguishes Canada’s emergency coverage from that of some other countries is the length and scope of protection. Canada’s 90-day temporary cover is three times greater than what is being offered airlines in the U.K. and the European Union. The Canadian government has also agreed to insure the ground as well as air product. In addition to airlines, the offer applies to airports, Nav Canada, the Air Transport Security Corp. and airport service providers such as ground handlers and re-fuellers.

Since Ottawa is guaranteeing third-party liability rather than subsidizing insurance payments directly, the cost to the government is zero as long as the air transport system is secure. Should an act of terrorism or war down a Canadian aircraft, the cost to the government could reach Cdn$1 billion. How close to the billion dollar mark is unclear. In the U.S., patriotism appears to have blunted class-action in the immediate aftermath of September 11. Organizations such as the Association of Trial Lawyers of America, has been actively discouraging lawsuits, and Congress is considering legislation that would restrict liability. Few, however, believe that the peace will last.

As the initial shock wears off, expect American and United Airlines, airports in Boston, Newark and Washington (where the flights originated), and airport security companies to be hit with huge lawsuits by the families of the victims. Some experts suggest that the final bill will exceed last year’s precedent setting US$1 million per passenger pay out reached after an Air France Concorde crashed into a hotel just outside of Paris. Also, back home, it is unclear the length of time Ottawa is prepared to expose itself to such risk.

The initial Canadian support package is for 90-days, and was always intended as a stop gap measure to give Canada’s airlines and the global insurance industry breathing room to re-assess cover and develop solutions. But, if the government thought that the invisible hand of the insurance market would return quickly, it appears that it will be disappointed.

At the time of writing this article, only one insurer, American International Group (AIG) has stuck its head above the trench by announcing that it will make coverage up to US$1 billion per airline available. While it is an encouraging sign, analysts agree that it is not enough to bridge the gap between need and reality.

Ticking clock

Ottawa’s 90-day stopgap measure expires on December 22, three days before the busy Christmas period – the final call for airlines to make the best of an otherwise bleak financial year. Still, the government is not without options should insurers and reinsurers refuse to restore full third-party cover, or the cost of protection is more than Canada’s air carriers can afford.

The most likely option is to extend the temporary measure by an additional 90-days. An extension to six months is already being considered in the U.K. and the European Commission. There is also speculation that the British may move to a more permanent arrangement, with airlines paying the government for added cover.

Transport Minister David Collenette has hinted at similar action in Canada. But, a return to self-insuring Canada’s air transport industry may trigger controversy, especially after the Chretien government has already agreed to subsidize the airline industry for lost revenue over the three days that the fleet was grounded. Con
troversial or not, the government may have no choice. Particularly if war risk coverage for Canadian airlines is designated “held covered,” meaning that underwriters have no fixed rate. Airlines are subject to a floating rate that is adjusted daily to reflect perception of terrorist risk. In this case, Ottawa would have to step in to stabilize the industry.

A final option would be to tack another 90-days onto the existing protection and let the airlines confront the marketplace once the extension runs out. Added insurance costs would likely be passed on to the passenger in the form of a surcharge. Low-cost Westjet has already added a $6 surcharge to a round-trip ticket to cover the cost of added insurance premiums. Other airlines may follow suit.

Security cost

Passengers can expect that such surcharges will swell if Ottawa heaps the cost of additional airport security onto the beleaguered airline industry’s already full plate. Such a possibility raises questions over the extent airlines should be punished for acts of terrorism which are, after all, a response to government policy and not an attack on the carrier itself.

The events of September 11 have done more to accelerate rather than trigger a reassessment of hull, liability and war (terrorism) risk. Premium hikes were already inevitable as the industry continued to struggle with four year’s of aviation claims exceeding premiums. According to the London-based Aviation Insurance Offices’ Association (AIOA), claims for 2000 were US$1.1 billion against premiums of US$924 million. This year was not shaping up to be any better even before the September attack. Indeed, the attack on the WTC has already overshadowed the subsequent downing of a Russian charter airline by an errant missile over the Ukraine, and the collision of an SAS jetliner with a private aircraft on a runway in Milan.

Concerns over terrorism had already returned to the radar screen following July’s raid on Sri Lanka’s Bandaransike International Airport by Tamil Tiger separatists. The attack destroyed four Sri Lankan Airline’s aircraft and severely damaged a fifth. An estimated US$500 million claim was considered to be the most-expensive aircraft hull claim on record for the time.

It is too soon after September 11 to predict what course the global aviation industry is going to take over the long-term. A full return to the market appears inevitable, although not in the same numbers as before given the level of over-capacity that has dogged the industry since 1997. There are stumbling blocks: terrorism remains a social risk that insurers have no way of predicting future exposure with any historical accuracy, and the appetite of reinsurers to provide added capacity has not returned.

Even so, there are signs that a return to normalcy is on the horizon. In addition to AIG offering new cover, insurers at Lloyd’s of London are said to be questioning all aviation policyholders over routes, security and overnight stopovers as they reassess exposure to war risk. Airlines considered to be at less risk may be offered amended cover for third party damage up to US$750 million, but with a US$50 million deductible.

Once again, it is not clear whether such cover would be offered to North American carriers, which are currently considered to be of higher risk. Some industry watchers suggest that airlines also have options. Air Canada, for example, could eventually use the purchase power of its Star Alliance partners (including United Airlines and Germany’s Lufthansa) to place downward pressure on rates.

Since September 11, Israel has become a model for airline and airport security. It may be so once again in its approach to insurance. The Israeli government covers direct losses from terrorist attacks, although not for business interruption. For now, aviation insurance is preoccupied with terrorism. But there are darker clouds forming. While growth in air travel has stalled, there is no evidence to suggest that this is anything but temporary. The industry must also address concerns in aircraft safety as a result of increased traffic volume. If growth continues at the same pace it has prior to this year’s economic slowdown, it is estimated by 2015 that there could be a major hull loss every nine to 10 days somewhere in the world.