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Aviation insurance and 9/11

Leasing industry professionals are all too familiar with the negative effects on the U.S. economy of the September 1 Ith terrorist attacks. The particular devastation of the aviation insurance market, given the nature of what occurred, should come as no surprise. Within days, the aviation insurance industry cancelled third party liability coverage of war risk for the entire airline industry Coverage was restored thereafter only on severely limited terms. As part of a larger initiative to help domestic air carriers absorb these and other escalating costs, the Federal government itself temporarily stepped in as the insurer of last resort. But this Federal support is a stopgap measure.

Moreover, the issue of terrorism insurance coverage is not limited to the aviation insurance industry. Insurers on commercial policies for other personal and real property are now routinely excluding terrorism and war risk, and insisting on high premiums for such coverage, in some cases more than the premiums for general commercial coverage. Every industry needs to develop long-term solutions to its terrorism insurance problem. The response of the aviation industry, may provide a viable model for certain other types of equipment. Overall, these developments emphasize the importance of a careful review of lessor and lessee insurance coverage.

Pre-9/11 Aviation Insurance

Commercial aviation insurance is commonly provided by a group of large companies represented in the London market. These primary insurers, in turn, rely heavily on re-insurers, based primarily in Western Europe and Asia.

The two standard components of commercial aviation insurance are hull insurance and liability insurance (passenger and third-party personal and property damage). Hull insurance, especially important in aircraft leasing, covers the insured airline against physical loss or damage to the aircraft itself (including the airframe, engines and other components), offering crucial protection of what is frequently the lessor's sole collateral.

Liability insurance, on the other hand, typically covers the insured airline for losses from injury to persons or property (other than the aircraft). Although they are often combined under the same policy, there is an important distinction between passenger liability and third party liability. Passenger liability indemnifies the insured airline for damages for injury to persons who are in a contractual relationship with the airline as passengers. The policies may also indemnify the airline for negligent acts of its employees committed in the course of their duties. By contrast, third party liability insurance covers the insured airline for injury to non-passenger parties arising out of operation of the aircraft. Coverage often includes such events as damage to another aircraft in a mid-air collision or destruction of property while taxiing.

Due to the potentially devastating losses involved, most hull and third-party liability policies expressly exclude war, terrorism and associated risks. The war risk exclusion used in the London market, known as AVN 48B, encompasses risks such as war, invasion, hostilities, civil war, strikes, riots, civil commotion or labor disturbances, acts of a political or terrorist nature, sabotage and hijacking, among others.

Indemnification for these events-or "war risk coverage"-is often offered separately through an endorsement to either the hull or third-party liability portion of the policy.

In recent years, insurers had come to view the risk of domestic terrorism as low. It thus became industry practice for the insurance provider to offer domestic airlines hull and liability war risk coverage at no or modest cost (typically a few pennies per dollar of coverage), using standard write-back language provided by Lloyd's war risk hull (AVN 51) and war risk liability (AVN 52C) clauses. However, insurers would retain the option to cancel the endorsement upon seven days' written notice. By contrast, aircraft flying into war-torn or politically unstable regions were required to pay substantially higher premiums for war risk coverage.

By early September 2001, commercial airlines in the U.S. market were facing increased economic pressure. High fuel prices and a decline in travelers had lowered airline profits and pushed some companies toward bankruptcy. Insurance concerns also loomed large. Premium rates had been on the rise. Yet, available coverage limits were just barely adequate to cover the increasing size of aircraft, mounting claims (now exceeding $3 million per deceased passenger on average) and the potential liability from property damage and personal injury in the event of an accident.

For their part, the aviation insurance companies were also struggling: the sector's global losses ranged from $1.8 billion to $1.9 billion annually over the last four years. As the industry consolidated, there were also fewer primary insurers, and re-insurers were reluctant to sign on for the same unprofitable terms that primary insurers were providing.

9/11's Impact

Immediately after the September 11 th terrorist attacks, the FAA closed all the nation's airports for the first time in history, and ordered all U.S.-based airlines to cancel domestic and international flights. On September 17, the London insurance market, on behalf of all aviation insurers, notified all carriers that effective September 24, liability war risk insurance coverage would be cancelled. On September 24, after reassessing their exposure to more realistically address the new political environment, insurers announced new policy terms for war risk third party liability coverage. While lenders and lessors typically require at least $750 million worth of third party liability war risk insurance, coverage would henceforth be capped at $50 million for certified air carriers. Other airlines were offered no coverage at all. Meanwhile, underwriters informed airlines that hull war risk coverage would be reviewed on a case-by-case basis to determine whether premiums needed to be increased. Hull war risk underwriters also announced a surcharge of .05 percent of the hull value on top of any increased premiums.

Just two weeks after the terrorist attacks, insurance companies started marketing new insurance packages on the commercial market. The new packages, however, offer drastically reduced liability war risk coverage at substantially higher prices. In total, the price hikes represent an increase of per annum insurance premium costs over what the airlines were paying prior to September 11th from about $850 million to $1.4 billion, imposing a heavy financial burden on carriers. At the same time, to protect their collateral in times of increasing uncertainty, lessors are more likely to insist that lessees purchase the war risk coverage regardless of the cost.

Federal Assistance

The Air Transportation Safety and System Stabilization Act (PL107-42) was signed into law on September 22, 2001 in order to provide protection to the beleaguered airline industry. This multi-faceted legislation authorized the Federal government to issue $10 billion in federal credit instruments to air carriers experiencing difficulty accessing the capital markets, and compensating airlines for losses through December 31, 2001 resulting from the initial disruption of service and operations following the attacks.

The Stabilization Act provides critical support to the airline industry in the area of aviation insurance. It authorizes the government for 180 days to partially reimburse airlines for increases in hull or liability war risk insurance premiums over those in effect during the period beginning on September 4, 2001 and ending on September 10, 2001. The Act also authorizes the Secretary to provide war risk insurance and reinsurance on commercial terms for both U.S. domestic and international flights, with coverage extending to airline vendors, agents and subcontractors. The FAAs Aviation Policy and Plans (APO) Insurance Program provides products to address the insurance needs of U.S. domestic airlines not met by the commercial insurance market. Currently, airlines running passenger and/or cargo flights are eligible for "gap" third-party liability war risk coverage beyond the $50 million limit now being set by the private insurance industry. An airline is eligible to purchase new coverage for up to twice the per-occurrence limit it carried in liability war risk insurance prior to September 11, 2001. Certain non-scheduled US air carriers who are not able to obtain needed insurance coverage from commercial insurance companies may also qualify for the policy, which remains in effect from the day it is accepted until the end of the 180 day period. Hull war risk coverage is not available under the program.

Finally, if an air carrier was the victim of terrorism in the 180 days following enactment of the Act, the Secretary has discretion to limit the airline's exposure to third-party, nonpassenger claims to $100 million, with the government absorbing any additional losses exceeding that amount. Liability for all claims arising out of the terrorist-related air crashes of September I th are capped at the limits then in effect of the airline's liability insurance. Furthermore, the awarding of punitive damages against either an air carrier or the federal government is prohibited.

Going Forward

While both the airlines and aviation insurers were experiencing difficulties before September 11, the attacks thrust both industries into even greater uncertainty. Even the largest aviation insurers felt the impact. By January 2002, Lloyd's of London had paid out $424 million in claims related to the attacks, and had revised its loss estimates from the attacks upwards by 47 percent to $2.8 billion. Overall losses for the insurance and reinsurance industry from the attacks are estimated as high as $50 billion.

The FAAs war risk insurance program ensured that at least some air carriers would not fail to comply with their obligations under international aviation regulations (and possibly have their flying rights suspended) and lease covenants due to inadequate coverage. The program also subsidized American Airlines and United for 9/11 claims exceeding the limits of their existing coverage.

These measures appear to have sustained the industry for the short term, but carriers likely will continue to have difficulty securing adequate "war risk" insurance coverage at current market rates. Although there are some indications the government is willing to extend the program in some form past its planned March 20, 2002 expiration date, as of this writing, it has not. (We will provide a brief update of the developments in this area in May ELT.) However, several initiatives are underway to devise a private solution to the insurance gap.

Most noteworthy is a proposal from the nation's major airlines to create their own insurance company, called Equitime, to protect themselves against terrorist attacks. Under the proposed plan, which has the government's backing, the government would continue to provide subsidized coverage for larger losses, but its role would diminish over time, provided no additional major attacks occurred. Insurance packages will be made available to the 22 members of the Air Transport Association, as well as to the regional airlines, other smaller carriers and companies that directly service aircraft. Coverage from Equitime would cost approximately $.50 to $.70 per passenger, compared to the $1.33 currently charged by the government (and the $2.25-$2.75 being offered by private industry) While it remains to be seen how the company, expected to become operational in the next few months, will fare, it is clearly an important step towards stabilizing the industry.

Consultants to other industries are watching this development closely, as it may set a useful precedent for them as well. As noted above, the issue of insurance coverage for terrorist acts is not confined to the aviation markets. In fact, several major project finance and commercial property transactions have stalled over the issue of terrorism coverage, and its effect on the marketplace in general remains to be seen. Clearly, lessors of all types of property need to be vigilant in their oversight of lessee insurance requirements.

 

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