Risk Management

Delta’s Strategy for Reducing Turbulence

Hit by labor woes and infrequent flying, Delta uses its captive insurance company to smooth long-term earnings risks.
David KatzMarch 15, 2001

It should come as no surprise that Delta Air Lines has financial perils on its corporate mind.

Beset by the threat of a pilot strike and by shrinking passenger rolls, Delta warned Tuesday that it expects to report a first-quarter loss of $85 million to $110 million, or 70 cents to 90 cents a share. Analysts reportedly had forecast a profit of 46 cents per share for the quarter. By the last trade on Wednesday, Delta’s share price had fallen $1.56, to $39.90.

Delta financial executives can be forgiven if they’re a bit obsessed with their current woes. And yet, to the airline’s credit, there’s evidence in its strategic use of its captive insurance company, Aero Assurance Ltd., that undaunted Delta is staying focused on long-term earnings health.

Chris Duncan, the company’s director of risk management and insurance calls Aero “our Swiss army knife for enterprise risk.”

By that he means that the Vermont-based captive is an all-purpose implement wielded as part of Delta’s strategy to take a broad view of the company’s loss exposures.

Delta executives had explored using Aero in a way more in tune with its other current woes: Underwriting strike-protection insurance for the airline. But they chose not to go ahead with the idea, Duncan tells CFO.com.

Traditionally, of course, captives insure the risks of their owners in a formalized setting, most often offshore. With the cost of property- casualty insurance rising by double-digit percentages, many senior financial executives are likely to dust off their captives to cut down on the transactional costs of buying conventional insurance.

Like those of other operating subsidiaries, the financial results of captives such as Aero are typically consolidated with those of the parent company’s balance sheet and income statement.

Let’s say, however, the captive underwrites $20 million of Delta’s liabilities, Duncan suggests. If it assumes $5 million of that risk itself and places the remaining $15 million liability with reinsurers, Delta can then take that $15 million liability off its books.

Delta, however, is pushing Aero into new strategic areas that go far beyond a captive’s traditional uses.

“We will funnel and consolidate traditional and not-traditional risk,” into the captive, Duncan tells CFO.com. That creates a “portfolio effect” in which risks can be hedged against one another.

For example, if Delta holds down its workers’ compensation costs (a traditional exposure), that can offset a rise in the company’s cost of funding frequent-flier awards (a non-traditional risk), the Delta risk manager explains.

Such a benefit might not be realized if the risks had been handled separately and the airline had spent too much on workers’ comp insurance in the traditional market.

Hedging Cost Hikes

In the future, the captive may be used to finance employee benefits and hedge the risk of hikes in fuel prices and the cost of buying aircraft, says Duncan. For now, besides workers’ comp, Delta is using Aero to finance these risks:

  • Frequent-flier miles. The awards program yields “a very large liability,” for Delta, says Duncan, who refused to quantify the exposure. “Four free tickets represents a future financial obligation, and we have to accrue for that,” the risk manager says.

The problem with accruing for such obligations is that they can vary considerably. Perhaps the biggest wildcard is the price of fuel, the carrier’s number two cost behind labor, Duncan notes.

By using Aero to cap the risk of a rise in the cost of supplying frequent-flier miles, Delta hedges itself against future fuel-price volatility. Here’s how it works: The airline assumes a part of the liability for the awards on its books. If that amount exceeds a certain level, an Aero insurance policy pays for the excess.

  • Environmental liabilities. Aero caps the risk that pollution cleanup costs will outstrip what Delta has reserved for them. In assembling the program, Delta found a host of environmental exposures for various company units “buried as liabilities on our p&l and balance sheet,” Duncan says. Aero provides excess-insurance coverage above those liabilities.
  • Airport construction. Delta is using Aero to reinsure self-insured and deductible parts of the insurance program covering the airline’s work in tearing down the current Terminal A of Boston’s Logan International Airport and constructing a new terminal.

Underwritten in traditional insurance markets, the basic insurance is in the form of an owner-controlled, or “wrapup” program, covering Delta’s risks and those of its contractors under a single insurance contract.

The program, which covers workers’ comp, builders risk, general liability, program liability, and the errors and omissions of architects, could save “several millions of dollars,” says Duncan. The savings stem from group- purchasing power and the high levels of self- insurance. Delta feels it can assume large parts of the risk itself because it scrutinizes the safety of the project tightly.

Overall, Delta is involved in “a very comprehensive risk- mapping process” that’s partly aimed at determining what traditional and non- traditional risks can be mingled in the captive. For Delta, it’s a matter of moving “these molehills of risk scattered throughout the balance sheet and p&l into a mountain of risk” that can be funded in a unified, cost-efficient way.

Things like earnings shortfalls have a way of roiling the strategies of even the most disciplined companies. But if Delta, with the help of Aero, can keep its eye on its long-term goals, that would be, well, captivating.