Airline Finance and Aviation Insurance

Airline Finance and Aviation Insurance
Airline Finance
and
Aviation Insurance
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Intentionally Left Blank
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Unit -1
Airline Finance
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1.1 Introduction Airline Finance Need & Importance
The global airline industry contributes to economic development. The airline industry is an important
contributor towards economic development. It has not only increased world trade activity by enabling faster
and easier movement of passengers and goods, but has also provided jobs to millions of people.
The purpose of the book is to provide, as far as possible, a broad understanding of all areas of airline
finance. To do this, it has been necessary to sacrifice some detail, but sometimes accountants and industry
specialists will be directed to other texts to explore more complex topics further. In many cases, however,
these other texts do not exist, at least in an air transport industry context. This significant gap, at least at the
level of the non-specialist, is the main reason for this book While there are obviously numerous financial
management, corporate finance and related texts available, none of these provide explanations, as this book
does, for some of the quirks of the airline industry (for example, the accounting treatment of frequent flyer
programmes or the various aircraft leasing options available). Furthermore, none of them provide worked
examples based solely on the air transport industry.
The valuation of an airline as a whole, its route rights and airport take-off and landing slots are dealt with
next, covering the techniques applied both in equity IPQs (Chapter 6) and airline privatisation (Chapter 7). First
sources of finance are discussed and the institutions that specialise in airline financing. This is followed by a
new chapter on equity finance that looks at way start-up airlines are financed. The application of some the key
techniques in financial analysis are then explained and applied to the airline industry, supported by practical
examples faced by airline planners. The role played by hedging and derivatives in the airline industry is
introduced in the next chapter, again supported by actual airline examples. Fuel price hedging has been
expanded in this third edition, both because of its close relationship with currency hedging, also because of its
more widespread use by airlines and greater relevance. Leasing is examined in some detail, and aircraft
securitisation is explained, as well as a new chapter on airline bankruptcy before concluding with an
evaluation of the financial prospects of the industry. Wherever possible, the thinks between the varions
elements of airline finance will be highlighted, although the textbook naturc of the book will ensure that each
chapter and topic could be consulted separately.
1.2 World Airline financial results
The airline industry has over the years been buffeted by both economic cycles and threats from terrorism
and epidemics. Following seven years of good profitability that stemmed from a relatively long world
economic upswing between 1994 and 2000, it suffered a severe setback in the 2000s with the post 'year 2000'
downturn and the aftemath of 9/11.
Cumulative net losses of the world's scheduled airlines amounted to US$20.3 billion between 1990 and
1993, but this was followed by almost $40 billion in net profits between 1995 and 2000. This highlights the
cyclical nature of the industry, and the need to treat with caution comments after the Gulf War recession and
9/11 about the continued ability of the industry to finance expansion.
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Since the end of the early 1990s recession, the airlines' balance sheets have been considerably
strengthened, even allowing for the replacement of large numbers of noisier aircraft that did not meet the
current Chapter 3 standards. ICAO figures show the debt/equity ratio for the world's scheduled airlines
declining from a high of 2.90:1 at the end ofl993 to 1.42:1 at the end ofl999. This had deteriorated to 2.46:1 in
2003, before improving somewhat to 2.41: I in 2004.' Clouds appeared on the horizon in 1999, with the price
of jet fuel jumping from 40 cents per US gallon a barrel to 75 cents in January 2000. This led to a drop in
operating profits, although net profits were maintained largely due to the sale of aircraft and non-core
investments such as holdings in IT and communications companies. The dollar price of fuel in 200 I was still
well below its high in 1981.
At that time fuel expenses rose to just under 30 per cent of total airline operating expenses. In 2000, they
were still only 12 per cent of the total, even after recent sharp increases. This has been helped by substantial
advances in fuel efficiency. For example, British Airways has reduced its average fuel consumption in terms of
grams per revenue tonne-km from around 440 in 1990/1991 to 345 in 1999/2000 (or by an average of 2.6 per
cent a year), and is on track to meet its target of306 g in 2010.
As stated above, the fuel price started increasing alarmingly in early 1999; a further advance occurred at
the end of summer 2000 to a high of 107 cents, before the price fell back to around 75 cents by the end
of2000.3 The next period of instability was in 2004, when prices ranged from a low of 92 to a high of 157 cents
per US gallon.
Some economists link any sudden and substantial rise in fuel prices to an economic recession about 18
months later. This appeared to be happening in 200 I, as the downturn in the US economy began to have a
serious effect on Asian exports, especially for countries such as Taiwan and Federation of Malaysia. The impact
of declining GDP for the major world economies such as the US, EU and Japan has in the past led to a
downturn in traffic (Figure 1.1). The first ever decline (as opposed to large reduction in growth rate) in world
air traffic growth in 1991 was due to the combined effects of the Gulf War and the world economic recession,
with a second in 2001.
The difference between the operating and net profit is cansed by net interest paid, gains or losses on
asset sales, taxes and subsidies, and provisions for restructuring. Interest paid is the largest of these items, and
this has declined in the second half of the 1990s due to the combined effects of falling interest rates and lower
debt outstanding. Profits from asset sales also make a good contribution in some years, generating over $2
billion in both 1998 and 2003.
1.3 Factors affecting financial results –
Airline financial results are highly sensitive to small changes in either costs or revenues because of the
historically high level of operational and gearing that has prevailed. Once the relatively high interest charges
have been covered, increases in revenues or reductions in costs flow through to large improvements in net
results and vice versa. Financial gearing might be expected to decline somewhat in the future, as more assets
are financed by operating leases, rather than with debt.
Airlines also display high operational gearing. This is caused by the fixed nature of operating expenses
and relatively small margins on sales; this results in large swings m operating results, III the same way as
described above for net results.
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The degree to which operating costs are fixed depends on the rime scale, and three periods can be
identified:
a. The medium term: once the schedule has been determined, the costs associated with operating flights are
relatively fixed, i.e., aircraft related costs (capital), flying, technical and other skilled staff and general
overheads.
b. The short-term: once the airline has committed to operate the flight, all the medium-term costs are fixed,
as well as airport charges, fuel, ATC and certain flight related variable costs (e.g., wear and tear on landing
gear and tyres).
c. The very short-term: once the airline has committed to carry passengers on the flight, additional costs
become fixed, i.e., ticketing materials, in-flight food, agent commissions and fuel required to lift extra payload.
The additional costs in point b are often described as variable costs, while the additional costs in point c
marginal or incremental costs. As long as the flight is not full, traffic and revenues can be increased at very
little extra cost, but once additional flights need to be scheduled, costs start to escalate. Conversely, when
there is an unexpected reduction in demand, induced by an economic recession or an event such as the Gulf
War, airlines find it difficult to shed costs: aircraft cannot be sold, and staff contracts are difficult or expensive
to break.
Many airlines have recently been trying to reduce this fixed cost burden by outsourcing and hiring part-
time staff to meet traffic peaks. This allows them to return some aircraft to lessees, and adapt staff to levels of
demand. There may be a trade-off in paying more for contracted out services during periods of traffic growth
(and lower profits) against lower costs and reduced losses or higher profits in periods of recession.
World airline financial results reflect the difference between the break-even and actual load factors. The
former can be described as the ratio of unit costs to unit revenues (yields). This ratio remained surprisingly
constant at around 58 per cent over the whole of the 1980s, dipping only in 1987 to just under 57 per cent as
a result of reduced fuel costs. In the 1990s, both yields and costs declined, but the faster reduction in the
latter at least until 1998 resulted in a gradual fall in breakeven load factor to just above 56 per cent in 1998.
The continued decline in yields in the face of increased fuel costs pushed up the breakeven point above 60 per
cent in the first half of the 2000s. The cause of declining yields was both increased competition and
overcapacity that in less regulated industries might be removed by consolidation or market exit.
Overcapacity can be alleviated by grounding uneconomic aircraft. Some of these are subsequently
brought back into service, but others are eventually broken up for spares or scrapped. The number of parked
aircraft doubled to around 1,000 in the year following the Gulf War, as traffic declined and deliveries
accelerated. This figure included a certain number that are parked even in good years on a short-term basis,
either between operators or for major re-fits. It also included some brand new aircraft that went into storage
direct from the factory. There were still 730 aircraft parked at the end of 1995, but, of those, 45 were Stage I
and 230 Stage 2 aircraft, neither of which were likely to enter service because of the cost involved in hush-
kiting them to meet current, more stringent, noise requirements. A similar pattern emerged after 9/11 with
668 aircraft, or 6 per cent of the total IATA member airline fleet parked by 2005, down from 2002]4 The
average age of parked aircraft in 2005 was 23.6 years suggesting that many of these aircraft (such as B727s
and early B737s) will never return to airline service.
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1.4 Asset Utilization –
The airline industry appears to be a relatively labour intensive one in terms of the share of labour costs in
total operating costs. These are between 25-35 per cent for the major scheduled airlines in North America and
Europe, while capital costs, including depreciation, rentals and interest charges, amount to just over 15 per
cent. This is not surprising, since it is a service industry that requires a substantial number of customer contact
staff, particularly on the passenger side of the business.
However, the industry could also be described, at the same time, as capital intensive. Anew Boeing 747-
400 aircraft cost around US$200 million in 2005, and an increasing quantity of capital is required in the form of
computers, component test equipment, ground handling automation and in other areas.
ICAO reported net fixed assets (after depreciation) ofUS$262 billion in 2004 for the world's scheduled
airlines, compared to around $60 billion in 1985. One dollar of fixed assets produced 2.2 revenue tonne-kms
(RTKs) in 1985, but this had fallen to 1.75 RTKs by 2002, increasing somewhat to 1.88 RTK by 2004.
Based on an estimated 1.3 million staff employed by the world's airlines, the average net assets per employee
was US$183,000 in 2002 (see Table 1.1). This had increased from about $50,000 per employee in 1986, or by over
8 per cent a year, compared to the US consumer price index increase of 3 per cent a year. Between 1999 and 2002,
net assets per employee advanced by 4 per cent a year versus the general price index rise of 2.6 per cent a year.
Inclusion of operating leased aircraft (at 7.5 times annual rental expenses) would increase the rate of growth
between 1995 and 1999 and reduce it slightly between 1999 and 2002. On this basis it is clear that the industry is
becoming more capital intensive although increasing less rapidly than in the early 2000s. This is caused by a
combination of reduced staff numbers, increasingly expensive aircraft, and investment in new technology. It is also
due to the outsourcing of the more labour intensive airline activities, for example ground handling and catering.
Investment and outsourcing together led to strong growth in labour productivity of 4.8 per cent a year between
1985 and 2002, but only 2.7 per cent a year from 1999 to 2002. On the other hand, fuel efficiency gains
accelerated over the latter period, as the late 1990s aircraft orders were introduced into the fleets.
The average size of aircraft operated has been largely unchanged from 1985 to 2002, both for international
services (36 tonnes) and domestic and international services combined (26 tonnes). However, the aircraft have
been operated over longer sectors such that aircraft productivity in terms of ATKs per aircraft has increased in line
with average sector length.
The average price of aircraft has increased at an average of 8 per cent a year between 1970 and 1995, based
on the 1970 price of a B737-200 ofUS$4 million, and the 1995 price of the equivalent B737-500 of$28 million. This
was faster than the rate of inflation of consumer prices in industrial countries, and has provided the stimulus for
airlines to increase the utilisation of their aircraft. However, the price of a new B737-500 only increased marginally
to $30 million by 2000, reflecting increased competition from Airbus and the slower increases in the consumer and
producer price indices. Heavier discounting of new prices were evident in the period immediately after 9/11, with
prices only starting to pick up again in 2003/2004.
Average aircraft utilisation for the world's airlines increased from just over 2,000 block hours per aircraft in
1985 to 3,000 hours in 2002, or by 1.9 per cent a year. However, a small dip occurred in the early 2000s, as a
response to the unexpected downturn in traffic and a situation of overcapacity.
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1.5 Key Financial Issues
As the industry approaches another downturn, it will be interesting to see if the same issues are as
relevant as previously. Certainly, many more airlines are now privately owned and thus might not be expected to
receive the amount of state aid that they were given in the early to mid-1990s. Two national flag carriers went out
of business in the early 1990s in Europe, and a number of major US airlines have been in intensive care. On the
other hand, two previously privatised flag carriers in Federation of Malaysia and New Zealand were re-
nationalised, and government support has continued to MO or three more medium sized EU carriers.
Thus, exit does not seem quite as free yet as other industries, and the track record of existing airlines and
other hurdles do not seem to deter new entrants unduly, at least for charter and LCC types of operation. Some
rationalisation has taken place among network carriers through the bankruptcies mentioned above and the
mergers of America West and US Airways, Air France and KLM and Lufthansa and Swiss. Bankruptcies and cross-
border investments have also occurred in Central and South America. In other world regions, however, the
national carrier is still the norm, more than likely to be still majority owned by its government.
More recently, airlines have devoted much management time to the formation of alliances, some
tactical, but many of a more strategic nature which require the blessing of the regulatory authorities. This is
argnably the easiest way for an airline to expand in scope and achieve the critical mass to compete against larger
airlines and airline groups. Other ways, such as merger and acquisition can run into regulatory obstacles more
quickly. Minority stakes or airline cross-investments were often used to re-affirm alliance commitments, but these
have not always worked very well (e.g., KLM/Northwest and British Airways/US Air). However, the maximum stake
permitted by foreign airlines has been creeping up from 25 per cent in many countries to 49 per cent in some. This
may be expected to be further relaxed, and thus valuation techniques for airlines, as well as slots and route rights,
should increase in importance
1.6 Airline Financial Ratio –
The previous chapter explained in some detail the individual items in an airline's profit and loss account,
balance sheet and cash flow statement. Some idea can be gained of the airline's size, capital structure, profitability
and the financing of its investments from an examination of these figures and the notes attached to them.
However, performance ratios will need to be calculated to be able to assess past trends of a particular airline
or to compare different airlines. These could be helpful in evaluating a shareholder's investment in an airline, of in
an assessment by banks or lessors before entering into a loan or lease agreement. The ratios can be categorized
under the following headings:
 Performance/earnings.
 Risk or solvency.
 Liquidity.
 Market valuation or investment.
The first group of ratios are designed to evaluate how the airline is trading, whether in relation to turnover,
assets or equity, while the second deal with the risk of the firm being unable to meet its financial commitments
overall, and continue trading. The third provides a measure of the airline's ability to meet its shorten financial
commitments. The last group are concerned with value, and are based on the market price of the airline's shares
or bonds and can thus only be calculated for companies that are traded on a stock market.
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Some ratios use only profit and loss account data, some use only balance sheet data, and some combine data
from each of these statements. The latter need to take into account the fact that balance sheet items are
measured on a particular date, whereas profit and loss account items are summoned over a particular period
(usually one year). The balance sheet items may need therefore to be averaged over the same period.
The next part of this chapter explains how the more important and widely used ratios are calculated with
reference to British Airways' last two financial years. In some cases it was impossible to compute comparable
ratios for the previous year, as a result of the change in accounting rules in 2005. This affected equity in particular.
The ratios for 200512006 were also compared with those for AMR using 2005 data. Ratios for a selection of major
international airlines are then compared, before concluding with some of the principal problems with
interpretation and comparison.
1.7 Performance Earnings Ratio –
Operating Ratio
The operating ratio is defined as operating revenue expressed as a percentage of operating expenditure; operating
margin is an alternative expression that is similar to margin on sales.
Net Profit Margin
The net profit margin is after tax profit expressed as a percentage of operating revenue or turnover.
Return on Invested Capital (Capital Employed)
Return on invested capital (R0lC) is the pre-tax profit before interest paid as a percentage of average total long-
term capital employed. For some airline accounts, the figure for interest paid or payable is not given. Here the
ratio could be calculated before net interest. Some airlines define this ratio as operating profit as a percentage of
capital, but it is more logical to include any income from asset sales and investments to show the profit available to
provide a return for the two classes of long-term capital providers, debt holders and shareholders.
Return on Equity
Return on equity is the net profit after interest and tax expressed as a percentage of shareholder's funds. The
numerator is before deducting minority interests and the denominator includes the capital belonging to these
interests. This percentage gives an idea of how successful the airline's management is in using the capital
entrusted to it by the owners of the company, or equity shareholders. It is sensitive to method of financing. Similar
comments apply as for the return on capital employed, in terms of marked year to year fluctuations.
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1.8 Risk and Solvency Ratio, Liquidity Ratio –
Interest Cover
Interest cover is the profit before net interest payable and tax divided by net interest expenses.
Some investment banks use the above formula using only interest payable. However, it is not always possible to
calculate this, since many airlines show only net interest, -without any breakdown between income and expense.
British Airways Group - Interest cover
2004/2005 2005/2006
Profit before tax and net interest ( £ million) (A) 681 748
Net interest payable (£ million) (B) 168 128
Interest cover (A) 0- (B) 4.1 5.8
This is the formulation used by BA, defining it as the number of times that the profit/ (loss) before tax
and excluding net interest payable covers net interest payable. This ratio is one of the more important ones,
showing the ability of the airline to meet the interest payments on its debt. Without a clear margin of cover (well
over 1.00), there will be little profit remaining for distribution to shareholders or ploughing back into the company.
Banks and investors generally look for interest cover of at least 2.5:1, while an lATA industry capital needs study
suggested that it should be not less than 1.5. The UK airports group, BAA, sets in internal target of 3.5 for its long-
term plans, and BA more than achieved a substantial margin above this target in both years.
Some investment banks use the above formula using only interest payable. However, it is not always
possible to calculate this, since many airlines show only net interest, -without any breakdown between income and
expense. . An alternative used by SAS is operating profit plus interest income divided by interest payable. For BA's
FY2005/2006, this would mean a slightly lower cover of 3.6. AMR had negative profit before tax and net interest in
2005, and thus had no cover for its net interest payable of $808 million. Interpretation of such trends as well as
comparisons with other airlines needs to take into account key variables such as depreciation and leasing policies.
BA believes that the formulation shown in the table above is useful to investors when analysing their
'ability to meet its interest commitments from current earnings' (BA's Form 20K submission to the SEC for
2005/2006). Finally, another way of approaching interest cover is to take the cash flow from operating activities
before interest paid from the cash flow statement and relate that to interest paid. That would give a 7.3 times
cover for BA in 2005/2006. For AMR it would have been 2.1 times covered for FY2005.
Liquidity Ratios
Current Ratio
A ratio of 1.00 is normally considered for industry in general to be broadly sound. Any ratio falling
substantially below this level indicates that the business may not be generating adequate cash to meet short term
obligations as they become due. Airlines' current liabilities often include significant amounts relating to sales in
advance of carriage (in BA's case £1,045 million at the end of March 2006). These might be excluded when
calculating the current ratio, since they are mostly nonrefundable claims on the airline. Such an adjustment was
not necessary for BA's ratio at end March 2006, but it was more appropriate to AMR. This US airline's current
assets totalled $6,164 million at the end of December 2005 compared with current liabilities of $8,320 million. This
gave them a current ratio of 0.74, well below industry norms. However, they had $3,615 million of air traffic
liability in current assets: these included some refundable tickets, but many that were not in addition to a sizeable
FFP liability that is not reimbursable. Excluding this from current liabilities leads to an adjust figure of $4,705
million and an adjusted current ratio of 1.31.
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1.9 Stock Market Ratios –
Performance
Dividend cover Net profit attributable to shareholders divided by dividend payable.
2000/2001 2005/2006
Profit for the year (£ million) 67 467
Dividend payable (£ million) 193 0
Dividend cover 0.35 n/a
There are no rules as to how high the level of dividend cover should be. Some investors, such as pension
fund managers, require an adequate and continuing income stream, but others perhaps driven by rates of taxation
look for capital gains. In a capital intensive industry, or one that requires the frequent application of new
technology, it is prudent to keep the dividend cover high. In general, cover should exceed 1.00 by an adequate
margin, and an earlier IATA study adopted a target of 2.00.
BA chose to maintain its dividend per share (l7.9p) in 1999/2000 in the face of a net loss for the year,
following profitable trading throughout the 1990s, including in the aftermath of the Gulf War recession. A dividend
was also paid in the following year, despite very low cover.
1.10 Inter – Airline comparison of financial ratio
So far in this chapter, examples of ratios have been given for only 2 years of data for British Airways to
assist in an understanding of how they can be calculated m practice. Some comparative figures have also been
shown for one or two. other major international airlines, in particular AMR. In this section, the comparison will be
broadened to include some of the major airlines from North America, Europe and Asia.
The comparisons are shown in Table 3.16 for the 2004 calendar year for the majority of airlines April
2004 to March 2005 for some airlines, and years ending in September (Thai) and June 1999 (Qantas) for two
airlines. Given the Variations in the ratios over the economic cycle, a stricter comparison would have adjusted the
figures to the calendar year. Most of the major airlines were profitable, having recovered from 9111 (for the US,
and to a lesser extent, European airlines) and SARS (for some of the Asian airlines). Ratios were not calculated for
some airlines because of negative results or negative equity, either of which. Produces meaningless. Figures. There
are numerous problems associated with comparisons such as these, which have been discussed earlier. They are
also summarized below. In spite of these problems, it is considered worthwhile presenting a view of the financial
position of the major world airlines after some recovery had occurred.
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Unit – 2
Airline Valuations
and
Source of Finance
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2.1 The valuation of tangible and intangible assets- The valuation of the airline as a whole
Airline accounts are not expected to show how much the airline is worth or even the value of its fixed
assets. Fixed assets are generally included at their original historical cost, less an allowance for depreciation. It is
unlikely that this book value of tangible assets at a given date would coincide with the market or re-sale value of
the same assets. The last part of the previous chapter highlighted these differences in terms of the stock market
value of an airline and its relationship to the book value of its assets.
This chapter will expand on this, and introduce the further issue of the absence of sizeable intangible
assets such as route rights and slots in most airline accounts. It will first examine how these might be valued for
international airlines, and then go on to review various approaches to valuing all or part of such airlines. This
problem is faced by advisers to governments on the privatization of their national airlines,
2.2 Rating agencies – Sources of Internal and External Finance – institutions involved in airline finance
Rating Agency
The two main agencies that publish ratings for quoted debt securities, including those issued by airlines,
are Standard & Poor's and Moody. A third is called Fitch. They rate all the obligations of all industries, but will have
a key role in commercial bank regulation from 2007. They have been criticised for not predicting collapses such as
Enron and Parmalat, but their defenders argue that in these cases they are supplied with fraudulent data. It is also
argued that competition is restricted by entry requirements, but this is being addressed in the US by Congress and
the Securities Exchange Commission (SEC).
These firms earn their revenues from companies, including airlines, which wish to issue securities (bonds,
commercial paper or preferred stock). as well as from selling reports to investors. For example, both Standard &
Poor and Moody received US$30,000 for rating a $100 million unsecured placement of Southwest Airlines'
securities.28
The agencies' analysis aims to evaluate the likelihood of the timely repayment of principal and interest
relating to debt securities, or dividends for preferred stock. The analysis covers both the airline industry in general,
and the particular circumstances and prospects for the airline concerned. The latter will examine operational and
management quality, success in controlling costs, revenue and yield management, cash flow and capitalisation and
other financial issues. The two major agencies together have over 100 analysts making detailed analyses of
company financial statements, making any necessary adjustments for variations in accounting practice.
Sources of Finance
Airline finance has in the past generally been readily available to the majority of airlines, in spite of a
worse record of profitability than many other industries, and the cyclical nature of airline earnings. This was
because of government involvement, either directly through ownership of the national airline or through loan
guarantees.
However, even privately owned airlines have found little difficulty in financing aircraft (historically 80-90
per cent of total capital expenditure), due to the possibility of re-possession and re-sale of the asset.
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The origin of finance for the airlines, as for any other industry, has been individual and corporate savings.
Money from individuals would be channelled through banks as well as pension funds, insurance companies,
mutual funds, investment and unit trusts. These institutions would in turn lend to banks, which would act as
intermediaries in lending on to airlines, buy airline shares or bonds, or participate in leasing arrangements.
Corporations would place surplus funds with banks or participate directly in aircraft leases. Leases might also
atiract wealthy individuals paying high marginal rates of tax.
In the 1980s, Japanese financial institutions supplied around half of the US$20 billion per atmum in loans
to the air transport industry.' This share has declined significantly in the 1990s, principally because of the gradual
application to Japanese banks of the 8 per cent capital adequacy level agreed through the Bank for International
Settlements (BIS).
Airline capital expenditure can be financed internally from cash or retained earnings or externally from
lenders or lessors using a variety of financial instruments. It is difficult to obtain comprehensive data on the
sources of finance for aircraft deliveries. Acknowledging the dangers of taking only one year's data, jet aircraft
deliveries totalled 911 in 2004, of which 457 were narrow-bodies, 135 wide-bodies and 319 regional jets. Taking
average aircraft prices in 2004 US$ for each category of aircraft gives a total delivered value ofUS$58 billion. ICAO
reported that airline operating profits before depreciation and after interest/tax payments (approximate cash
flow) was $16 billion in the same year. They would thus have financed only 28 per cent of deliveries from cash flow
leaving a further $42 billion to be financed by banks and leasing companies. Export credit supported bank lending
totalled around $15 billion (including some operating lessors), operating lessors $10 billion leaving more than $17
billion for unsupported lending, new equity and finance leasing.
It is possible to get a rough idea from the financial statements of the world's scheduled airlines
(published by ICAO) of how the stock of airlines assets are financed. In the table below operating lease rentals have
been multiplied by seven to give an approximate capital value:
Financial Year 2004 (US $ Billion) % Total

Operating lease capitalized 194.5 42.3
Finance lease 36.0 7.8
Long-term debt 159.6 34.7
Capital stock and surplus 69.6 15.2
Total 459.7 100.0
The figures above show the high share of operating leases, although perhaps the amount reported to
lCAO includes some finance leases. Finance leases may also be underestimated by being included by some airlines
under long-term debt.
Sources of Internal Finance
Internally, generated funds come from the cash retained in the business, or net profits (after paying interest,
tax, and dividends) but before providing for depreciation. Deferred taxes and the profits from the sale of assets will
also be internal sources of finance. For many airlines, depreciation is the largest single internal source; some
airlines, such as Singapore Airlines, have also in the past generated substantial cash from aircraft sales. The
identification of the cash available for investment from an airline's financial statements. The amount of retained
earnings available for capital investment will depend on:
 The airline's dividend policy.

 The government's taxation policy.
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The proportion of capital expenditure financed from internal sources is often called the se/f1inancing ratio.
The ratio is subject to very wide swings from a low at the low point in the airline economic cycle, when aircraft
deliveries and investment is high and cash flow low, to a high when cash flow is improved and investment lower.
Taxation for the world's scheduled airlines averaged at just under US$3.5 billion over the six profitable years to
2000, or 35 per cent of pre-tax profits. Few major airlines pay dividends, given the need to find finance for capital
expenditure. No major US airline pays a dividend apart from the more profitable all-cargo carriers such as FedEx.
British Airways has traditionally Paid a dividend, but did not pay one from 200112002 to 200512006.
External Finance
Short-Term
Bank Overdraft Most airlines will have a facility with one or more commercial banks to run a deficit on their
current account up to an agreed limit, which will be based on the overall financial health of the company. This may
be secured against certain assets. The rate of interest charged will vary with market rates.
Short-Term Loans- These will differ from overdrafts by being for fixed amounts to be re-paid at a fixed future date.
A fixed or variable interest rate will be charged, and security or other conditions may be stipulated (such as a
maximum debt/equity ratio).
Trade Creditors Goods and services purchased by airlines do not generally have to be paid for upon delivery in
cash, such that some short-term finance will be available. This will either be free credit, or there will be an implicit
cost in terms of cash discount foregone. This should be offset against trade debtors, where the airline is providing
short-term finance to others.
Long-Term
Shareholders equity capital Finance from owners of the airline. These owners or shareholders have the right
to vote at meetings of the company, the right to a dividend (if one is paid), and the right to a capital distribution on
liquidation (if sufficient cash is available after settling all other claims). Outside the USA and many European
countries, many of the world's scheduled airlines are still more than 50 per cent owned by their governments.
Other categories of shareholder might be:
 Other airlines.
 Financial institutions.
 Employees.
 Other individuals.
Lufthansa's shareholding in 2005 was 30 per cent held by private and 70 per cent institutional investors.
Employees or other individuals do not generally hold shares unless they can be traded either on a stock market, or
through a special company arrangement. United Airlines in the US used to be 55 per cent owned by three labour
unions that held shares on behalf of their members.
A large shareholder may wish to sell their holding by offering it to another company or the public (e.g., the UK
Government privatisation of British Airways). Care must be taken to comply with company law, which grants all
owners of the same class of shares certain rights, relating both to profit distribution and share acquisition. Certain
protection may also be given to minority shareholders.
Financing assets by raising additional equity has the advantage of improving the relationship between equity
and both output and existing debt, and permits further borrowing. It may, however, dilute the control of existing
owners and facilitate a take-over by another company. Thus, share issues are not often used by private companies
to fund equipment purchases.
Page 15 of 45
Institutions Involved in Airline Finance
Banks
Banks acts as intermediaries between savers and users of funds. Bank loans to the airline Industry might
be from money deposited with them or their own capital. They would appear on their balance sheet and be
subject to lending limits and liquidity ratios. Banks will have Limit’s up to which they can lend to a particular
company, a particular country, or a particular industry. They might also underwrite debt or equity issues, but this
would be off balance sheet. Some observers see banks focusing more on off-balance sheet activities in the future,
such as underwriting and fee earning services. This has traditionally been the preserve of the smaller merchant
banks, which did not have a large balance sheet.
Many of the larger international banks have traditionally been involved in aerospace and aircraft
financing, and have often had specialist departments dealing with this industry. Up to 1990, the big US banks, such
as Citibank and Chase Manhattan Bank headed the table of top loan providers for aircraft transactions. By 1990,
however, these two names had disappeared from the top 20, and were largely replaced by Japanese banks, such
as Fuji Bank, Sumitomo Bank and the Mitsubishi Trust and Banking Corporation. More recently, the position has
been reversed, with the Japanese Banks being replaced by the large US and European banks, and some new
entrants from the UK, such as the Halifax and Abbey National (both formerly building societies).
An indication of the banks most involved in aircraft financing can be obtained from those doing export
credit deals. In 2004, BNP Paribas and Barclays were offering low cost export credit backed finance to airlines such
as Ryanair at rates close to LlBOR, and happy to bid for a large number of deals. Then came banks like Calyon (The
Credit Agricole Group that incorporated Credit Lyonnais), Citigroup, Natexis Banque Populaire and Rabobank that
would be more selective, preferring deals for relationship airlines. Other banks were that had previously' had a
significant presence in aircraft finance, such as Deutsche Bank, Bank of Scotland and WestLB, were less active in
the market.
Airlines invite banks to compete for the mandate which would give the winner the authorisation to be
the lead bank in any subsequent financing. For larger airlines, there may be 15-20 banks competing for the lead
mandate, with a further 100 or so banks happy to accept the smaller level of risk implicit in a secondary role in
syndicate financing.
Export Credit Agencies
Most of the major exporting countries will have export credit agencies (ECAs) which are either a part of
government or a, government supported organization. Their purpose is to encourage exports of goods from their
countries, generally by guarantees or insurance rather than direct loans. Thus, they are there to provide support or
complement bank lending, especially in cases where banks would be reluctant to assume 100 per cent of the risk.
This could be where the country is high risk or low credit standing, or the purchaser of the goods is high risk, or a
combination of the two.
The export credit volume varies significantly from year to year, with just under US$10 billion of deals reported
in 2004,' compared to $16.5 billion in 1999. For 2000, 35 per cent of backing went to airlines in Asia, followed by
27 per cent in Latin America, 17 per cent Europe, 15 per cent Middle East and Africa, and 6 per cent in North
America. The following are the Export Credit Agencies in the countries which have some aircraft or aircraft
component manufacturing capability, and could therefore be involved in aircraft financing:
Page 16 of 45
 Ex-Im Bank (USA).

 Export Credit Guarantee Department (UK).
 COFACE (France).
 Euler Hennes (Gennany).
 NEXI (Japan).
 Export Development Corporation - EDC (Canada).
 ESACE (Italy).
The above institutions generally provide only guarantees, although the Exim Bank and ECGD have also lent
money directly, with the actual finance being provided by banks nnder syndicated loans. This is a way of spreading
the risk between a number of commercial banks, with a lead bank inviting others to participate jointly in the
financing.
Under a gentleman:S agreement, the US Eximbank does not support exports of US aircraft to airlines based in
UK, France, Gennany and Spain, and the European ECAs does not assist Airbus aircraft exports to US airlines.
Where an export of an aircraft from one country incorporates a substantial share of airframe or components
from another conntry, then two or more ECAs would be involved. This would be essential for Airbus aircraft, with
financing support generally proportionate to each ECA's national manufacturer's share in the production of the
aircraft (e.g., for anA320 with IAE engines: UK 32 per cent France 32 per cent and Gennany 36 per cent; or anA321
with CFM engines 17 per cent, 52 per cent and 31 per cent respectively). Another example would be the
involvement of both Eximbank and the ECGD in the financing of a Boeing 757 with Rolls-Royce engines. Eximbank
(USA) Ex-ImBank provides official support for aircraft finance through long-term guarantees for up to 85 per cent
of the US cost of aircraft exported. It also offers loans and subsidies, but this is a small part of its overall business. It
complies with the LASU guidelines. Ex-1m Bank provided little support for aircraft exports in the 1980s, since
finance was relatively easy to obtain from US and Japanese banks. When many Japanese sources dried up in the
early 1990s, however, the bank expanded its aircraft lending and support. For example, the agency only provided
two aircraft loan guarantees in 1988 compared to 67 during 1992/1993.
The agency has recently been restructured and a dedicated aviation department established, as opposed to
supporting all sectors through geographic regional divisions. This was necessary because of the increasingly
complex asset-based financing, which now comprise around two-thirds of total bank transactions.
Operating Lessors
The operating lease business has until recently been dominated by two firms: International Lease
Finance Corporation (ILFC) and General Electric Capital Asset Services (GECAS), which effectively took over the
failing GPA in the mid-1990s. At the end of 1994, these two firms owned 62 per cent of the 1,820 commercial jet
aircraft leased by 40 companies. By 2005, this had fallen to 42 per cent of the jet fleet numbers owned by the top
50 lessors. The two companies accounted for a larger share of total jet fleet value, 52 per cent in 2005.
ILFC started in 1973 (at the height of the early 1970s energy crisis) with the lease of a DC8 to Aero
Mexico. It subsequently expanded to reach turnover ofUS$30 million and pre-tax income of $5.5 million in 1980.
By 1985, turnover was $58 million and profits $20 million, but the fastest period of growth was the second half of
the 1980s, with 1990 revenues approaching $500 million and profits $124 million. The number of aircraft owned
by ILFC grew to 106 in 1990, and at the end of 2005 was 911 (see Table 5.3). ILFC's turnover in 1994 was $1.11
billion, and $2.5 billion in 2000 (93 per cent of which came from the rental of flight equipment). AI Times in Europe
provided the largest part of ILFC's business with 45.8 per cent of the total rentals, followed by Asia Pacific with
20.1 per cent and the US and Canada with 19.1 per cent. It is the only lessor of the B747-400, and the only
operating lessor to order theA380 (up to mid-200l).
Page 17 of 45
ILFC was originally owned by the founders, and operated until 1990 with a staff of only 28. This gave it
one of the highest ratios of turnover to employee of any US company. In 1990, they were acquired by the large US
insurance company, AIG, for $1.3 billion with the increasing need for access to cheap debt finance that its new
parent could provide.
GPA was founded in 1976, principally as an aircraft management services company. Initially, GPA was
involved with wet leasing aircraft and some operating leases of used aircraft. It was not until 1984 that they made
their first order for new aircraft. They then switched emphasis from aircraft trading and acquiring aircraft for
known customers to ordering aircraft purely on the basis of expected industry growth. This culnlinated in a 1989
order at for 300 aircraft worth $17 billion (some of which were options). Deliveries of these aircraft took place
after the Gulf War and subsequent world-wide economic recession (and in mid-1991 they still had 376 frnn orders
outstanding). At the end ofl991, GPAhad 392 aircraft in its fleet, which were leased to 100 airlines in 47 countries.
The group's armual revenues grew from $360 million in 1986/1987 to more than $2 billion in 1991/1992, when
they recorded a net profit of$268 million. However, the financial strain imposed by falling lease rates and the lack
of customers for some aircraft (22 aircraft were in storage in 1992) led to the collapse ofGPAin 1993. This was
afterrepeated attempts to raise new equity finance. Commenting on the Group's downfall, the Financial Times
stated that 'rarely can so much have been borrowed by so few, on the basis of so insubstantial a balance sheet'.
The company that came to GPA's rescue in 1993 was the aircraft leasing arm of General Electric of the US,
or GE Capital Aviation Services (GECAS). GE had acquired 22.7 per cent ofGPA in 1983, and having tried to buy
control, sold almost all its stake in 1986 for a profit of almost $40 million. IS When GPA's $1 billion stock offering
failed in 1992, GE purchased an 85 per cent interest in 45 of GPA's stage 3 aircraft for $1.35 billion. Once the
collapse came in 1993, it was the obvious rescuer. Under the rescue agreement, GECAS was established to manage
the GPA's aircraft under a IS-year contract for a fee paid by GPA. GPA remained as a separate company, retaining
ownership of just over 400 aircraft at the end of 1993 (many of these have since been removed from their balance
sheet through securitization or sale). GE had an option to acquire 67 per cent of GPA for between $11 0 million and
$165 million, which was eventually exercised. GECAS is part of the equipment management division of GE Capital
Services; the division as a whole generated
$14.7 billion in revenues in 2000.
The next largest operating lessor in terms of owned aircraft value after GECAS and ILFC, was Aviation
Capital Group, owned by a major US life insurance company (Pacific Life), and followed by Boeing Capital. AWAS,
which was number three in the mid-1990s, was originally owned by the Ansett/Murdoch group, but they were
eventually sold to Morgan Stanley, and in 200 I were again up for sale. Many of the remaining frnns have Japanese
shareholders, such as Orix which acquired a portfolio solely of A320 aircraft, but has recently added Boeing 737s to
their fleet.
The average number of aircraft placed with each airline is between 3 and 4 for most of the larger lessors.
This strikes a happy medium between putting all their eggs in one basket, and avoiding the higher operating costs
which come from dealing with too many different airlines. Aircrafts manufacturers with largish leasing subsidiaries
were Boeing Capital (349 aircraft), Airbus Asset Management (56 aircraft) and BAE Systems (267 aircraft, but
mostly small jets or turbo-props). Neither of the two major manufacturers market their leasing arms very
proactively, since this would compete with their major lessor customers. Many of the lessors are owned by banks:
In 2001, Westdeutsche-Landesbank made an offer for Boullioun Aviation (later sold to Aviation Capital), while
Morgan Stanley bought Ansell Aviation.
Page 18 of 45
Governmental Financing Organisations
International Bank for Reconstruction and Development (IBRD) The IBRD or World Bank has financed
both airport and airline projects in the past. More recent Funding as gone towards privatization studies, but it has
also sponsored a study into the feasibility of estalbishing a multinational airline in Southern Africa (through the
Southern Africa Development Coordination Council), as well as a study of the West African airline, TAGB Air Bissau.
Cumulative lending to the air transport sector up to the end of June 1993 amounted to US$299 million out of total
transport sector lending of $33,604 million and total lending of $235.2 billion. Thus, although transport accounted
for 14.3 per cent of total ending, mostly on roads, air transport was under 1 per cent of transport lending.
International Civil Aviation Organization (lCAO) ICAO plays a major role in air transport training
programmes and technical assistance, but does not have the funding capability to lend or give grants for capital
investment. In fact, its programmes are largely financed from the United Nations Development Programme (UNDP)
resources. Furthermore, lCAO tends to support projects for aviation authorities or airports, rather than airlines.
Airline training and some technical assistance is provided through the airlines' own trade association, the
International Air Transport Association (lATA).
Other development banks Development banks such as the, the Asian Development Bank and the African
Development Bank have usually only financed airport projects. They have, however, sometimes funded airline
studies or transport sector studies that have included airlines." One exception to this, however, is the Caribbean
Development Bank, which is a shareholder in the regional airline, LIAT, and has played a major role in that airline's
finances.
2.3 Term loan payment, book profit and manufacturer‘s prepayment
What Is a Term Loan?
A term loan is a loan from a bank for a specific amount that has a specified repayment schedule and
either a fixed or floating interest rate. A term loan is often appropriate for an established small business with
sound financial statements. Also, a term loan may require a substantial down payment to reduce the payment
amounts and the total cost of the loan.
Types of Term Loans
Term loans come in several varieties, usually reflecting the lifespan of the loan.
 A short-term loan, usually offered to firms that don't qualify for a line of credit, generally runs less than a
year, though it can also refer to a loan of up to 18 months or so.
 An intermediate-term loan generally runs more than one—but less than three—years and is paid in
monthly installments from a company’s cash flow.
 A long-term loan runs for three to 25 years, uses company assets as collateral, and requires monthly or
quarterly payments from profits or cash flow. The loan limits other financial commitments the company
may take on, including other debts, dividends, or principals' salaries and can require an amount of
profit set aside for loan repayment.
Page 19 of 45
Calculation of Term Loan Repayment Amount
The repayment amount can be calculated from the following formula:
1-(1+i)-n
0=PV + (1+i.s) (PMT)
i
Where:
PV = Present value of the loan

i = Periodic interest rate (decimal form)
N = Number of compounding periods
S = Payment factors (0 for arrears/I for advance)
PMT= Periodic payment
If an airline borrows US$I 0 million at 10 per cent interest and is required to repay the loan over 10 years, with
repayments annually in arrears:
i.e.,
PV = $10,000,000
i = 0.1
n = 10
S = 0
From above formula, the periodic payment would be US$ I,627,454 annually in arrears throughout the loan term.
A lower payment of US$ I,479,400 would be required if paid in advance (i.e., with s ~ I).
The airline will also pay for the preparation of the loan documents, and the bank commitment fees. There may be
other conditions such as debt/equity ceilings or minimum net working capital levels. A common practice is to
amortise the loan by making periodic payments to reduce the loan balance:
Loan amount = US$ IO million
Interest rate = 10 per cent a year
Loan term = 10 years
Repayment = US$ I,627,454 annually in arrears
Page 20 of 45
Book Profit
Book profits refer to the profit earned by the business entity from its operations and activities and is
calculated by deducting all the business expenses incurred within a financial year from all the sales revenue and
other income generated from the selling of goods & services within that same financial year.
We can define Book profit as the leftover money after the entity pays off all its expenses and as shown in
the statement of profit and loss. In other words, it refers to money earned by an entity during a financial year by
selling products and services deducted by all the expenses incurred during the same financial year.
Book Profit = Revenues – Expenses
Calculating Book Profit
The airline borrows US$1O million to acquire an aircraft which is then depreciated over 15 years to 10 per
cent residual value. After five years the airline decides to sell the aircraft for its market value of US$8 million. What
is the book profit realised, and what is the cash flow after repayment of the outstanding loan balance?
Annual Depreciation = ($10,000,000 -$1,000,000)/ 15 - $600,000
Depreciated value at year end:
Year Value ($000)

1 9400
2 8800
3 8200
4 7600
5 7000
Book Profit = Sale price less depreciated value

= $8000000 - $ 7000000 = $ 1000000
Cash Flow = Sale Price less loan outstanding

= $ 8000000 - $ 6169370 = $ 1830630
Effect of Prepayments to Manufacturers
What is Prepayment?
A prepayment is any payment that is made before its due date. Prepayments may be made for goods and
services or toward settling a debt. They can be categorized into two groups: Complete Prepayments and Partial
Prepayments.
A complete prepayment involves payment for the full balance of a liability before its official due date,
whereas a partial prepayment involves payment for only a part of a liability’s balance. Understanding
prepayments is important when performing financial analysis.
Page 21 of 45
The airline is required to make the following prepayments totalling 33 per cent of the aircraft price (probably
the upper limit of what the manufacturer requires):
 5 per cent at contract signature, 30 months before aircraft delivery.

 5 per cent at quarterly intervals between 12 and 24 months before delivery.
 3 per cent 9 months before delivery.
What is the effect of these prepayments on aircraft price if the prevailing interest rate is 10 per cent?
The aircraft price quoted is US$1O million, estimated at date of delivery (including manufacturer's
escalation). If the airline had no prepayment obligation, these payments could have been invested at 10 per cent a
year which would have amounted to $3.867 million, rather than the 33 per cent of aircraft price or $3.3 million.
Thus, the effect of the prepayment schedule is to raise the cost of the aircraft by $0.567 million, or by 5.7 per cent.
Page 22 of 45
Unit – 3
Aircraft Leasing
and
Finance
Page 23 of 45
Aircraft Leasing
A lease is a contract whereby the owner of an asset (the lessor) grants to another party (the lessee) the
exclusive right to the use of the asset for an agreed period, in return for the periodic payment of rent. Leases may
be for houses, offices, telephones, cars trucks or computers. In this chapter, the focus will be on aircraft, although
there is no difference in principle with the arrangements for aircraft and any other asset.
Leasing should not be confused with hire purchase, which also features periodic payments from the user
to the owner of the asset. The key difference between the two is that hire purchase agreements are essentially a
deferred payment mechanism for the user eventually to own the asset. This could be over a five-year period for a
fax or photocopy machine. Since the intention is to own the asset after a few years, the tax benefits of ownership
can be used by the asset operator from the outset. It is this ownership feature that distinguishes hire purchase
from leasing.
An aircraft lease is a contract between a lessor and a lessee such that the lessee:
 Selects the aircraft specifications.

 Makes specified payments to the lessor for an obligatory period.
 Is granted exclusive use of the aircraft for that period.
 Does not own the aircraft at any time during the lease term.
The lessor could be a bank or specialist leasing company, or it could be a company set up by high tax-paying
investors seeking capital allowances to offset against their income, thereby reducing their tax payments. The
lessee will normally be an airline.
The airline may of may not have an option to acquire the leased aircraft, or share in the proceeds from the sale of
the aircraft at the end of the lease term. Certain characteristics of a lease follow from these broad definitions:
 The lessor cannot terminate the lease provided the lessee meets the conditions specified.
 The lessor is not responsible for the suitability of the aircraft to the lessee's business.
 The lease may be extended at the end of the obligatory period for a further period.
The advantages of leasing to the airline are:
 Volume discounts for aircraft purchase can be passed on to airline (particularly attractive to smaller
airlines).
 The conservation of an airline's working capital and credit capacity.
 The provision of up to 100 per cent of finance, with no deposits or prepayments (up to 33 per cent of the
cost of the aircraft paid in advance to manufacturers, or I 5 per cent of the cost required by banks to be
paid by the airlines as a condition of loan finance),
 Shifting the obsolescence risk of aircraft to lessor (shorter term leases),
 No aircraft trading experience needed.
 The possibility of excluding lease finance from the balance sheet (see Appendix 22 at the end of Chapter 2
for more on this),
Possible disadvantages could be:
 A higher cost than, say, debt finance for purchase

 The profit from eventual sale of the aircraft going to the lessor (as title holder),
 Higher gearing than, say, purchase with equity finance,
 Aircraft specification not tailor-made for lessee airline (short-term leases),
Page 24 of 45
Leasing is clearly advantageous to manufacturers and lessors, since it increases opportunities for business, the
documentation for leasing is usually simpler than debt or equity financing. The greatest disadvantage is the risk
that insufficient care will be taken of the equipment
3.1 Finance Lease- Meaning, objectives, Different types of leasing, major differences between wet, sale and
operating lease.
Finance Lease
Finance leases accounted for around 30 per cent of newer jet aircraft financing in 1997 for the world, and
around one-half of financing for North American airlines, but has declined significantly since then due to the
withdrawal of Japanese Leveraged Leases and the decline of US tax leases. A finance lease can be for between 10
and 26 years but more likely for a period of at least 10-12 years. It is non-cancellable, or cancellable only with a
major penalty. The lessor expects to gain a nominal profit on the asset from one airline through a combination of
rentals, tax benefits and conservative residual value assumptions, without being involved in, or necessarily having
an understanding of, the lessee's business. The lessee is likely to have a purchase option at the end of the lease
term, at fair market value, for a percentage of the cost, or for a nominal (very low) price.
The nominal risks and benefits of ownership are the responsibility of the lessee, although they are not
the legal owner of the aircraft at any time during the lease period (title mayor may not be eventually transferred to
the lessee). Because the lease period is for the major part of the aircraft's life, finance leases are often called foil
pay-out leases. It follows that the lessee is responsible for repairs, maintenance and insurance of the aircraft, and
that the risk of obsolescence lies with the lessee.
The lessor does not consider the residual value of the aircraft at the end of the lease period important,
and does not need to be technically knowledgeable about the aircraft or airline business.
The lessor may demand that the lessee pay a specified number of rentals on the first day of the lease
payment, with a corresponding rental holiday at the end of the lease term.
Types of Lease
Japanese Leveraged Leases
A leveraged lease is one where the aircraft is acquired using a large amount of debt finance and a small
amount of equity finance. Equity is normally between 20 and 40 per cent of the total value of the aircraft, resulting
in high gearing and thus high risk and potential reward for the equity investors. Equity investors are prepared to
accept this risk, often because they are able to capture significant tax benefits from having title to the asset.
One form of leveraged lease is the Japanese Leveraged Lease (ILL). This involves the establishment of a
special purpose company to acquire the aircraft, with between 20 per cent and 30 per cent of the finance coming
from equity provided by Japanese investors, and the remainder from a bank or group of banks. The equity share
must exceed 20 per cent to satisfy the Japanese tax authorities.2 The aircraft is acquired by an airline, immediately
sold to the special purpose company, and leased back under normal finance lease terms for 10 years (narrow
bodied aircraft) or 12 years (wide bodies). This approach permits the airline to claim tax allowances from the tax
authorities in its own country, and the Japanese investors also to claim full tax allowances on the same asset. This
is known as 'double dipping'. It clearly gives substantial benefits to both lessee and lessor, and results in the airline
having a very attractive cost of finance. The discounted present value of the allowances could amount to between
6-11 per cent of the cost of the aircraft.
Page 25 of 45
US Leveraged Leases
Financial leases at favorable rates have also been available in other countries, such as the US and in
recent years Germany. US based leveraged leases provide the maximum benefits for deals relating to aircraft
based and registered in that country. However, foreign airlines had been able to make use of the US Foreign Sales
Corporation (FSC) provisions, which were designed to foster exports of US manufactured aircraft. Tax exemptions
were available on foreign generated lease income for FSCs, as long as the aircraft has at least a 50 per cent US
content, and at least 50 per cent of the flight miles operated by the aircraft are outside the USA. FSCs were,
however, quite costly in terms of documentation and administration, and only high value aircraft, such as JAL's
B747-400s, and could support these costs. Lease terms ranged between 10 and 20 years, with typical terms for
aircraft leased to non-US airlines of between 12 and 15 years. FSC's were subsequently outlawed, following EU
country claims to the World Trade Organization that they provided unfair subsidies. However, they were soon
replaced by a similar cross-border lease structure, the Extra Territorial Income (ETl).
Before the development of FSCs, US leases required a lessee to be placed between the US lessor and the
non-US lessee. This was necessary to avoid the provisions of the 1984 Pickle Bill (named after its sponsor, a Texas
congressman named Pickle), which disallowed investment tax credits for property leased to non-US taxpayers.
These leases were called 'Pickle leases', but were not economically very attractive.
European Leveraged Leases
The German aircraft lease market increased rapidly over the three years to 1996 to reach more than $1.5
billion. These leases have been similar in structure to JLLs and their growth has been dependent on the high
marginal tax rates that also apply in Japan. An France, Cathay Pacific and Lufthansa were the three leading lessees
in 1995/1996, and a high percentage of leases involved Airbus aircraft (65 per cent).6 Of the other European
aircraft finance lease markets, the next largest was the UK with only around $0.5 million of aircraft financed a year.
Extendible Operating Leases
Finance leases, with walk-away options at various break-points, appear to be more like operating leases
(see below), but the intention of both lessor and lessee is generally to pay off the full cost of the aircraft. An
example of this was British Airways' extendible operating leases on their Boeing 767s, where the airline could walk
away at no cost after 5, 7, 9, 11, and 13-year breakpoints. Manufacturer's guarantees were used to underwrite the
aircraft values at each breakpoint.
Operating Lease
Although the dividing line between finance and operating leases has recently become more blurred, but the
key features of an operating lease are:
 It allows airlines to respond rapidly to changes in market conditions.

 It is of shorter term, usually between one and seven years, or an average of five years, and can be
returned to the lessor at relatively short notice and without major penalty.
 The lessee cannot choose the aircraft specification (except for good customer first user of aircraft).
 An airline gains the use of an aircraft without the obligation to pay off its full cost.
 The lessor expects to profit from either selling or re-Leasing the aircraft.
 The lessee is usually responsible for the maintenance of the aircraft but often has to pay to the lessor a
maintenance reserve.
Page 26 of 45
The aircraft's residual value is important to the lessor, and is a key factor in determining the lease rentals
that can be offered. The cost of re-marketing or placing the aircraft with another lessor also needs to be
considered in rate negotiations, given that aircraft may be placed with at least three different operators over their
lifetime. Operating lease rentals vary quite significantly over the economic cycle, with lessors often accepting a
short-term drop in monthly rentals to avoid re-marketing or even parking aircraft.
Operating leases may have a purchase option for the lessee to buy the aircraft at the end of the lease
term, sometimes at a fair market value and sometimes at a stated price. There will almost definitely be an option
for the lessee to extend the lease for a further two to four period.
Wet Lease
A wet lease is the leasing of an aircraft complete with cockpit and cabin crew, and other technical
support. The lessor is usually responsible for maintenance and hull insurance. This type of lease is generally for a
very short period, say for operations over a number of months or summer season. Haj pilgrimage flights are often
operated on this basis. The aircraft retains the paint scheme and logo of the lessor, although a temporary sticker
can be used to show the lessee's name on the fuselage. A wet lease is often described as an ACMI lease (i.e., an
aircraft, crew, maintenance and insurance lease), although in this case the aircraft is generally considered to be an
integral part of the lessee's fleet.
Quite often the lessor will provide only the aircraft and some of the operational support services. For
example, the lessee may wish to use their own cabin crew because of language requirements. This can be
described as a 'damp lease,' the name given to a lease that falls between a dry lease and a wet lease.
A wet lease has many similarities with the chartering of an aircraft, the key difference being the fact that
the lessee would have the necessary operating licenses and permits, and operate flights with the wet leased
aircraft under its own flight designator. A chartered aircraft would operate under the designator of the owner!
Operator or the aircraft.
Since 1990 a number of wet leasing specialists have established themselves, notably Atlas Air (which
spent six months in Chapter II in 2004 following the post 9/11 downturn) and Gemini in the US and Air Atlanta
Icelandic. These generally operate freighter aircraft and try to negotiate two- to three-year contracts, although two
to 12 months is the norm, possibly because of opposition from regulatory authorities to longer wet lease contracts
with foreign registered aircraft. The longer term contract is likely to include painting the aircraft in the lessee's
livery (e.g., Atlas Air's lease to British Airways World Cargo), and the agreement is based on a price per block hour
operated with a minimum number of hours charged.
Sale and Leaseback
Sales and leaseback occurs when airlines which own aircraft often decide to realize the capital value of
the aircraft, but at the same time continue to operate them. This may be because they have cash flow problems,
but it may also be for the following reasons:
 To meet capital requirements for new aircraft or investments.

 To realize the current value of an aircraft that is likely to be retired in a few years' time, especially when
the market price of the aircraft will probably decline significantly over that period.
The typical duration for such deals is three to five years. The other party involved (the lessor) is likely to be a
bank, which will structure the lease to gain tax benefits. The risk to the bank is relatively low, first because the
term is short and second because the lessee will probably be a good credit risk airline, perhaps one that is already
well known to the bank.
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In 1990, British Airways sold 20 B737-200s at what in retrospect was a very advantageous price ($6-7 million
more per aircraft than the market value six years later) and leased them back. Ten of the same aircraft type were
sold and leased back for six years by Varig, and II by Canadian International for five and a half years.
3.2 Securitization Of Aircraft- meaning, purpose and advantage, airline traffic and financial forecasts
Securitization of Aircraft
Securitisation, which started in the US in the mid-1970s, is the conversion of identifiable and predictable cash
flows into securities. The advantages of this to lenders are:
 Risk is spread over a number of lenders.

 Risk may be spread over a number of world regions.
 Greater size reduces costs of administration.
 The loan or asset is removed from the balance sheet.
For the borrower, the cost of finance would be significantly lower than would otherwise be the case.
Securitisation involves the re-packaging of cash flows or receivables into securities which are then sold to
investors. This is often done in different tranches, each tranche having different rights and risks attached. Higher
credit ratings, and thus lower borrowing costs, can be achieved than would be possible for the separate parties
involved in each lease or mortgage. Ratings are given to each of the securities by agencies such as Standard &
Poor's or Moody, thereby making them more saleable to institutions. The cash flows could be short-term, for
example with the sale of accounts receivables from travel agents, or on credit cards. They could be medium-term,
with the sale of five- to ten-year aircraft operating lease or vehicle loan receivables. Or they could be long-term,
with the sale of home mortgage receivables of loan principal and interest.
In the case of house mortgages, the loan portfolio is sold to a third party company by the bank that
originally provided the finance. This bank would continue to earn fees from the management of the portfolio, and
the loans would be removed from the balance sheet to allow it to expand its business.
There has, however, been some debate about whether securitised assets should be removed from the
balance sheet, even though substantially all of the risks and rewards of owning the assets has been transferred
(sold) to another company. A London law firm, Freshfields, described securitisation as:
The packaging of assets, backed by appropriate credit enhancement and liquidity support, into a tradable
form through an issue of highly rated securities, which are secured on the assets and serviced from the cash flows
which they yield.
More Recent Securitisations (2005/2006)
The first securitisation since 2003 was offered by AerCap (previously debisdebis Air finance) in September
2005 for US$942 million. This was followed at the end of 2006 by Aviation Capital Group which securitised leases
on 74 aircraft to finance its purchase of operating lessor, Boullioun. The ACG Trust III deal raised US$1.86 billion, by
issuing a triple Arated G-l tranche ($1.62 billion), anA-rated E-l tranche ($117.5 million) and a tranche ($122.5
million) rated at BBB - (non-investment grade). Most of the aircraft portfolio consisted of newer narrow bodied
aircraft, with over 50 per cent B737-800s and A320-200s, and an overall average age of only 4.8 years.
Aircastle, a fast growing operating lessor, securitised leases valued at US$560 million in June 2006, in addition to
their IPO which raised $194 million to repay debt.
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Conclusions
Securitisation has not been widely used since its establishment at the beginning of the 1990s. If were
solely a device for GPA to avoid bankruptcy, then the next major economic dowuturn may see another impetus to
its use. Its future will also clearly depend on future trends in operating leases: will they continue to increase in
importance, particularly in areas like Asia, where they have not to date been so popular? This is part of the larger
question of the separation of ownership and operation of assets. Next is the question of accounting practice, and
whether securitised assets will be removed from balance sheets.
The advantages are persuasive, and centre on the reduced cost of borrowing for airlines: before the ALPS
92-192-1 securitisation, banks had lent GPA 75 per cent of the value of its leases at LIBOR plus 2 per cent. When
the leases were securitised, the special purpose company could borrow 87 per cent of their value at LIBOR plus
1.4 per cent.'
Possible disadvantages of securitisation are a weakeuing of the relationship between the lessee and the
lessor, as well as the additional worldoad imposed on the airline as a result of the increased number of parties
involved. Second, it might be argued that the contracting out of the monitoring and technical administration tasks
to specialist firms might prove to be less thorough than when they were perfonned by the operating lessors
themselves.
World Airline Traffic and Financial Forecasts
Most of the recent longer term forecasts of world air traffic are assuming average growth rates of around
5 per cent a year, with significant regional variations. These tend to be based on simple econometric models which
relate traffic growth to growth in world GDP. In this respect, they can only be as good as the GDP forecasts which
are produced by firms such as Global Insight, Standard & Poor's, or international organisations like The World Bank
Some forecasting models also try to incorporate a fare or yield variable, given the price elastic nature of a large
part of the market.
Short-term forecasts of up to five years ahead are provided by lATA. These are generally built up from
individual airline forecasts. Care needs to be taken in identifying whether the forecasts are measured in passenger-
Kms or in passengers (or include air cargo). The Avitas forecasts referred to in Table 13.1 are for air traffic, without
specifying units of measurement. Generally, passenger-kms would be expected to grow faster than passengers.
There has been a gradual shift for both business and leisure travellers going further afield, and trip length has been
increasing at between 0.5 and 1.0 per cent a year. This is evident in the differences between lCAO's two forecasts.
World Airline Financial Requirement Forecasts
If the major aircraft manufacturer forecasts discussed above tum out to be accurate, there will be a need
for between US$1.9 trillion (Airbus) and US$2.1 trillion (Boeing) to finance the cost of the aircraft over the next 20
years, both at 2004 prices. This amounts to around $100 billion a year, and looks large in comparison with 2004
cash generated by the world's airlines from internal sources of only $16 billion. However, 2004 was not a good
year for the airlines, with many North American airlines struggling to be cash positive.
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3.3 airline capital expenditure projections and airline financial requirement forecasts
World Airline Capital Expenditure Projections
An average of almost 90 per cent of capital expenditure by the world's airlines has historically gone
towards aircraft. Future aircraft needs are derived from the above traffic forecasts by making further key
assumptions on load factors, flight frequencies, aircraft utilization, and aircraft retirements. The latter are hard to
predict, given uncertainties in future fuel and maintenance costs, and whether aircraft will be modified to meet
new noise and emission rules. For example, most or all aircraft such as B727-200s and B737-200s were phased out
by 2002, the year in which these aircraft did not meet the noise standards without expensive hush kitting or
reengaging.
Assumptions on the future degree of hubbing and passenger transfers are also required, with point-to-
point services recently boosting traffic in many world regions. Boeing see a relative decline in hubbing witb more
hub by-pass flights, while Airbus are more optimistic on hubs. The Boeing argument rests on passenger preference
for non-stop flights and increasing hub congestion; the Airbus view is supported by the economics of hubs and
concentration of population in Asia with few secondary airports.
Focuses on aircraft deliveries and retirements and reflects the differing philosophies of the major
manufacturers. The retirement figures may vary insofar as they include or exclude aircraft that are in storage and
never expected to return to airline service. Boeing's view is of a higher rate of deliveries and also a greater number
of retirements a year, the lower average price per delivery indicating higher turnover and demand of smaller
capacity aircraft. Rolls-Royce is closer to the Boeing forecast and is probably more optimistic at the regional jet end
of the spectrum.
World Airline Financial Requirement Forecasts
If the major aircraft manufacturer forecasts discussed above tum out to be accurate, there will be a need
for between US$1.9 trillion (Airbus) and US$2.1 trillion (Boeing) to finance the cost of the aircraft over the next 20
years, both at 2004 prices. This amounts to around $100 billion a year, and looks large in comparison with 2004
cash generated by the world's airlines from internal sources of only $16 billion. However, 2004 was not a good
year for the airlines, with many North American airlines struggling to be cash positive.
Boeing give a detailed breakdown of forecast aircraft demand by region over the 20 years to 2024. This
shows the continued dominance of North America, Europe and Asia, but with demand in Asia for larger more
expensive aircraft.
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Unit – 4
Principles of Insurance
and
Risk Management
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4.1 history of aviation insurance- Basic principles of insurance- basic terminologies in general
insurance
History of Aviation Insurance
The history of aviation insurance closely follows the growth in aviation - all too quickly intrepid pioneers
realised the value of insurance if (or perhaps, when) their flying machines crashed!
Despite the demonstrable risks posed by these early flights, insurance providers were willing to provide
rudimentary insurance policies from the 1910s onward. These early providers were based in Germany and Italy but
also in the City of London.
The 1929 Warsaw Convention marked a significant milestone in the aviation insurance sector, establishing
the principle of liability for passengers, boosting demand for aviation liability insurance which remains today,
essentially, the only legal requirement for aircraft owners and operators, globally. EC regulation 785 in 2004 more
formally “updated” minimum liability limits for all aircraft types including business aviation aircraft.
As scheduled passenger air travel began to expand after 1945, the need to “spread” aviation risks
between insurers – recognised by the Deutsche Luftpool and the USAIG in the USA from as early as 1920 and 1928
respectively and from the early 1950s, La Réunion Aérienne in France; increased.
The dual launch year of the Concorde and Boeing B747 in 1969 opened a new chapter in commercial
aviation that has ultimately led to the globalisation of mass passenger air travel enjoyed today. At the same time,
aviation insurance providers needed to widen and deepen their sector involvement, to diversify their risk base.
For aviation insurers, providing policy cover for the business and private aviation sector has always been a
critical element of their product portfolio - a logical extension to commercial airline insurance. The business or
private aviation sector has grown in parallel to the commercial aviation sector although at a far smaller scale; the
risks are largely the same as commercial aviation but with smaller exposures.
The relative size and scale of the business aviation sector has historically supported domestic insurance
markets, resulting in the majority of business aviation / general aviation risks being insured in local, domestic or
regional insurance markets; providing an entry level exposure to commercial airline insurance products.
Business Aviation insurance is built on three crucial foundations that are culturally typical of the sector it supports:
 Personal, individual relationships

 A community that works best when working together; and
 The willingness to adapt and change to meet the future.
Business aviation insurance will undoubtedly continue to learn from history to shape the future.
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Basic Terminologies in General Insurance
Declaration Page
The first page of the insurance policy which “declares” pertinent information describing pertinent information
about the Risk such as the Named Insured, the policy period, aircraft number and description, limits of liability and
hull value, territory, pilot clause. Sometime the declaration page is accepted as proof of insurance rather than
getting a specific Certificate of Insurance.
Aircraft Hull and Liability Insurance
Aircraft Insurance in the US comes in two parts, Hull and Liability as defined below, issued in the same policy. In
other parts of the world policies may be issued as two separate policies for the same aircraft.
Aircraft Liability Insurance
Protects the insured against claims for bodily injury and property damage caused by or arising out of the
ownership, maintenance, or use of the aircraft.
Aircraft Physical Damage Insurance
Reimburses the insured for physical damage to the aircraft due to an accident or incident. Typically, does not cover
loss of use, diminished value, or wear and tear. Also known as Hull Insurance.
Medical Payments
Voluntary payments to passengers for direct medical expenses as a result of an accident or incident. Paid without
regard to legal liability.
Purpose of Use
Defined in each policy, this spells out the approved uses of the aircraft under the policy. Some common uses are:
Pleasure and Business
Non-commercial use of the aircraft for personal or business travel where no charge is made for such use.
Industrial Aid
Non-commercial use of the aircraft for business travel where no charge is made for such use, but the aircraft is
flown exclusively by professional pilots employed for that purpose.
Commercial
Commercial uses include such operations as instruction, rental, charter, aerial photography, banner towing, and
many more.
OPW OR OPC
The open pilot warranty or open pilot clause sets forth the minimum requirements for a pilot to fly the aircraft
under a policy without specific approval of the insurance company.
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Named Insured
The policy owner. The person or entity whose name appears on the first page of the policy and who has the
authority to change or cancel the policy.
Insured
The party in the insuring agreement the insurance company agrees to indemnify. For example, an employee of the
Named Insured.
Additional Insured
A person or entity with an interest to be protected but who is not a named insured.
Breach of Warranty
In the event a Named Insured may have violated the terms of the agreement thus invalidating the policy, a breach
of warranty endorsement guarantees the insurance company will make payment to the lienholder for any damage
to the aircraft up to the outstanding balance of the loan or a percentage of the agreed value whichever is less. An
example could be violating the open pilot warranty.
Combined Single Limit
A combined limit of liability applying to bodily injury and property damage. Usually stated as a limit per
occurrence.
Smooth Limit
A single limit as above with no internal per person limits. The entire limit is available to satisfy a claim by one
individual.
Sub-limit
A single limit of liability for bodily injury and property damage per occurrence which is further limited to a smaller
maximum amount payable to one person or passenger.
Subrogation
Gives the insurance company (in lieu of the Named Insured) the right to pursue a third party for recovery of
damages paid that they feel is responsible for the loss.
Waiver of Subrogation
The insurance company agrees to give up the right to pursue recovery from a third party, usually in conjunction
with granting Additional Insured status. Waiver of subrogation only applies to physical damage to the aircraft. For
example, it is common for a contract pilot to be asked to be named as an Additional Insured with a Waiver of
Subrogation to defend him against third party liability and to protect him from being sued by the insurance
company for mistakes he might make in the operation of the aircraft which may have contributed to the damage.
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Premises Liability Insurance
Part of a General Liability policy that insures the policy holder against any third party damage or injury arising out
of a faulty premises.
Products/Completed Operations Liability Insurance
Part of a General Liability policy that insures the policy holder from third party liability arising out of the use of the
product they manufacture and/or install on the airplane. This is not warranty insurance.
Hangar keepers Legal Liability Insurance
Hangar keepers Liability is a form of bailment and part of a General Liability policy that insures the policy holder
against damage the policy holder does to a third party’s aircraft while in their care, custody, and control. This
cannot take the place of the aircraft owner’s aircraft insurance. Hangarkeepers Liability pays only for the policy
holder’s (FBO’s) mistakes. It does not cover the policy holder’s aircraft, pay for damage caused by the owner of
the aircraft, or acts of god like the aircraft being destroyed by a tornado while in the policy holder’s hangar.
WAR & Related Perils Coverage
A group of perils which includes confiscation, nationalization, seizure, detention, hijacking, war, invasion, act of
foreign enemies, rebellion, strikes, riots, civil commotions, sabotage, etc. that are normally excluded from the
basic policy and can be purchased as an endorsement to the policy for additional premium.
TRIA
Terrorism Risk Insurance Act – Provides coverage for a Terrorist Act as certified by the Secretary of Treasury, in
consultation with the Attorney General and the Secretary of Homeland Security. This coverage is usually excluded
in the basic policy and can be purchased as an endorsement to the policy for additional premium.
There are many more common terms and phrases which you may come across that are unfamiliar to you. If they
are not defined within the policy itself, call your agent and broker and ask for an explanation. When you purchase
insurance you are also purchasing the services of the agent to act as a knowledgeable adviser and consultant for
the policy period.
4.2 Insurers- Risk and Insurance- Risk Management
The Risk in Business Aviation
There are various risks to be considered at different stages of the aircraft lifecycle. Elements of risk
appear from initial aircraft delivery (purchase, contractual obligations) to its utilization (preparation at home base,
ground handling and in-flight operations).
In this context, several risks could be transferred to insurance professionals such as damage to Hull of the
Aircraft, Liabilities towards Third Parties or Passengers and Personal insurance for Crew members.
The insurance industry has been working proactively for decades to find the most suitable solutions for
each insured to provide increased reactivity, financial security and capacity. The Business Aviation industry has
proven to be an ever-evolving sector and as such is demanding on innovation, leading many participants in the
field to improve and re-invent their products and commitment on the long-term basis.
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The members of our working group have diligently contributed to the contents of this booklet from their
own very diverse experience. As risk professionals, they remain eager to act efficiently and keep improving
understanding of the business from the experts involved in flight and ground operations. We invite you to share
with us your own experience of risk.
What Is Risk Management?
Most people think of "risk management" as purchasing liability and first party insurance coverage. Indeed,
most businesses of any considerable size have a "risk manager" or even a "risk management department." Their
main responsibility lies in deciding which types of insurance the company should carry and with which carriers. As
will be shown, insurance also plays an important role in creating an overall risk management plan to increase
safety. But this Comment is not wholly concerned with risk management in this popular sense; a comprehensive
risk management plan accomplishes three goals:
A. Evaluating loss potential;

B. Utilizing risk management techniques; and
C. Putting together a risk management plan.
A. Evaluating Loss Potential
First, the entity seeking to manage its risk must determine which of its activities create a potential for loss or
exposure to liability. Once the entity determines which activities create potential losses, it must calculate the
potential amount of loss. The potential amount is not simply the total amount the entity stands to lose. Rather, it is
the total potential loss multiplied by the percentage chance that the loss will occur. Loss is not just confined to
economic setbacks. For example, besides the physical and monetary losses due to accidents, airlines face the
public relations setbacks that stem from disasters.
At present, crashes are relatively infrequent and the public reacts with predictable initial shock. After a
while, however, faith in air carriers returns. As the number of flights increases and the number of crashes increases
proportionally, the public may become less forgiving. Major fatalities are easy to ignore when they happen once or
twice a year. If they begin happening every two or three months, public faith in air carriers may begin to suffer.
When the entity understands the amount of its potential loss it then engages in risk management. By creating
operational plans and procedures, the loss can be minimized. Four basic techniques are used to minimize the loss:
elimination, reduction, transfer, and retention.
B. Risk Management Techniques
1. Elimination
The first approach to risk management is elimination.' An air carrier can eliminate its potential for loss by
choosing not to engage in the risk-bearing activity. In most cases, this is the least viable option. An air carrier can
no longer function if it refuses to engage in the risky practice of flying aircraft. But limited adoption of this
technique is possible. For instance, removing aging aircraft from the fleet eliminates the higher crash risk that
those craft impose.
Elimination, also called avoidance, is usually the furthest removed from traditional insurance practice. With
some exceptions, insurers are usually willing to insure any activity for which they can quantify risk and attain an
adequate pool of insured’s. Because of the availability of insurance for most risk-bearing activities, insurers have
no incentive to guide their insured’s to eliminate all risk-bearing activities. If there is no risk, then there is no need
for insurers. The decision to avoid risk is primarily economic. The greatest incentive for avoidance is "to minimize
operational and revenue disruptions."
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2. Reduction
Reduction is very similar to elimination, but often involves something less than totally abstaining from the
risky action. The party seeks to reduce the risk accompanying the activity rather than refusing to engage in it. A
good example of reduction is Southwest Airlines' short commuter-type flight routes. By creating several shorter
flight plans, Southwest has created broad regional coverage without accepting the higher risk of longer flights.' Its
exemplary safety record reflects this reduction.
In addition to the obvious pre-loss reduction methods of reducing the chance of an accident, there is also the
post-loss method of loss control. The two main methods for minimizing a loss that has already occurred are
minimization and salvage. This Comment is mainly concerned with flight safety, so post loss control is not instantly
apparent. It is important to remember that the potential losses involved are not just economic, but also social.
Given the destructive nature of air accidents, post loss control of hull damage and casualties is unlikely. But rapid
response, interaction with grieving families, and excellent public relations can minimize the loss of passengers due
to poor consumer confidence. If the public perceives airlines as large corporations that can afford to lose an
occasional aircraft, then no amount of safety calculations and comparisons will erase the fear caused by a fatal
accident.
3. Transfer
Another common type of risk management is transfer. This technique involves shifting the risk of loss to
another party, typically an insurance carrier. This technique is the easiest to implement and serves the valuable
purpose of creating a risk pool. The risk-encountering entity can then cooperate with other entities to ensure a
greater likelihood that money will be available to cover losses. The problem with this technique is that it carries
the chance of "moral hazard." Essentially, the insured entity may decide to exercise less caution because it no
longer bears the risk of the loss. Insurers try to mitigate the moral hazard by employing different techniques. But
these are not always effective in creating an incentive for the insured to exercise more care or in mitigating the
total cost to society from the losses.
4. Retention
The fourth method of risk management is retention. Retention involves the entity assuming some of the risk
itself, either through a "self-insurance" plan or through a "deductible" imposed by the insurer. Self-insurance, for
the purposes of this Comment, involves setting aside a periodic premium amount based on the entity's potential
loss and using the created pool to pay for actual losses as they occur. A deductible is a gap in initial insurance
coverage for which the entity must assume responsibility. Both of these techniques create an incentive for the
entity to lower its risk of loss, thus increasing profits.
Interestingly, complete retention of risk is actually economically advantageous for the air carrier. If the carrier
can determine with reasonable accuracy what its losses will be for the year, it can set aside enough money every
year (or quarter or other measuring period) to cover those losses. Essentially, an insurer engages in this same
practice, but on a larger scale. Of course, the insurer also builds in a profit for itself. By engaging in complete
retention, the air carrier can save this profit amount. Unfortunately, the air carrier still runs the risk of unforeseen
losses or unusually high accident rates for the year. While the air carrier should be able to recover the amount of
the loss by the savings from years without accidents, the present catastrophic loss could put the carrier out of
business before later savings could be realized.
Insurers mitigate this risk by creating large pools of insured’s from which to draw premiums. The more
insured’s that fit into a risk group, the more effectively the insurer can estimate the potential risk losses. A highly
organized form of retention is "captive insurance" where the insured actually creates a private insurance company
that covers that company's risks only. This is feasible mainly for very large companies that want something
resembling traditional insurance, but prefer to generate underwriting profits for themselves rather than an insurer.
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C. Putting Together A Risk Management Plan
It should be pointed out that these different techniques are not exclusive. Elimination, for example, can be
conceptualized as a type of reduction. The entity can reduce its overall risk by eliminating its riskiest endeavors or
by eliminating factors and procedures that create higher risks. Transfer and retention do not, in themselves, create
efficient risk handling. But they can create incentives for entities to reduce their risks, thus benefitting both
themselves and society.
Given that air carriers already engage, at least to some degree, in transfer and retention, the main concern of
this Comment will be applying reduction techniques to the industry. Certainly, the industry already engages in
some reduction of risk. Federal Aviation Regulations impose reduction requirements as well. But industry experts
have recently called for more reduction type practices in the industry. 29 There are three methods by which
reduction of loss-risk can be accomplished.
The first method is reducing the frequency of the hazard. This might also be considered a type of elimination
technique. By engaging in risky activities less often, or refusing to engage in them at all, the airline lowers its
overall risk of loss." An excellent example can be found in recent headlines. Faced with the increasing threat of
terrorist attacks, the FAA restricted parking within 300 feet of terminals and banned unattended curbside. Vehicles
Airport authorities identified unrestricted parking as potentially risky because a bomb could be planted in a car
next to the airport, causing considerable damage. By restricting parking, airports reduce their risk of loss.
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Unit – 5
Aviation Insurance
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5.1 aircraft hull and liability insurance- sample policy and endorsement- airport premise liability and
other aviation coverage
What Is Aircraft Liability and Hull Insurance?
Many firms use airplanes, jets, or helicopters for business purposes. Some only use them occasionally for a special
project or a business-related social outing. Others, like crop-dusting businesses and aerial mapping companies, use
aircraft regularly.
Flying creates unique risks for businesses that own and use aircraft. Accidents can cause serious injuries or even
death, and the aircraft and/or other property can be damaged or destroyed. Thus, insurance coverage for aircraft
is so important.
Businesses that use aircraft shouldn't rely on their Commercial General Liability (CGL) policy for protection. The
standard policy contains a broad aircraft exclusion that eliminates coverage for most aircraft-related claims.
To protect themselves, businesses should buy aviation insurance. There are two main categories of coverage:
aircraft liability insurance and hull insurance, which covers physical damage to the aircraft. They can be purchased
together or separately, and in a variety of iterations.
How Aircraft Liability and Hull Insurance Works
Aircraft policies from insurers including Great American, QBE, and Arch cover third-party bodily injury and property
damage claims against an aircraft owner or operator.
Aircraft Liability Coverage
The policies include three types of liability coverage:

 Bodily injury or death sustained by third parties other than passengers
 Bodily injury or death sustained by passengers
 Damage to property owned by third parties

These coverage’s may be purchased individually, with each form of coverage subject to a separate limit per
occurrence. Alternatively, all three may be covered under one agreement subject to what’s known as a “smooth
limit,” or a single combined limit per occurrence.
If your insurer insists on a bodily injury sublimit, try to avoid a per person limit that may restrict payouts for people
injured on the ground as well as passengers. Opt instead for a “per-passenger” limit, which only limits coverage for
passengers. A per-person limit means that you could be liable for costs if a non-passenger is extensively injured
and sues for damages beyond your policy limits.
For example, if a plane makes an emergency landing and collides with a vehicle, the driver of the vehicle is a non-
passenger. Suppose your policy has a $1 million per occurrence limit and a $100,000 per person limit. In that case,
it will only cover the driver's injuries up the $100,000, and you're responsible for any costs beyond that. If your
policy has a $100,000 per passenger limit, any injured passengers would be subject to that limit, but the driver
could be paid up to the per occurrence limit.
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Liability Exclusions
Some risks may be excluded from aircraft liability policies. Common exclusions include:
 Expected or intended injury

 Bodily injury to employees
 Liability imposed under a workers’ compensation law
 Contractual liability, which is when you assume liability by signing a contract
 Injury or damage caused by the application of fertilizers or other substances (crop dusting)
 Injury or damage caused by pollution, noise, or electrical or electromagnetic interference
Aircraft Hull Insurance
To insure against physical damage to an aircraft, businesses need to purchase aircraft hull insurance. Many policies
offer the following three coverage options:
 Ground and flight: Covers damage to the aircraft caused by any peril (including disappearance) not
specifically excluded, whether the damage occurs when the aircraft is on the ground or in the air
 Not in flight: Covers damage that occurs while the aircraft is on the ground, whether stationary or in
motion
 Not in motion: Covers damage that occurs while the aircraft is on the ground and stationary
Hull coverage
Typically excludes damage caused by wear and tear, electrical breakdown, war and related perils
(including terrorist acts), excessive heat (to the engine), hijacking, and confiscation by a government authority.
Both the not in flight and not in motion coverage options exclude damage caused by fire or explosion following a
crash or collision that occurred while the aircraft was in flight.
Loss Calculations
Claims are based on the agreed value of the plane. If an aircraft is declared a total loss, the insurer will pay its
agreed value. If the plane suffers a partial loss, the amount the insurer pays depends on who performs the repairs.
If the plane is repaired by someone other than the insured (such as an aviation repair shop), the policy typically
pays the cost to repair or replace the damaged property plus the cost of transporting the plane to and from the
repair facility. If the insured performs the repairs, the policy pays for materials, labor, overhead (based on a
percentage of labor costs), and transportation (the cost of moving the plane to and from the place of repair).
Warranties
A warranty is a promise by an insured that certain requirements have been met. If the promise is broken, the
insurer can void the policy. Aircraft policies contain warranties that are unique to the industry. First, a pilot
warranty states that the plane will be piloted only by the person named in the declarations or by someone who
meets specific qualifications described in the policy. If the plane is piloted by someone else, the policy affords no
coverage.
Similarly, an airworthiness warranty voids the policy if the insured aircraft doesn't have a valid airworthiness
certificate. Federal regulations prohibit the use of any aircraft that does not have a valid airworthiness certificate.
A third type of warranty relates to how the insured aircraft is used. For example, Arch’s policy states that the policy
is only valid if the aircraft is used for the stated purpose. Choices include pleasure and business, charter/taxi, and
commercial.
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Airport Premise Liability and Other Aviation Coverage
Definition
Airport Premises Liability — an aircraft liability insurance policy additional coverage that covers damages
for bodily injury or property damage arising out of the use of airport premises for the parking and storage of
aircraft.
There are many responsibilities that go along with owning, leasing or operating on an airport in Georgia,
one of which is insurance. This applies to people who may lease hanger space for purposes not involving aviation-
related activities. Most agreements require leaseholders to have liability insurance related to possible instances of
tenant negligence. Options with liability coverage include general liability, public liability and owner/landlord-
tenant liability. However, it’s premises liability that may be especially beneficial for anyone owning or leasing
airport property.
The Purpose of Premises Liability Insurance is to cover expenses related to unsafe conditions on airport
property. Some agreements that leaseholders are asked to sign include stipulations that may not be entirely fair.
For instance, some agreements contain clauses that automatically pass all responsibilities to the lessee regardless
of who the negligent party may be. For this reason, it may be helpful for individuals presented with such
agreements to consult with an attorney first.
A reasonable contract related to airport property typically requires a leaseholder to acquire coverage
that would apply to their own negligent acts. If an existing aircraft or hangar insurance policy does not include
premises liability coverage, it can usually be added for little or no additional premium cost. Another option for
anyone leasing airport property is to have a separate general liability policy to provide protection against slip-and-
falls and other types of personal injuries that may involve customers, clients, employees or passengers.
A Personal Injury attorney may help a client who owns or leases airport property to determine if liability
exposure exists. This may also be case if an agreement does not specifically have an indemnification or hold
harmless clause. Additionally, an attorney may review agreements to identify clauses that need to be added to
provide sufficient protection against personal injury claims. Conversely, a personal injury lawyer may be able to
advise clients who may have been injured on airport property determine their legal options.
Coverage Levels and Types of Aircraft Insurance
Insurance companies may provide different levels of coverage depending on whether the aircraft is being
used for pleasure or for commercial purposes. An aviation business may need coverage if it provides flight training
services. A financial company may purchase aircraft insurance for its fleet of corporate jets.
Some insurance companies will also provide insurance coverage for aircraft that is rented by the operator
rather than owned, since the operator could be liable for thousands of dollars in damage if something were to
happen to the aircraft. Aircraft insurance is also available to organizations, such as flying clubs, in which members
may share in the use of one or more aircraft.
Page 42 of 45
5.2 Underwriting and Pricing Aviation Risk- Aviation Business Property Insurance and Transport
Insurance.
Introduction
The tide of this paper is "Aviation Underwriting". Last year's working party on Aviation produced a paper
which gave an outline of the market and description of the main classes of business and outwards reinsurance, but
very little on how Aviation is underwritten or how rates are determined. This paper was therefore intended to fill
in these gaps. To this end we talked with a number of aviation underwriters to establish how rates are set. We
were not able to find anyone who used any "scientific* basis for determining rates. The copious statistics
obtainable from various organisations giving loss statistics and data related to various risk factors (numbers of
aircraft, airline, passenger miles, etc) are not used by any of the underwriters we spoke to. Rates tend to be based
on past experience of the insured, the previous rate charged, consideration of rating factors, how rates are
changing in the market and the cost of reinsurance. The members of the working party would like the discussions
at the workshop sessions to concentrate on the rating process:
1) Has anyone experience of rating using market statistics?

2) Can actuaries contribute to the rating process?
Pricing Issues in Aviation Insurance
Airlines are in the business of transporting passengers or freight from origin to destination as efficiently
as possible. They do this with mixed financial success. However, they do it with remarkable physical success. The
accident rate for airline travel is lower than for any other mode of transportation, and it continues to decline.
Nevertheless, when accidents do happen they can cause considerable financial, as well as emotional, distress.
Airlines choose to avoid the financial distress by purchasing insurance against loss-through-accident. Aviation
insurers accommodate the desire of airlines to get rid of loss-due-to-accident by assuming all such losses. The
remarkable thing is that the insurers have provided this cover on a ground-up basis for each and every loss, i.e., on
an unlimited basis. The question such large and unlimited cover provokes is, how should it be priced?
To illustrate the magnitude of the problem, reflect back on the tragic events of 9/11. On that day United
Airlines and American Airlines each lost two aircraft to terrorism. The insurers covering those two accounts faced
the prospect of claims for a) loss of hulls, b) liability for passengers and crew, and last but by no means least, c)
liability for on-the-ground third party fatalities. Worse, at one time during the harrowing hours of that day, as
many as eight other planes were thought to be under the control of terrorists, with the prospect of financial losses
several multiples of what was already known. One month later American Airlines insurers faced another
(unrelated) loss over Queens. Airclaims, the aviation loss adjuster, gives “[a] provisional estimate of incurred
aviation losses in 2001 [as] just under $5.8 billion”. This was more than twice the previous worst year, $2.3 billion
in 1994, even if adjusted for inflation, etc. (Ironically, absent the 9/11 events, 2001 was one of the best safety
years ever.) To cover these claims Swiss Re estimated world wide premiums for 2001 of $1.9 billion.2 Losses would
have to be paid out of capital or higher future premiums. PRICING ISSUES IN AVIATION INSURANCE AND
REINSURANCE Airlines are in the business of transporting passengers or freight from origin to destination as
efficiently as possible. They do this with mixed financial success. However, they do it with remarkable physical
success. The accident rate for airline travel is lower than for any other mode of transportation, and it continues to
decline. Nevertheless, when accidents do happen they can cause considerable financial, as well as emotional,
distress. Airlines choose to avoid the financial distress by purchasing insurance against loss-through-accident.
Page 43 of 45
Aviation insurers accommodate the desire of airlines to get rid of loss-due-to-accident by assuming all
such losses. The remarkable thing is that the insurers have provided this cover on a ground-up basis for each and
every loss, i.e., on an unlimited basis. The question such large and unlimited cover provokes is, how should it be
priced? The insurers responded quickly to correct the cost of insurance that was immediately seen to be drastically
under priced, given the exposures assumed. Swiss Re suggests that the premiums for 2002 would be in the range
of $4-5 billion. In addition, the “price” of insurance was raised indirectly by changing coverage terms. Terrorism
was excluded as a cause of loss and third party coverage was limited to $50 million. Terrorism coverage has since
been reinstated and/or assumed by various government programs. The question nevertheless remains, what is an
appropriate price for aviation insurance coverage? What capital is necessary and what return should insurance
capital providers expect?
Pricing
If an insurer were to insure the whole aviation industry, what price should it charge? Traditional
approaches might be to charge expected losses plus some premium to cover overhead, brokerage and some profit
margins. Given the aggregate numbers above, the industry premium would be $2,079 million plus overhead etc.
Setting the overhead, etc., to zero the premium would be exactly $2,079 million. This is not exactly the same as
pricing at “burning cost”, but it is a forward looking version of it. (Remember, the suitably adjusted ten year
historic burning cost is $1,987 million.) A consequence of pricing at expected losses, if the expectation estimate is
an accurate one, is that underwriting profits will be made approximately half the time and underwriting losses the
other half. This is not the reason investors enter into the risky world of insurance! It would be acceptable behavior,
perhaps, if the profits when they occur were much greater in magnitude than the losses. Sadly, this is not the case.
In insurance it is usually the reverse, with limited upside profit and unlimited (or at least vastly greater) downside
losses. There is no agreed upon theoretical method for pricing insurance risk. Several approaches have been
designed but none can claim ascendancy over another. The feature that is most agreed upon, however, is that the
price should contain elements of “load” related to the riskiness of the subject insurance. (This would be in addition
to overhead, etc., that we have herein assumed to be zero).
Aviation Business insurance
Assured Partners Aerospace insurance services include comprehensive coverage for aviation businesses—
from university flight schools and single-ship instruction, to FBOs, airports, and charter operators, to maintenance
facilities and aviation product manufacturers. In sum, if your business supports aviation, we can help you obtain
the right insurance coverage to ensure all of your operations are properly protected.
Insurance for all types of aviation businesses
Comprehensive means more than a type of coverage – it means providing coverage for virtually every type of
aviation business, including:
 Aircraft Sales
 Airports
 Avionics Installers
 Charter (Part 135 Operators)
 Fixed Based Operators (FBO’s)
 Flight Schools
 Hanga rkeepers Liability
 Hangar (Building and Contents)
 Helicopter Operations
 Maintenance Facilities
 Power line/Pipeline Patrol
 Products Manufacturers
Page 44 of 45
Aviation and transport insurance provides financial cover specific to aircraft and transport operations, and the
associated risks involved in the aviation and transport sector.
Aviation insurance policies differ from general transport policies by reference to use of specific aviation
terminology, limits and clauses.
End
Page 45 of 45

Airline Finance and Aviation Insurance

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1.1 Introduction Airline Finance Need & Importance

1.2 World Airline financial results

1.3 Factors affecting financial results –

1.4 Asset Utilization –

1.5 Key Financial Issues

1.6 Airline Financial Ratio –

1.7 Performance Earnings Ratio –

Net Profit Margin

Return on Invested Capital (Capital Employed)

1.8 Risk and Solvency Ratio, Liquidity Ratio –

British Airways Group - Interest cover

1.9 Stock Market Ratios –

Dividend cover Net profit attributable to shareholders divided by dividend payable.

1.10 Inter – Airline comparison of financial ratio

Financial Year 2004 (US $ Billion) % Total

Sources of Internal Finance

 The airline's dividend policy.

Institutions Involved in Airline Finance

Export Credit Agencies

 Ex-Im Bank (USA).

Governmental Financing Organisations

2.3 Term loan payment, book profit and manufacturer‘s prepayment

What Is a Term Loan?

Types of Term Loans

Calculation of Term Loan Repayment Amount

The repayment amount can be calculated from the following formula:

PV = Present value of the loan

Loan amount = US$ IO million

Interest rate = 10 per cent a year

Loan term = 10 years

Repayment = US$ I,627,454 annually in arrears

Book Profit = Revenues – Expenses

Calculating Book Profit

Annual Depreciation = ($10,000,000 -$1,000,000)/ 15 - $600,000

Depreciated value at year end:

Year Value ($000)

Book Profit = Sale price less depreciated value

Cash Flow = Sale Price less loan outstanding

Effect of Prepayments to Manufacturers

 5 per cent at contract signature, 30 months before aircraft delivery.

 Selects the aircraft specifications.

The advantages of leasing to the airline are:

Possible disadvantages could be:

 A higher cost than, say, debt finance for purchase

Japanese Leveraged Leases

European Leveraged Leases

Extendible Operating Leases

 It allows airlines to respond rapidly to changes in market conditions.

Sale and Leaseback

 To meet capital requirements for new aircraft or investments.

 Risk is spread over a number of lenders.

More Recent Securitisations (2005/2006)

World Airline Traffic and Financial Forecasts

World Airline Financial Requirement Forecasts

World Airline Capital Expenditure Projections

World Airline Financial Requirement Forecasts

History of Aviation Insurance

 Personal, individual relationships

Basic Terminologies in General Insurance

Aircraft Hull and Liability Insurance

Aircraft Liability Insurance

Aircraft Physical Damage Insurance