Optimal risk sharing

The wife moved to Ann Arbor over the weekend, where she will be spending three months. She took an Air France flight (AF191) in the wee hours of Sunday morning, and then switched to a Delta flight at the legendary Charles de Gaulle. I must mention upfront that she seems to have had a peaceful journey.

Except that people following the same schedule exactly twenty four hours earlier would not have. AF191 that departed from Bangalore i n the wee hours of Saturday morning returned to Bangalore after a bomb scare. The flight was subsequently cancelled.

There are many risks to flying. Schedules nowadays are packed so closely that your flight might be delayed. Occasionally it might be cancelled even, sometimes without a good reason. A delay might sometimes mean that you miss your connecting flight.

The question is who bears the risk on this one. If I’m booked on a flight that gets cancelled or delayed (because of which I miss my connection), whose responsibility is it that I’m transported to my destination? There are three possibilities – the passenger himself, the airline and an external insurer. The question is which of these is most optimal.

The traditional model in aviation as I understand it is that it is the airline’s responsibility. While this makes sense because a large number of delays/cancellations are on account of faults on account of the airline, even when the delay is not due to the airline’s fault, the airline is best placed in terms of mitigating the risk.

Leaving the risk on the passenger has the advantage that he can choose his own risk profile. If you are flexible about your trip, you might choose to go without insurance, and take the hit yourself. If you’re a frequent flyer, then the “insurance cost” thus saved will compensate for the occasional delay. Yet, the problem with this kind of a model is that people tend to underestimate the risks, and will more often than not not insure, and get hit badly when the delay happens.

Which brings us to the final absorber of risk – the insurance company. I’d purchased “travel insurance” for a recent trip, and there was a component on account of delayed or missed flights. If my flight was delayed by a certain amount of time, my insurer would pay me a fixed amount of money.

While this financial hedging is good, it may not adequately represent the costs of making a new booking (including the hassles) when my flight is delayed or cancelled. So this is not a workable solution at scale.

Another solution is for the insurer to guarantee that you will reach your destination by a certain time in case your flight gets delayed or cancelled. This might work out to be more expensive than a fixed cash payout but this removes the cost and hassle of figuring out the next best alternative on the part of the customer. The problem, however, is correlation. Insurance works when people’s risks are uncorrelated or negatively correlated. Here they are positively correlated – all passengers on Saturday’s AF191 to Paris were affected similarly, and this pushes up the cost for the insurer to rebook people.

Unless they tie up with the airline itself! If they reach an agreement with the airline such that the airline commits to transport the stranded passengers, then this “positive correlation” I mentioned earlier will be taken care of. Seems workable, right? Except that what is being insured here is the risk that the airline abandoned in favour of the passenger, who insured against it from an insurer, who reinsured it with the airliner! Can we just cut out the middle men?

From this rather unscientific argument above, it looks like airlines are best placed to insure passengers against disrupted flight schedules. Back in the days of regulated air fares where competition had to be “on service”, airlines would take responsibility. This might have disappeared with the move towards unbundling over the last 2-3 decades. For good reason – insuring a schedule results in an additional (albeit hidden) cost, and getting rid of it can result in cheaper (base) fares.

Yet, given that airlines are best placed to insure schedules, we need a solution. Maybe they can charge a premium for insuring schedules apart from the base fares? Or would they argue that the current “unrestricted fares” are such insured fares (implying the premium is rather high)?

Short of  government mandated regulation, what is the best way for allocating the risk of disrupted flight schedules, and pricing it appropriately?

Tailpiece: A decade ago, our valuation professor (at IIM Bangalore) had told us that “risk cannot be eliminated. It can only be mitigaged by selling it to someone who can handle it better”.

Put Comment