MAINTAINING FLIGHT SAFETY DURING A TIME oF AUSTERITY

MAINTAINING FLIGHT SAFETY DURING A TIME oF AUSTERITY

The Challenge for airlines, regulaTors and underwriTers in 2016

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FLIGHT SAFETY DURING AUSTERITY

In the next 20 years or so (20�4-2033), according toAirbus’ Global Market Forecast, passenger trafficwill grow annually at 4.7% driving a need for around3�,400 new passenger and freighter aircraft (�00seats and above) worth US$4.6 trillion. Thepassenger and freighter fleet will increase fromtoday’s �8,500 aircraft to 37,500 by 2033, anincrease of nearly �9,000 aircraft. Some �2,400older less fuel efficient passenger and freighteraircraft will be retired.

The economic growth rates in emerging marketssuch as Asia, Latin America, Africa and the MiddleEast, are outstripping more economically developedregions. One significant effect is that the middleclasses in Asia are expected to quadruple in size by2033 whereas globally they will double from 33% to63% of world population. As a result of increasedurbanisation and concentration of wealth, thenumber of aviation mega-cities worldwide willdouble to 9�. These cities will be centres of worldwealth creation with 35% of World GDP centredthere, with more than 95% of all long haul trafficgoing to, from or through them.

A Confused Picture?

It is tempting to say that the world of aerospace hasnever had it so good. Yet the same thing, clearly,cannot be said of the global economic environment,which is as volatile as the airspace over the MiddleEast at the moment. From an underwritingperspective, the picture is confused. Aviation risk isproliferating as political and economic risks (somefuelled by concerns surrounding corruption),

business interruption, supply chain exposures, lackof sufficient regulatory oversight and newcompetition pressures are eclipsing the wellunderstood risk of a major hull and liability incident.

Cuts to Government budgets caused by austerityprogrammes also have the potential to transfereconomic risk to the private sector, as we outlinelater. Other political factors also come into play:corruption, for example. In this white paper we alsoask the question: does the aviation market needmore transparency over the insureds - and eventheir Governments and regulators - that areultimately being insured and reinsured to properlyenforce good accumulation controls?

Meeting international aviation standards in today’scomplex aviation environment is particularlyimportant and increasingly critical given the recentdramatic growth in airlines and fleets and the everincreasing numbers of people flying between cities,countries and regions around the globe.

Meeting International Standards

That’s why insurers were interested to read the –not entirely unexpected - announcement inDecember 20�5 from the Federal AviationAdministration (FAA) that Thailand does notcomply with International Civil AviationOrganization (ICAO) safety standards and has beenassigned a Category 2 rating based on areassessment of the country’s civil aviationauthority.

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As aviation underwriters will know, a Category 2International Aviation Safety Assessment (IASA)rating means that the country either lacks laws orregulations necessary to oversee air carriers inaccordance with minimum international standards,or its civil aviation authority – a body equivalent tothe FAA for aviation safety matters – is deficient inone or more areas, such as technical expertise,trained personnel, record-keeping, or inspectionprocedures.

According to the FAA, the International CivilAviation Organization (“ICAO”) conducted an auditof the Thai Department of Civil Aviation (“DCA”) aspart of its Universal Safety Oversight AuditProgramme (“USOAP”). This Programme is intendedto ensure a consistent global standard for aviationsafety and the civil aviation authorities of ICAOmember states are subject to regular audits underthe USOAP by ICAO. The audit covers a broad rangeof areas relevant to aviation safety and airlineoperations but is intended to assess theperformance and expertise of the civil aviationauthority and not of individual airlines. Some of thekey areas considered are personnel licensing andtraining, airworthiness assessment and certification,accident investigation and airline operationsoversight and licensing.

Supervising the Growth of the Booming AviationBusiness

With a Category 2 rating, Thailand’s carriers cancontinue existing services to the United States. Theywill not, however, be allowed to establish newservices to the United States. The FAA cut Thailand’s safety rating to category 2from the top-tier category � rating because of itsconcerns about the country’s ability to properlysupervise the growth of the booming aviationbusiness. Its announcement in Washington putThailand alongside six other category 2 countries,including Ghana and Indonesia.

As a recent Bloomberg Business article reported:“Indonesian carriers, air traffic controllers, andIndonesian airspace in general have becomenotorious for weak safety regulations.”

In an age of global airline alliances and networks,which integrate the services of multiple carriers,each member airline plays a significant and criticalrole in the alliance and its network. A downgradingof Thailand and blacklisting of Thai carriers wouldbe the first time this will have affected a majoraviation and alliance hub in South East Asia andmay have global repercussions. [Source AN ICAODOWNGRADE: IMPLICATIONS AND ISSUES FORTHAI AVIATION – Watson Farley & Williams]

A downgrade may result in higher insurancepremiums and Thai carriers may find it moredifficult to acquire and lease aircraft given thepotential operating restrictions. If the impact islimited to the US and EU, the majority of Thaioperators should be able to continue to operate asthey currently do.

The FAA’s downgrade comes amid growingconcerns over airline safety in parts of Asia.A crash investigation report into the loss of AirAsiaFlight 850� in the waters between Surabaya,Indonesia, and Singapore last December, found thatsystem malfunctions and improper pilot responseswere to blame. All �62 people on board were killed.

It could take some time for Thailand to recover itstop-tier ranking with the FAA, though.It took Israel four years to regain its category �status after a downgrade, and the Philippines had towait more than five after it was downgraded in2008, although upgrades can happen sooner.

It took India just over a year to regain its category �status after a downgrade last year, enabling it toadd additional flights to the U.S., while Mexicorecovered its top-tier ranking after four monthsafter those countries quickly addressed the FAA’sconcerns.

The Impact of Corruption on Efficiency

In their 20�4 White Paper Effects of GovernmentQuality and Institutional Choice on Efficiency of theU.S. Commercial Airports, the authors focus on theimpact of corruption on airport efficiency. Theywrite:

“In our analysis, corruption matters for airportefficiency by affecting airports’ decision making. Weexplain such impacts based on the fact that theaccountability of public policy outcomes in highlycorrupt environments is low. As a result of lowaccountability of public policy outcomes, the boardof an airport authority puts low efforts inmonitoring. Therefore, transferring airportmanagement from local governments to airportauthorities cannot improve airport productivity incorrupt environments. Furthermore, airportauthorities in corrupt environments tend to useoutsourcing to replace in-house labor.”

The authors of that paper were primarily interestedin the efficiency/productivity gains and a debatesurrounding a local Government as opposed to aprivate model of airport authority control, however,they do not explicitly refer to the impact ofcorruption on safety or risk management bestpractice.

In another paper focusing on the impact ofcorruption on European airports Effects ofCorruption on Efficiency of the European Airports,the author’s state:“We find strong evidence that corruption hasnegative impacts on airport operating efficiency;and the effects depend on the ownership form ofthe airport. The results suggest that airports undermixed public-private ownership with privatemajority achieve lower levels of efficiency whenlocated in more corrupt countries.”

Airports are an intensely political risk. Theseemingly never ending debate about a new runwayfor Heathrow confirms that airports will always

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feature in the public consciousness and airports areindeed often symbols of national prestige. The otherpoint to make about airports is that theirgovernance structure has been until relativelyrecently, state-owned. But that all changed in the�980s.

Since them, among a sample of 47 airports duringthe 2003-2009 period, 5 were fully private, 7 wereowned and/or operated by mixed public-privateenterprises with private majority, 9 were ownedand/or operated by mixed public-privateenterprises with government majority, and 2� wereowned and/or operated or by �00% government (orpublic corporations).

Airports, their geographical environments, thepeople that work in them are defined by theirpolitical jurisdiction, which is important. PauloMauro argues in his �995 white paper Corruptionand Growth that “the efficiency of institutions isrelevant for any firm operating in the country ofinterest, since they are assessed independently ofmacroeconomic variables. Therefore, we includegovernment stability, quality of bureaucracy,internal and external conflict and law and order asindicators of institutional quality variables.”

What of the rest of the world? As the authors of theEffects of Corruption on Efficiency of the EuropeanAirports, state, the impact of corruption may beheightened and you can also throw extra credit andsurety risk into the equation. Although they do notexplicitly mention credit and surety risk, they reportthat:

“This research, which is limited to Europe, can beextended to airports in other regions including Asia,Oceania and more specifically developing countriesand highly corrupted regions. Major airinfrastructures in developing countries are fundedby the World Bank and/or funding agencies. Ifcorruption not only causes misuse of resources butalso impacts on airport operating efficiency, therecipient countries may not be able to pay back theloans. As such, the infrastructure projects lendersmay want to retain a certain percentage of theirloans, and use it for the country to set up cleanproject bidding and tendering processes withproper checks and balances, to educate and trainofficials and employees, and auditing during theproject implementation period as well as ex-postauditing.”

Suffice to say that many commentators have beenscathing about standards in Asia, which hassuffered a rash of accidents in the last couple ofyears. A 20�4 Bloomberg Business article addressesthe potential causes head on when it reports: “Tosome extent, the three Malaysian air disasters arejust brutal bad luck. Still, they point to severaldisturbing trends that raise the question of whetherflying in peninsular Southeast Asia is completelysafe. The air market in the region has embracedlow-cost carriers, leading to a proliferation of flightsthroughout Southeast Asia, stretching air trafficcontrollers, and possibly allowing some airlines toexpand too rapidly. Indonesian carriers, air traffic

controllers, and Indonesian airspace in general havebecome notorious for weak safety regulations.”

Aerospace is now Fiercely Competitive

As we have seen, the rapidly growing world –particularly in emerging markets - of aerospace isnow fiercely competitive and that brings a wholehost of opportunities as well as threats to airlinecarriers as well as their insurers. Traditional “fullservice” carriers and low-cost budget operatorsalike are under pressure from their investors andregulators to deliver increasing value to passengersand stakeholders so how does that translate intocustomer safety? Is there an expectation that riskmanagement standards could be compromised inthe search for profitability?

It must be a concern, however, some aerospacecommentators remain relatively sanguine.

Getting Away with Sub-standard Safety Practices?

“Low-cost carriers get their savings from efficiencyand less money spent on customer service ratherthan by skimping on safety issues,” said MaxLeitschuh, a transportation analyst for iJETInternational. “In places like North America andEurope, where there’s a well-regulated airlineindustry, they are not going to let any airlines getaway with sub-standard safety practices. The majorbudget carriers have very good safety records. Infact, many of them have never had a crash before.”

Asia, where regulatory standards vary widely andlow-cost carriers are booming, is not as clear cut.Budget carrier AirAsia, for example, suffered amajor crash in January but had a spotless recorduntil then. But Indonesia’s Lion Air -- with eightincidents since 2002 -- has an atrocious safetyrating and has actually been banned by the EU.

“Asia is much more of a mixed bag, both in terms ofthe airlines and the regulatory authorities,” saidLeitschuh. Certain authorities like Singapore’s areexcellent. Malaysia’s regulatory agency is mediocre,while Indonesia has major problems, he said. “Butjust because there’s poor regulation still doesn’tmean the carrier is unsafe -- it’s just on the carrierto regulate itself.”

Until recently, Lufthansa subsidiary Germanwingshad an unblemished safety record in its �3-yearhistory. While investigators have not yet determinedthe cause of its tragedy – the official investigationinto German Wings Alps crash closes �3 March sountil the report is released everything else must bebased on assumption - it’s unlikely that it hadanything to do with Germanwings’ low-cost status.The problem is not necessarily the carriers but moreso the approach to their regulation.

Inspectors Not Qualified for the Job

According to the Flight Safety Foundation,“regulators across the world have always had adifficult time recruiting and retaining operationsinspectors. It is very difficult to find someone who is

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qualified for the job and who is not already flyingfor an airline that will pay a lot more money. If theyfind someone to take the job, the civil aviationauthority (CAA) is lucky if these recruits stay in thegovernment for five years, unlike typical youngbureaucrats that stay for 30.

“The problem is that these inspectors are vital.Without them, the papers move through thebureaucracy and fees are paid, but the operatorscan do pretty much as they please. When there is ashortage of operations inspectors, airplanes tend tocrash.” It is a lesson that has been learned over andover again and the International Civil AviationOrganization (ICAO) reportedly has the facts toprove it.

Austerity: the Big Secret

As the Flight Safety Foundation reports: “This leadsus to the big secret that many people know but feware willing to discuss. Many of the major regulatorsin Europe are desperately short of operationsinspectors, and the government budget austeritymeasures being taken across Europe likely will takethe situation from desperate to dangerous.”

It is not just the regulators and lower cost budgetcarriers that are under pressure, however, as theexample of Air France reveals. It was reported that atense employee meeting at the French flag carrierturned violent when Xavier Broseta, the HR director,was descended on by an angry mob who tore offhis shirt and forced him to flee half-naked over afence.

With labour relations at a low point, analysts andsome individuals close to the company worry thatAir France could go ahead with inefficient reformsthat do not improve its ability to competesufficiently. This increases the risk that Air Francebecomes a second-tier player in the global aviationindustry.

That is not to suggest in any shape or form that AirFrance is more of a safety hazard as a result but thecompany’s travails do help to illustrate the pressuresof operating an airline at, dare we say it, the highestlevel!

Proliferating Aviation Risks

As international air-fleets increase in size and scopein line with a growing and increasingly prosperoustravel-hungry global population there may be a riskof not being able to see the wood for the trees. If itis difficult enough for increasingly stretchedregulators to keep up with the growing demand forair travel, how complicated is it going to be forinternational insurers underwriting growing booksof aerospace risks, which encompass the creation ofnew airports, new planes and technologies, and newdangerous flight routes across war torn territoriesand terrorist enclaves?

As Russell Group has written in previous whitepapers this year on the subject of airport groundaccumulation risks and other aviation perils, we are

confronted by a murky geo-political picture thatshows few imminent signs of clearing up while newthreats such as drone and cyber risks increasinglycause underwriters more concern.

Meanwhile, as an Allianz Global Corporate andSpecialty Global Aviation Safety Study outlines:

“Every day the aviation sector faces a multitude ofrisks that can potentially jeopardize the success oftheir operations if they are not managedadequately. Business interruption (both physicaland non-physical damage) and supply chain risksare currently the greatest concern for aviationpractitioners.” The AGCS study reports: “Intensifiedcompetition and market stagnation/decline, naturalhazard risk, regulatory change and technologicalinnovation also rank highly on this risk register.”

According to the same AGCS survey of riskconsultants and claims experts, businessinterruption, supply chain risks (for example,damage to machinery) features high on the riskregister for 35% of respondents while intensifiedcompetition (35%), market stagnation or decline(30%) and our old friend changes in legislation andregulation (24%) also disrupted people’s beautysleep.

Risk Selection is Key

In such an environment, do we truly know our peakaggregate risks in the way that we probably did 20,30 or 40 years ago? Furthermore, if we in theaviation risk management community are going tobe honest with ourselves can we say �00% that wecan actually name our – proliferating - risks?

In other words does the aviation market need moretransparency over the insureds that are ultimatelybeing insured and reinsured to properly enforcegood accumulation controls? Is there now a needfor expanding the aviation market questionnaire?Finally, is a more efficient naming conventionrequired which (re)insurers could use withconfidence knowing that they are talking about thesame insured risk?

The key challenge that underlies this softcompetitive environment is that underwriters needimproved risk selection controls which allow capitalto be smoothly diversified across the portfolio inorder to achieve premium income targets. This inturn requires controls which enforce deeperknowledge of the portfolio’s underlying risk andaccumulating exposure.

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Russell Group is a leading risk managementsoftware and service company that provides atruly integrated risk management framework for(re)insurance clients operating across the specialtyclasses through its ALPS suite of products.Underwriting risk is, or should be, the primaryconcern of specialty (re)insurance companies inquantifying portfolio exposure, pricing risk,optimising reinsurance purchase and evaluatingthe amount of capital needed to support theportfolio.

Russell through its ALPS product provides anunderwriting risk framework which delivers acomplete and integrated understanding ofunderwriting exposure, capital utilisation andportfolio return on equity. If you would like tolearn more about Russell Group Limited’s ALPSsolution for aerospace loss exposure management,please contact [email protected] [email protected]

www.russell.co.uk

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MAINTAINING FLIGHT SAFETY DURING A TIME oF AUSTERITY