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”.

Vistara and Indigo

Earlier today the Air Traffic Controller of Bangalore tweeted that Air Vistara had a 100% on time performance in Bangalore.

My immediate reaction was that this was because Air Vistara is positioned as a premium service, and hence their schedule is more “sparse” and has greater “slack”. That, I mentioned, has a direct consequence on their on-time performance.

The Directorate General of Civil Aviation puts out monthly reports on the performance of airlines in India. The data they dispense is very interesting, but the format is horrible. It’s a PDF embedded into a 20th century web page. If you can parse the above link there are a number of insights to be gleaned.

Firstly, a full 63% of flight delays in India (for the month of June) have been classified as “reactionary” (not cutting and pasting the image here because I don’t want to desecrate this blog by putting a pie chart on it). This is what airport announcers term as “delay caused due to delay in incoming aircraft”.

In other words, what happens is that airlines try to over-optimise their schedules too much leaving little slack between two consecutive flights for a particular aircraft. And so any delay in any flight cascades through the length of the day for that particular aircraft. My hypothesis (haven’t found data to back this up) is that Vistara has a more relaxed schedule than other airlines and hence has better on-time performance.

It is also pertinent to mention that Vistara has a much lower passenger load factor compared to other airlines. The average Vistara flight in June was only about 60% full, comfortably putting it in last place. Perhaps the premium pricing hasn’t been attracting the kind of passengers as hoped for. Or they’re not marketing well to the right kind of people.

The other airline which merits mention here is Indigo, which seems to be literally running away with the market. Not only is it comfortably number 1 with a consistent 37% market share, it also has the lowest proportion of cancelled flights, a pretty high passenger load factor (86%) and better on-time performance than any of the other large airlines.

Airlines is an industry where there are significant positive feedbacks – if you are on time, not only do more people want to fly you but you can also have a more efficient schedule. And so forth. And there are definite economies of scale in maintenance and schedule density and so forth. Indigo is taking advantage of all of those.

It may not be a particularly profitable industry, but the airline industry is surely interesting to watch!

Cancellation charges in the airline industry

So seat 2B in flight number I5 1322, Air Asia flight from Bangalore to Goa this morning, went unfilled. I wasn’t on this flight, but perhaps for that precise reason I can assure you that the above statement is true. For that seat belonged to me, as I had booked my tickets to go to the Goa Project.

So I initially decided to go to the Goa Project, and booked my tickets for it (on AirAsia). And then work and other things meant that I decided against going, but when I went to the AirAsia website to cancel my ticket, I realised that I wasn’t able to do it! Essentially AirAsia has no concept of cancelling a flight!

This is option pricing taken to one extreme, where the entire price is taken in the form of an option premium! The airline industry was at the other extreme not so long ago – where options weren’t priced at all. In other words, until a decade or a bit more back, you could change or cancel your bookings at little extra cost, though this optionality (and other things such as regulation) meant that the ticket was  quite expensive!

Now it seems like some of the “extreme low cost carrier” (such as AirAsia or RyanAir) have moved to the other extreme – where there is no concept of cancellation. And I’m not sure of the wisdom of this strategy. For I believe that this strategy does not maximise either the social utility or the airline’s profits.

The social utility bit is easy to see – I ended up paying full price for a ticket that I didn’t travel on, so I’m hurt. The marginal passenger who wanted to travel on today’s flight to Goa but didn’t find a ticket was hurt (this person could’ve flown had I cancelled my ticket). And the airline missed an opportunity to resell my ticket to someone else (potentially at a much higher price) and make money on it! So it’s a lose-lose situation all round.

The commercial aspect follows from the above – in case demand for this flight was low, then it perhaps made sense to not refund any of my money, for now the airline would not be able to sell the ticket to another passenger. However, if demand were higher (a very probable event), the airline missed an opportunity to make much higher revenue on this seat than what they did by making me not cancel it. I wave my hand here a bit, but it is easy to see that the airline is letting go of potential profits by not letting me cancel my ticket!

I’m not saying that the airline refund my full amount, or anything close to that – that doesn’t make sense for them since they’ve sold me an option. All I’m saying is that the price of zero (between total cost and option cost) doesn’t make sense. Even if the airline were to refund a thousand rupees (I paid around 6000 for the two-way fare) if I cancelled it, and the cancellation procedure were smooth, I would have cancelled it. And the expected revenues on this one seat would definitely exceed this kind of refund, you would expect?

Possibly it’s time for airlines to indulge in dynamic pricing for cancellations also. If the flight is near full, the airline can resell my cancelled ticket for a fairly high amount, so they can induce me to cancel by offering me a decent refund. If at the time I want to cancel, however, demand is low, then they need not offer me much. These things are not at all hard to price!

So by going extreme on the cancellation charges Air Asia and its ilk are leaving money on the table! If only someone were to tell them to pick it up!

Airline delays in India

So DNA put out a news report proclaiming “Air India, IndiGo flyers worst hit by flight delays in January: DGCA“. The way the headline has been written, it appears as if Air India and Indigo are equally bad in terms of delayed flights. And an innumerate reader or journalist would actually believe that number, since the article states that 96,000 people were inconvenienced by Air India’s delays, and 75,000 odd by Indigo’s delays – both are of the same order of magnitude.

However, by comparing raw numbers thus, an important point that this news report misses out is that Indigo flies twice as many passengers as Air India. For the same period as the above data (January 2015), DGCA data (it’s all in this one big clunky PDF) shows that while about 11.65 lakh passengers flew Air India, about 22.76 lakh passengers flew Indigo – almost twice the number. So on a percentage basis, Indigo is only half as bad as Air India.

airlinedelays

The graph above shows the number of passengers delayed as a proportion of the number of passengers flown, and this indicates that Indigo is in clear second place as an offender (joined by tiny AirAsia). Yet, to bracket it with Air India (by not taking proportions) indicates sheer innumeracy on the part of the journalist (unnamed in the article)!

I’m not surprised by the numbers, though. The thing with Indigo (and AirAsia) is that the business model depends upon quick turnaround of planes, and thus there is little slack between flights. In winters, morning flights (especially from North India) get delayed because of fog and the lack of slack means the delays cascade leading to massive delays. Hence there is good reason to not fly Indigo in winter (and for Indigo to build slack into its winter schedules). Interestingly, the passenger load factor (number of passengers carried as a function of capacity) for Indigo is 85%, which is interestingly lower than Jet Airways (a so-called “full service carrier”)’ s 87%. And newly launched full service Vistara operated at only 45% in January!

We are in for interesting times in the Indian aviation industry.

Irreversible policies

Some policies are so badly designed that they become irreversible. Take, for example, the “5/20” rules for airlines in India. For an airline registered in India to fly abroad, it needs to have been in operation for 5 years and have at least 20 aircraft. The rule is silly, and the government wants to change it. But established players say that changing the rule will be unfair to them, for they have sunk costs in order to comply with the rule and want newer competitors to go through the same.

Now, given that the airline industry is dynamic in terms of firms going in and out of business, there will always be new firms and old firms in the market. And given that the rule is fundamentally senseless, there will be proposals to change it at many points in time. Now, notice that the arguments that today’s established players are making can be made at all those points in time! In other words, if you were to postpone changing the rule because older airlines are going  to be unhappy, you are giving reason to postpone the rule change indefinitely!

When you design a policy, you should keep in mind that there is a chance that changed market environments might render it useless/absurd (as for the 5/20 rule, it was absurd from inception!). Hence, you need to consider how easy the rule is going to be to dismantle when it goes past its use-by date. If such a “poison pill clause” doesn’t exist in the rule, then it will be very difficult to undo and the absurdity will propagate into perpetuity, causing much more damage than necessary!

Then again, if the rule has been framed due to the influence of bootleggers (the 5/20 rule definitely has indications of that, and it is hard to identify any “baptists” who could have backed the rule), then the bootleggers are likely to prevent any such “poison pill clause” from being put in. Such are life.

Market Share Of Indian Air Operators

Not so long ago, we had a CAG report that discouraged giving sixth freedom rights to Gulf-based airlines, the argument being that it was reducing the market share of Indian airline companies, and was reducing the chances of Delhi airport ever becoming a hub. In that report, the CAG had also claimed that the granting of these sixth freedom rights was hurting the financial performance of Air India.

The Ministry of Civil Aviation, via the government data portal, has put out data on the market share (in terms of number of passengers and amount of cargo) of Indian and Foreign airlines for flights to and from India. While the data strangely refuses to mention the units for some of the variables, that doesn’t prevent us from calculating the market share of Indian carriers in the passenger and freight markets. The graph below summarizes this:

airlinemarketshare

 

What is interesting is that the market share of Indian carriers in terms of both passengers and freight grew significantly between 2006 and 2011, slowing down a bit towards 2012 (wonder if Kingfisher’s demise adequately explains that). While this was the time when many of those sixth freedom rights (that the CAG was so opposed to) were granted, this was also the time period when privately owned Indian airlines started expanding globally and adding international routes.

This suggests that the reason for Air India’s losses lie less in the grant of the sixth freedom rights – which only grew the market, and more to do with the quality of service provided by the airline vis-a-vis both foreign carriers and privately owned Indian carriers.

What can also be seen from the above graph is that there is perhaps significant scope for expansion of Indian carriers when it comes to Air Cargo where their market share is minuscule compared to their passenger market share.

Indigo’s Food Policy

My last few flights on Indigo Airlines have not been pleasant, at least from a food perspective. It is said about the airline that they put a great amount of thought into each of their processes, but while it might have been working earlier (I used to positively prefer Indigo’s food experience a while back) of late it doesn’t seem to be doing too well.

Firstly, I don’t have a problem with the food itself. I most definitely prefer Indigo’s cold sandwiches and Real Activ fruit juice to the reheated omelette/pulao that Jet Airways serves. It is much lighter on the stomach and feels healthier, and doesn’t give you that usual bad aftertaste of “airline food”. I also understand that it makes sense from the company’s perspective, since the lack of hot food reduces their cost of serving it and also makes the plane easier to clean.

The problem, however, is with the process. Firstly, Indigo has these “corporate program customers” (I’ve never understood how to get into one of these), whose meal is pre-paid. So you have stewardesses walking around with printouts to know who is eligible for a free meal. I’ve also noticed some kind of priority in terms of service – that the corporate program customers are served before others (which is logical, since they’ve already paid), which disrupts the flow.

Then there is the problem of cash management. For whatever reasons the price points are not in multiples of 50 (sandwiches cost Rs. 170, fruit juice Rs. 70), so change management (!!) is a huge problem. While they have credit card machines they don’t work uniformly, and end up causing further delays.

The biggest issue, however, is the choice! For probably good reason Indigo serves a variety of meals, enough variety that the menu runs up to a full page in their in flight “retail therapy magazine”. There are two problems that result from this – firstly, there is a problem of inventory. When you offer so much choice, how much of each type do you carry? I know there must be some science going into how many packets of ready-to-make Uppit they carry and how many chicken sandwiches. However, on days when I’m (unfortunately from a food perspective) seated in the vicinity of Row 14 or Row 30, it is reasonably unlikely that I don’t end up getting my preferred choice.

The second problem with the variety in food is the time lost in decision-making. “Give me a chicken sandwich. Oh, it isn’t there? Then give me biryani! Oh, but that’s a Ramen kind of thing? No I don’t want that. Give me cashew nuts. Not pepper flavour, give me chilli”. The amount of time it takes for a passenger on Indigo to decide on what to eat is significantly more than the corresponding time it takes for a passenger in a so-called full-service carrier (veg/non-veg). Again, it doesn’t help (from this perspective), that an Indigo flight operates with four stewards, as opposed to six in a “full-service” carrier of the same size.

Overall, it makes the entire process of ordering for, paying and getting a meal rather unpleasant for significant proportions of passengers. My solution to this would be two-fold. Firstly, include the cost of the meal in every ticket. The current cost of an Indigo meal is Rs. 240 (170 for sandwich, 70 for juice). With economies of scale (everyone ordering a meal) I’m sure this can be brought down to about Rs. 200. When I’m paying Rs. 5000 for a flight, I wouldn’t mind the extra Rs. 200. I may not eat (note that half the time I fly Jet I don’t eat), but the point here is that given the brand Indigo has built I may not change my decision on flying Indigo because it costs Rs. 200 more.

The second idea is to drastically reduce the choice. Yes,  I know that might end up pissing off some customers who have their own favourites from the Indigo menu (mine is spinach-corn-cheese sandwich) but it makes the logistics much easier to handle. Imagine having just two choices of sandwich and two choices of juice (and no more, maybe less) and you think of how much quicker the service will get then. Going even more drastic is also an option (this is something Jetlite used to do in 2008, and I’ve noticed the same with Turkish Airline’s low-cost brand Anadolujet). Give absolutely no choice and just deposit one sandwich and one can of juice on every single tray-table. They could even.

The point of this post is that uncertainty hurts, and sometimes even those that it is intended to benefit. The choice in the Indigo menu is meant to be a boon for the passengers, but it has significant costs attached – in terms of availability and timeliness.

PS: There are no good food stalls in the airport terminal (Mumbai 1B) also that one can peacefully carry on to flights. Last two times I carried muffins from Cafe Coffee Day and Cafeccino respectively and both were downright horrible. I miss Delhi’s terminal 1D and the double chocolate chip muffin at the Costa there.

The curse of geography on Air India

International flights are regulated by a strange agreement, in which at least one end of the flight should be in the country that is the “home” of the airline. For example, Jet Airways runs flights along the Mumbai-Brussels-New York route, but is forbidden from carrying passengers solely from Brussels to New York (that market is a monopoly for airlines based in EU or USA). However, if Jet has flights from Mumbai to say Brussels and Singapore, it can carry passengers from Brussels to Singapore, since they’ll be touching the ground at Jet’s home country.

Secondly, airline ticketing is usually done on a “source-destination” basis, and not based on each leg. For example, the price of  a Brussels-Singapore ticket on Jet Airways has nothing to do with the price of Brussels-Mumbai and Mumbai-Singapore tickets. As far as the airline is concerned, all these are independent “markets”, and the price for Brussels-Singapore is set partly based on what other airlines charge for Brussels-Singapore (taking into account flying time, layover time and all that).

These two together give an undue advantage to airlines that are situated in countries that are “in the middle”. The best example for this is Emirates, which flies, on the one hand, to several destinations in Asia, and on the other to several destinations in Africa, Europe and the Americas. This allows Emirates to effectively aggregate demand from all these destinations and connect them up in the form of a hub.

For example, there may not be too many people who want to fly Bangalore-Venice. However, if you aggregate all destinations Emirates serves to the West of Dubai (in Europe, Africa, US, Middle East, etc.) there will be a lot of people who will want to fly from Bangalore to all these places put together. Similarly, if you aggregate all destinations in Asia, there will be enough people from Venice to fly to all these places put together and thus Emirates, by providing a hub, creates an effective market. This is what I mentioned earlier as the advantage of geography, of being situated “in the middle”.

Now, if Air India were to be profitable in the international sector, one way of doing so would be to create a “hub” in India, where Air India connects up passengers to the east to those in the West. While that sounds simple enough, what we need to see is if any place in India is situated conveniently enough to function as a hub. Now, look at the map of India, and see what is around.

To the north-east lies China. There is a lot of nothingness between India and the parts of China that generates high airline traffic (the coast). To the northwest, you have Pakistan, Afghanistan and barren republics of Central Asia. The “business parts” of Russia, again, are quite far away. To the South of India you have vast oceans, the south-east and west already have thriving hubs (Singapore, KL, Bangkok, Dubai, Doha, etc.) and India is again not well placed to compete effectively with any of them. I know this isn’t a rigorous analysis, but look in any direction, and you’ll find it hard to believe that there is reason enough for people living there to fly internationally using India as a hub.

This is the curse of geography that India suffers from, and there is nothing we can do about it, and this is something we need to accept. Given this scenario, the best airlines from India can do is to connect various places in India to places abroad where there exists a “direct market” (for example, Kochi-Dubai by itself is liquid enough so you can have Indian carriers operating that route). Thus, airlines from India can never aspire to achieve the scale and connectivity of an Emirates or a Malaysian. The sooner the airlines accept it, the better.

The moral of the story for Air India is that it should recognize this curse of geography and give up on its dreams of connecting the world. It should stick to connecting destinations within India, and “direct markets” from India  to destinations abroad.