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Aviation Insurance 101 - Part 1: Reinsurance

Aviation101_plane.jpgMany wonder how an aviation insurance company can offer coverage for such a high severity/low frequency exposure. There are very few companies that can offer the limits and retentions that aviation insurers can handle, but the only way this can be accomplished is with reinsurance. Essentially insurance for an insurance company.

Aviation insurance is a capital intensive coverage, where insurers commonly offer limits exceeding $100,000,000 (!). Taken to theoretical extremes, this could result in astronomical payouts. Naturally, this fact puts a strain on the capital requirements from rating companies like A.M. Best which in turn can lower your financial ratings.

In order to mitigate the amount of capital allocated for limits offered, the insurers are often wise to pass some of the risk to reinsurers, by buying reinsurance. In other words, just as there is a market for an aircraft owner to buy coverage for their hull and liability, there is a market that offers an aviation insurer coverage, to limit the downside of some of these very high limits.

Yes, hindsight is always 20/20 with any kind of insurance. But prior to buying reinsurance, companies can play the odds by carefully evaluating their own book of business, business strategy, loss history and risk appetite. Armed with a solid understanding of reinsurance options, companies can optimize a re-insurance plan to meet their unique needs.

For starters, here’s a brief lay of the land. There are two main types of reinsurance – Treaty Reinsurance (annual or longer term coverage) and Facultative Reinsurance (one off placements usually). These two types can be purchased separately or together in a blended approach. Within the category of Treaty Insurance, there are two ways to go: proportional or non-proportional, the latter also known as Excess of Loss (XOL).

Let’s start by focusing on Excess of Loss (XOL), because it’s so common, and an efficient springboard for understanding reinsurance. XOL provides coverage for losses in excess of a certain retention. Programs are typically divided into layers of coverage, up to the limit desired by the insurer. Policies are written with different clauses based on company preference and are renegotiated annually. In any given program there may be a combination of reinsurers participating, each with its own appetite for different coverages and layers.
Take a look at a hypothetical XOL program in excess of a $1m Retention, to a maximum recovery limit of $10m.

XOLProgram.jpg

The retention of the insurance company (reinsured) is the first $1,000,000 of any loss. In the event of a loss of $5,000,000, the reinsured retains the first $1,000,000; the next $3,000,000 (100%) is paid by the first layer of the XOL program, and there would be $1,000,000 (50%) of the second layer. Therefore, the GROSS recovery in this example is $4,000,000 from the reinsurers.

But that’s merely part of the story. It’s crucial to consider the NET recovery – after all, the reinsured pays a premium to the reinsurer for reinsurance coverage. This premium is rated using what’s called a rate on line (ROL). For layer one, let’s say the ROL is 25%, making the premium $750,000 (25% of the $3m line); layer two’s ROL is 10%, or $200,000; and layer three’s ROL is 5%, or $200,000. The entire premium comes to $1,150,000.

But there’s more to consider: in addition to the premiums due upfront, there’s a reinstatement premium shown for each layer, usually shown as a percentage. In the case of the above, layer one has a 100% reinstatement premium, layer two has a 100% reinstatement premium, and layer three has a 50% reinstatement premium. This means if you use the layer, you’ll have to pay an additional amount. In our example, after the $5m loss, the reinsurers will charge another $750,000 for layer one, and since we only used 50% of layer two, we would get charged 50% of 50%...or $50,000. Finally, the insurer must deduct the costs of the reinstatement premiums from the GROSS recovery, which then gives a NET recovery of $3,200,000.

Still with me? Yes, reinsurance can be complex, but the main takeaway is simple: in the field of aviation insurance, reinsurance programs are a cost of doing business. The example highlights a loss, but the simple fact is, premiums paid for a reinsurance program are expenses that come off the insurer’s bottom line. While it affords coverage and protection from catastrophic losses, it isn’t the same as insurance where the object is to make you whole. Some companies are of the philosophy that only buying coverage for super catastrophic losses is the best way to go, while others buys coverage with very low retentions. There’s no one-size-fits-all answer, and hindsight is indeed 20/20. But as companies begin to understand the nuances of reinsurance options, some measure of prudent foresight can be gained.

In our future installments we will be discussing proportional and facultative reinsurance.

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