No end for aviation's woes - Special Report: Marine/Aviation

Last year, the aviation market condition was the worst on record. Today, the industry is still fighting to stay airborne and asking for federal intervention. The aviation industry is facing an uncertain horizon.

Without question, 2001 was the worst year in aviation history. An already struggling industry was crippled by terrorism and a week-long grounding of flights across the country. The insurance industry, distressed due to the same terrorism, rushed to exclude terrorism coverage from all policies. Airlines were left with few options: buy new coverage at unheard of prices or stay grounded.

A year later, the situation is no less frustrating for the aviation industry. Insurers have terrorism cover, but the airlines argue that the premiums would cripple their eroding profit margins. Responding to what they call a lack of affordable coverage, U.S. airlines are planning the creation of their own insurance entity, which many believe will allow them to insure against terrorism and acts of war at half the market price.

Airlines' top brass are also calling on Congress to bail out the aviation industry, which is riddled with debt even after Congress' $15 billion bailout of the airlines in 2001. Indeed, the industry is suffering. News releases from the Air Transport Association (ATA) have reported a sharp decline in passengers and fare prices in September 2001, 32 percent and nearly 19 percent respectively, and a steady average decline in passengers from November 2001 through August 2002 of 10.8 percent. Fares were equally dismal, declining an average of 12.8 percent from September 2001 through August 2002. American Airlines' chairman and CEO Donald Carty told the House of Representatives aviation subcommittee, "Without relief, our efforts to control our own costs will likely be futile."

How did the industry get to this point? Airline execs say that some of the blame lies at the feet of insurers, thanks to war risk liability insurance premiums, which according to Delta's chief executive, Leo Mullin, has had a devastating effect on the bottom line. U.S Airways is in bankruptcy protection. United Airlines is rumored to be heading there in this last quarter of 2002. Speaking to Congress, Mullin said that 35 percent of the industry's pre-tax operating losses for 2002 could be tied to aviation security issues, as well.

State of the Industry

Third-quarter results show that the pressures are immense. Delta announced $326 million loss, Continental and America West $37 million and $31 million losses respectively, and American posted a $475 million loss. US Airways is still working to restructure under its chapter 11 filing in August 2002.

"It's been a really interesting year," says Chris Duncan, chief risk officer, at Delta Airlines in Atlanta. "We continue to have uncertainty in pricing and future access to aviation insurance, driven partly by terrorism. Pricing is at an all-time high. That again is driven by terrorism, but also the industry is still catching up on their historical losses, including World Trade Center. We're looking at a 400-percent to 500-percent increase in aviation costs year over year. That's for all U.S. carriers."

"If you're doing an illustration to describe the plight of the airline industry, it's a series of cinder blocks rather than straw when you're talking about the straw breaking the camel's back," says Harold Clark, chairman of the U.S. Aviation Underwriters, New York. "In this case, these are pretty big cinder blocks being piled up. Everything would seem to have hit them at once and simultaneously. I think they're getting hit from every side."

Financially, the aviation industry is limping along. Duncan says: "We're staying in the air because we have a deep balance sheet and because people still need to travel. For the third quarter, we had positive operating cash before our lease obligations...our focus is on controlling the things we can control, which is our cost, our capacity and our cash."

At the moment, insurance coverage across the industry is at an average of 4,000 percent more than the beginning of 2001, says Duncan.

Wayne Wignes, president of Aon's aviation practice in Chicago outlines the coverage available through the FAA--"The typical terrorism coverage available to airlines is part of their main hull and liability placement, and it's subject to a sublimit of $50 million in third-party bodily injury/property damage on the ground. The full policy limits continue to be available for terrorist acts that involve passengers, but the limit available commercially is now subject to a $50 million sublimit."

To his knowledge, Wignes says that there is no U.S. carrier currently buying a commercial product, opting to purchase the FAA coverage.

But insurance industry executives argue that insurers are struggling as well. "Insurers have lost on a cumulative basis about $3 billion," says Andreas Peter, global head of aviation and space at Swiss Re, Zurich. "There is a current market reserve out for that part, and if you add it up, we're missing something like $7 billion. If you were in this business giving cover to the airlines on whatever-percentage basis, you basically lost tons of money." Says Clark; "They're depleting equity. There have been management shakeups in the corner offices. There's a lack of confidence in the whole segment."

Federal Intervention?

One way the aviation industry plans to control costs is through a proposed self-insurance program. A proposed plan, Equitime, will pool the efforts of most of the major carriers in an attempt to cover the risk at a much lower premium. Marsh and the ATA worked with several airline carriers to develop a risk retention concept that would be domiciled in Vermont. The program was named Equitime, an aviation term that describes the point in flight where the risk of returning equals the risk of going forward.

"The idea was that the airlines could combine their balance sheets to take a significant portion of the terrorism risk of another 9/11, but we didn't have the balance sheets to support the risk of another 9/11," Duncan says. "The idea was that we were going to take a significant risk early on, and ask the federal government via the FAA to act as a reinsurer."

In the short term, the self-insurance plan may help to alleviate the pressures on the airlines' bottom line. Under the airlines' proposed plan, coverage for terrorism risk would cost 50 cents to 70 cents per passenger, compared with $1.33 charged by insurers. About $330 million in startup funding would be provided by airlines, which would also cover first-year premiums. Coverage would be $1.5 billion per event for liability. Final approval has not been given to any plan, says an ATA spokesperson.

That's the sticking point, says Duncan. "We had 26 airlines sign a letter of intent to participate. It still requires the federal government to sign on." In fact, the plan is stalled at the federal level. Duncan says that the plan, conceived through meetings with the group, was approved through its domicile, Vermont. The federal government has only to sign on as reinsurer to make the plan happen.

Yet the federal government is currently steeped in debate about the role of the government in terrorism and insurance. "We're caught up in the whole debate," says Duncan. "The government is struggling with some pretty philosophical and insurance-related questions about their role. In the meantime, the U.S. airlines are paying about $15 million a week in terrorism insurance."

The insurance community by and large supports government involvement. Wignes says, "The single most unanimous position from the reinsurers is that they do not Want to be in the terrorism business. They are providing the $50 million limit incredibly reluctantly. They would far prefer to have the entire terrorism exposure assumed governmentally and get out of that business completely."

Risk Management Challenges

Wignes says that as much as the insurance industry wants to help, it can't. "There's a great deal of sympathy from the underwriting community. The underwriting community, however, has to fix its own ship. There's no question that the price of the product has gone up geometrically at a time when the airlines are least able to deal with the cost increase. But there is also a mission that has to be accomplished by the underwriting community. They can't charge the historical prices they've been charging and stay in business. Their capital providers and their stakeholders simply will not support them."

The lack of choices, says Clark, is the cause of much risk management frustration. "If you didn't know the CFO and the chairman really well, you got to know them this past year. The frustration comes from the fact that there aren't a lot of alternatives to buying full insurance. The banks insist on full insurance on the aircraft that are leased and financed. They recognize the third-party liability exposure including passengers, so you can't cut limits. They don't get a big credit if they take a self-insured retention. They feel boxed in a bit. Of course, the workers' comp market is in the tank, as well. If the risk manager can keep a program, it's a hell of a lot more expensive.

The aviation market is by no means grounded. The airline industry has been working toward minimizing the losses felt by the rapid and numerous changes this past year. There are three major legs to recovery, says Duncan. "The first is that you're seeing Delta and the others trying to work toward a lower cost structure. Second is that we think it's very appropriate that the federal government own the cost of securing airports and air travel. It's really a national security issue. That's a pretty heavy cost for us that's been overlaid since 9/11 that we quite honestly didn't expect. When you combine that with the revenue challenge that we have, getting the government to fund the security mandates as well as address the hassle factors that have been created in the airports, it's a critical issue for us for our industry to recover successfully."

"Then there is the general economic recovery," he adds. "In a downturn, one of the first things that's cut is travel. As the economy improves, our business will improve.

Experts are predicting another 12 months to 18 months of tough times before the market begins to show signs of recovery. Clark thinks that the airline industry leaders will prevail in what has been their toughest market ever.

"Everyone we visit has a plan and articulates it well--rightsizing, rapidly deploying strategies, being tough and disciplined about efficiencies where you can be efficient," he says. "There's no one magic potion for all airlines. Each airline has its own issues and problems. Time is really the cure here if the airlines are given the breathing space to let things settle down."

Lori Widmer can be reached at lwidmer@lrp.com.

COPYRIGHT 2002 Axon Group
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