Letting your captive fly
Airlines are no strangers to captive insurance. Lufthansa has a reasonable claim to being the first company to form a captive, Delvag, as far back as 1924. Today, a large number of airlines of all sizes have captives. However, few of these captives are central to their parents’ group risk management strategies.
Charles Allen, executive chairman of Artex Guernsey, says at least 30 of the larger airlines have some form of captive insurance operation, and this doesn’t take into account the manufacturers and major aviation support services that make up their supply chains that are also in many cases users of captives.
“The extra capacity they can deploy may mean that they are not a hostage to fortune, if rates go up too much, or capacity declines.” Nigel Weyman, Gallagher
However, airlines are less prolific users of captives than other commercial sectors, says Allen.
“Over the years we have discussed captive ventures with a number of the world’s larger carriers and it is apparent that while risk management is high on their agenda the use of a captive to assist in their insurance strategy does not feature in the same way,” he says.
“Only when the head of risk management has some previous experience of captive insurance strategies do we find that the idea meets with an immediate positive reception, and even then it is often an uphill battle to convince senior management of the benefits.”
The primary reason for this is the availability of affordable coverage from the commercial market. “Rates in aviation have gone up a significantly in the last 24 months but they still represent incredible value,” says Nigel Weyman, global executive of aerospace at Gallagher.
“There is no need for airlines to take the risk themselves when they can transfer it to insurers at rates that are arguably below cost.”
Aviation insurance premiums have been steadily declining for years. They sat at extremely elevated levels after the 9/11 2001 terrorist attacks, when insurers overreacted to the terrorism threat, but then fell steadily for many years after that. At one point rates fell through the level at which the business was profitable for insurers, but even this did not stop them writing the coverage, with commercial insurers hoping the market would eventually turn back in their favour and become profitable again. Protecting their relationships with the airlines was seen as more important than profiting from those relationships in the short term.
Weyman says: “It’s analogous to the large airlines continuing to run a route that is no longer profitable for them because of the competition from low-cost airlines.
“They don’t want to give up the route, the landing slots and everything else that goes with it, because they hope one day it will come back and be profitable again.”
From the airlines’ perspective, it still made sense to have a captive, even if there was no plan to lean heavily on it for their insurance coverage. Captives are typically seen as defensive weapons that can be used to mitigate the impact of excessive cost increases or capacity shortages, if and when they arise. They increased competition for the commercial insurers and helped keep costs down.
“Airlines mainly use captives on the periphery of their insurance portfolios, generating just enough income to cover the cost of managing the captive and build up the capital base,” says Weyman.
“If the captive has the capability to write 5 to 10 percent of the hull and liability insurance coverages the airline needs, the extra capacity they can deploy may mean that they are not a hostage to fortune, if rates go up too much, or capacity declines.
“Currently they are principally a strategic negotiating tool, but it is definitely important for the airlines that they have a credible alternative if the terms being offered in the commercial market are not acceptable.”
What is covered
This is a very general picture. The reality is that different airlines use their captives differently, which typically depends on the sophistication of individual buyers and brokers involved in each case, says Allen. There is also a considerable difference in the attitudes of the large traditional legacy or flag carriers and the recent low-cost and more digitally sophisticated carriers, he adds.
The most common policies are hull deductible, hull and liabilities, spares, pilots’ loss of licence, crew personal accident, medical and repatriation, property and employers liability coverage, says Allen.
“The enormous exposures on policies such as hull and liabilities often mean the captive will take only a small proportion of the overall risk and use the reinsurance market extensively,” he says.
Beyond these traditional lines, things such as contingent business interruption, environmental, cyber and supply chain risks are increasingly written in captives, says Alexandra Gedge, business development and captives executive at Marsh Captive Solutions.
A new chapter for the air industry
COVID-19 has hit the whole global economy hard, but few industries can claim to have been hit harder than aviation. The pandemic has left vast swathes of the world’s airplanes grounded, and social distancing measures have created considerable uncertainty about what air travel will look like in coming months, at least until science provides a vaccine or a cure.
Flying in the age of social distancing creates a significant risk management headache for airlines. Michael Zuckerman, associate professor at the Temple University Fox School of Business, says: “Causation is a significant potential issue. Who is going to be liable if passengers contract COVID-19 while flying on airplanes?”
If there is a risk of a systemic breakdown in the airlines’ mitigation of risk, Zuckerman argues, a parametric insurance programme may be the appropriate response—but he warns it would need to be carefully designed to ensure the wording was clear and narrowly defined.
“It might also be possible to use cat bonds to fund this exposure,” he says. “Nonetheless, if they want to pass the risk off in the reinsurance market airlines will need to use their captives.”
Zuckerman points to the example of the Metropolitan Transportation Authority (MTA) in New York after 2012’s Hurricane Sandy, which created the first storm surge cat bond. “Loss portfolio transfer can play a big role helping large companies in this crisis,” he explains.
In the case of the MTA, a New York-domiciled captive was used to form a special purpose reinsurance vehicle in Bermuda, which then issued cat bonds. Proceeds from this issue were used to reinsure a portion of the MTA’s storm surge exposure insured in its captive. Zuckerman believes something similar might be possible for airlines.
“Doing this through a captive can generate revenues, diversify the captive, and ultimately improve the customer experience.” Alexandra Gedge, Marsh Captive Solutions
There are plenty of other ways captives can be used that could potentially generate revenues for their parent groups, at a time when the normal sources are not delivering as much as they have in the past.
“Airlines should definitely be using their captives as profit centres, writing coverage for their customers for things such as travel insurance, cancellation and lost luggage, in much the same way companies such as Apple have done for customers buying its equipment,” says Zuckerman.
Gedge agrees this is an interesting growth area for airlines.
“Loyalty programmes can help to increase customer commitment, and offer additional benefits at the point of sale,” she says. “Moreover, airlines have a wealth of information on the purchasing and flying patterns of customers and are able to offer a bespoke, top-quality experience to consumers.
“Doing this through a captive can generate revenues, diversify the captive, and ultimately improve the customer experience.”
Captives can also be used to extend insurance coverage to the airlines’ customers. “The consumer insurance space is a huge industry, with cancellation cover particularly seeming relevant at present,” says Gedge.
“A captive can be an efficient way to manage this risk, as well as offering real added value to the end consumer.”
“Travel insurance is sometimes a class which lends itself to captive participation,” agrees Weyman. “In this case the captive can charge a premium for providing cover for the difference in conditions between where the normal insurance has declined the claim but the airline is obliged to step in, for instance, to repatriate the passenger, and that cost can be claimed against the captive.”
Airline captives have also been used to cover such risks as travel agent default, says Allen, while things such as air miles liability and EU flight delay compensation are under discussion.
Artex has been discussing sophisticated means of selling insurance to passengers with the use of artificial intelligence (AI), covering things such as flight cancellation, medical, baggage, missed event cover and car rental insurance.
“Mobile apps and pre-and post-flight follow-up offers are all possible in the increasingly digitally enabled world of AI offers,” Allen explains. “The captive will in certain cases be able to write direct, but in many instances will need the support of authorised front-end insurers and the reinsurance market to make the product successful.”
Allen adds: “If there is one vitally important link in the attempt by any captive to be more creative and dynamic in the products it offers it is the availability of well-rated flexible reinsurance that can cover cross-class exposures ceded by the captive.”
Zuckerman sees an opportunity for airlines to provide supplementary employee benefits related to COVID-19, for things such as mental health coverage, to supplement global health insurance programmes provided to their employees.
Allen says airlines have shown some interest in including employee benefits into their captive insurance programmes, as well as risks handled by human resources teams.
“Until recently corporate covers such as property, hull and liabilities, etc, were dealt with in an area quite separate from the HR team and their insurance responsibilities,” he says.
For one client Artex created an air rage policy which specifically protected crew from on-board incidents relating to disorderly passengers, including physical and psychological injuries and associated legal costs.
“The flexibility of the captive to underwrite with specific reference to the needs of its parent are key in these matters,” says Allen.
Gedge says: “Broader employee benefits programmes can help businesses to support their employees with things such as wellness programmes and—particularly important for airlines—consistent coverage for employees all around the world.”
Captives can do more for their parent groups than simply write insurance. They can assist their parents by allowing premiums to be paid over a much longer period than they usually would, by lending back surplus liquidity that has built up in the captive, or by making dividend payments.
“Attention to solvency implications and parental security is paramount,” says Allen. “However, most loan-back arrangements may include a claims offset clause in the event funds are not repaid when claims are made beyond the captive’s immediate cash resources.”
Given this plethora of options, Allen believes that for airlines, and for any organisation with a premium spend in excess of about $3 million, the COVID-19 pandemic has made the case for captives stronger.
“Not for well over a decade has the case for the creation or more effective use of captives been so compellingly strong,” he says.
He says some of Artex’s airline clients are actively looking at whether they should expand their use of captives, and the breadth of coverage they provide, in the face of potential large increases in market rates.
“The aviation market has experienced huge disruption, so many options will be considered for their insurance going forward,” agrees Gedge. “A captive could be a vital part of these insurance programmes.”
Weyman warns against getting too carried away, however.
“We are a long way off being in a position where I would recommend airlines start using their captives to write the majority of their own insurance,” he says. “Premiums would have to substantially increase from their current levels before it would be worth their while.”
Insurers can take a more proactive view of marginal premiums, because they get the spread of risk and income from a portfolio of clients, but a captive is exposed to the fortunes or misfortunes of just one client, he warns.