Risk management in Finnair is a Group management responsibility. Risk management measures are directed primarily at risks that threaten the fulfilment of the Group's business objectives. Finnair's risk management activity is guided by business objectives set by shareholders, finance providers, customers, management, personnel and other important interest groups.
In order to exploit business opportunities Finnair is prepared to take controlled and calculated risks. Meanwhile, no risks are taken in flight safety matters. Risk management and safety thinking are an integral part of Finnair's operating practices and culture as well as its management and supervision procedures.
Finnair strives to anticipate the realisation of risks. The Group's risk management activity includes risk recognition and analysis. Based on this, a range of risk management measures are used, taking into account the optimisation of costs arising from risk management. Administrative means are used to avoid and remove risks, to reduce the probability and impact of risks as well as to spread and transfer risks. As a part of risk management, effective special situation management preparedness has been put in place.
The Board of Directors and the Chief Executive Officer are responsible for the Group's risk management strategy and principles as well as for the management of risks that threaten the fulfilment of strategic objectives. The Executive and Senior Vice Presidents of business units and Managing Directors of subsidiary companies are responsible for risk management in their areas of responsibility.
The Group's Chief Financial Officer is responsible for developing the management of financial risks with the assistance of the VP, Group Treasury and the SVP, Administration and Personnel Resources for developing the management of accident risks. The management of flight safety risks is the responsibility of a separately appointed organisation of responsible personnel approved by the authorities. The level of risk management as well as the development and practical application of risk management principles is directed by a risk management steering group and monitored by internal and external auditing.
Finnair's risks are classified into strategic, operational, financial and accident risks. Based on this risk classification, the Group constantly surveys and analyses business risks, determines acceptable risk levels and formulates risk management measures for various risk categories. The Group's subsidiaries and business units have conducted analyses of the most significant risks to which their own business activities are exposed.
Operating environment risks
Demand for passenger and cargo traffic demand has been most influenced by various unexpected events, such as environmental disasters and epidemics. The current trend clearly indicates that competitiveness in the air transport sector depends on how flexibly the company can react and adapt to unexpected events, changes in demand and to a changing competitive environment.
A critical factor for operational flexibility in future is the adjustment of fixed costs to fluctuations in demand. Moreover, the company's ability to react quickly in adjusting capacity, routes and costs to correspond to changing demand and economic conditions is also an essential factor in maintaining the company's profitability. During the past few years, several projects have been implemented at Finnair which have increased structural flexibility.
Unexpected events require preparation
Preparing for epidemics is part of Finnair's crisis management planning. Finnair continually and actively monitors developments in the situation with regard to epidemics throughout the world. The company strives to anticipate changes relating to infectious diseases and the resulting changes in customer behaviour and to react quickly to altered circumstances.
If necessary, the development of an epidemic and the measures taken in response are communicated quickly and reliably. The company's air transport capacity is redeployed in regions that are deemed safe. Guidelines are prepared to protect customers and employees.
At the end of 2004, the business impacts of the Southeast Asia tsunami catastrophe were alleviated by capacity and route changes in leisure traffic. The quick evacuation of Finnish tourists showed the ability of Finnair's different units to act quickly and flexibly when faced with unexpected events.
Finnair will defend its operating rights
An airline domiciled in the European Union can operate freely within the entire area of the Union. To date Finland, like other European countries, has negotiated bilateral operating agreements with countries outside the European Union.
In future, regulation at the European Union level will bring the negotiation of aviation agreements between countries inside and outside the European Union under the European Commission. Existing bilateral operating agreements will remain in force in the new situation.
As a negotiating party the Union is stronger than an individual country and thus can strengthen the position of European airlines when negotiating operating rights. In some cases this may have an adverse impact on Finnair and may weaken the company's competitive position in relation to other European airlines. Finnair for its part will endeavour to influence actively the parties who negotiate operating rights in order to safeguard its interests.
The company's operations are subject to legislative changes, to regulations and to changes in airport charges and taxes on both national and international levels. Possible changes are actively monitored by the company and an effort made to influence them via airline industry bodies, such as the International Air Transport Association (IATA) and the Association of European Airlines (AEA).
Market risk
The air transport business is sensitive to both cyclical and seasonal changes. Competition in the sector is intense and the decline in average ticket prices has been considerable due to over-capacity and the changed market situation. Airlines are cutting their prices in order to increase volumes, achieve sufficient cash flow and maintain market share.
Finnair has successfully responded to these challenges by reforming its pricing structure and by permanently reducing its cost structure. Already in autumn 2003, pricing of domestic, Scandinavian and European flights was changed to flight-based pricing determined by management of supply and demand. Finnair's strengths are service quality, an extensive route network as part of the oneworld alliance and the advantages of cooperation acquired through strategic partnerships.
A change of one percentage unit in the average price level of scheduled passenger traffic services affects the Group's operating profit by around 10 million euros. Correspondingly a change of one percentage unit in the load factor of scheduled passenger traffic services also affects the Group's operating profit by over 10 million euros.
To improve profitability, a division of labour has been effected between the parent company and Estonian subsidiary Aero in traffic between Helsinki and Tallinn as well as on routes within Finland. With the acquisition of a majority shareholding in the Swedish airline flynordic in November 2003, the company is expanding its operations in Scandinavia. flynordic is developing into the leading budget airline in the Nordic countries.
Variation in industry supply and demand also affect the market value of aircraft. Finnair manages the residual value risk related to aircraft ownership by leasing approximately half of the fleet under operative lease agreements of different duration. Aircraft leasing also allows for flexible capacity control in the short and long term.
Reliability of flight operations
Reliability is an essential prerequisite for operating successfully in the airline industry. The air transport business, however, is exposed to various disruptive factors such as delays, bad weather and strikes. As well as their impact on operational and service quality, air traffic delays also increase costs.
Finnair invests continually in the overall quality and punctuality of its operational activities. The Network Control Centre brings together all the critical parties for flight operations, thus enabling the most effective overall solutions to be implemented. Finnair Technical's service punctuality and diverse expertise as well as its detailed specification of technical functions ensure the reliability of flight operations.
Furthermore, in operational activities the contribution of partners and interest groups is essential. Finnair monitors the quality of external suppliers within the framework of standards specified in advance and through regulations prescribed for flight operations.
According to statistics compiled on European network airlines, Finnair was the most punctual airline in Europe in 2004 on the basis of flight arrival punctuality.
Information technology risk
Development of information system solutions demands continuous investment. An IT environment's unmanageability, complexity and inefficiency represent risk factors in a rapidly changing technological landscape. These factors have a direct influence on information technology and security costs. Situational management readiness in case of serious disruptions in data systems and traffic has been improved at Finnair.
Finnair has under way a number of system renewal projects, which aim to simplify, standardise and replace ageing systems. Clarifying the structure will also enable the data security of the IT environment to be maintained more effectively. The ever-increasing provision of services via the Internet demands a new approach to investment in data security solutions.
The careful selection of external agreement partners in IT solutions also reduces the technology risk. The Group has also gained access to technological expertise through co-operation between Finnair and IBM.
The coordination of the Group's information system architecture as well as its IT purchases and strategies has been centralised in the Group's information management department. This will bring synergy benefits and improve cost-efficiency through economies of scale.
Accident risk
Accident risks can be divided into two main categories: risks that threaten flight safety and risks that threaten corporate security. Accident risk management work is coordinated by the flight safety and corporate security departments.
In Finnair the focus of accident risk management has been on managing risks to the security of flights, individuals and data. Other accident risk sub areas are property, environment, product, liability and loss of business risks.
In its operations the company must take into account the possibility of various environmental risks. The effect of Finnair's operations on energy consumption, emissions and noise values is monitored activity by the company. Every year Finnair publishes a separate Environmental Report, which includes measures and key figures for the assessment of environmental efficiency.
Principles of financial risk management
The operations of the Finnair Group are by nature international and require significant amounts of capital. This means exposure to risks related to exchange rates, interest rates, credit, liquidity and commodity prices. The policy of the Group is to minimize the negative effect of such risks on cash flow, financial performance and equity.
Financial risk management is based on the risk management policy approved by the Board of Directors in November 2004, which defines acceptable minimum and maximum levels for each type of risk. Financial risk management is directed and supervised by the Financial Risk Steering Group. Practical implementation of financial policy and risk management have been centralised in the parent company's finance department.
In its management of foreign exchange, interest rate and jet fuel positions the company uses a wide range of hedging instruments and methods, such as forward contracts, swaps and options.
Foreign exchange risk
The Group's policy is to eliminate the identified foreign exchange risk. Foreign exchange exposure includes balance sheet items in foreign currencies, estimated cash flows for next 12 months and fixed aircraft purchase orders and sales contracts.
At the end of financial year 2004, the majority of the Group's interest-bearing liabilities were denominated in US dollars and euros. The exchange rate risk of the loans was almost fully covered. Around 75% of Group turnover is denominated in euros. The other key foreign sales currencies are the US dollar, the British pound, the Japanese yen, the Chinese yuan and the Swedish crown.
Approximately 30% of the Group's operating costs are denominated in currencies outside the euro zone.
The main purchasing currency is the US dollar, which accounts for almost half of all operating costs denominated in foreign currency. Acquisition of aircraft and their spare parts also takes place mainly in US dollars.
Clearly the biggest foreign currency risk to Finnair arises from the dollar. Significant dollar-denominated operating expenses are aircraft leasing fees and jet fuel purchases. The dollar risk is diminished by sales in dollars and in Asian currencies which correlate strongly with the dollar. Without the hedging programme, a one per cent decline in the dollar rate has a positive impact on the result of 2.0-2.5 million euros.
The weakening of the dollar by one per cent - without hedging - increases the annual result by approximately 2.1 million euros. At year end - hedging included - the weakening of the dollar by one per cent improves the result by approximately 0.5 million euros. Respectively, the strengthening of the dollar weakens the result. The aforementioned dollar risk sensitivity analysis includes the Chinese yuan and Hong Kong dollar which have a historical correlation of 100 per cent with the dollar.
Jet fuel price risk in flight operations
Jet fuel swaps and options are used to manage the price risk of jet fuel used in flight operations. The hedging period is up to 24 months. At year end, Finnair had hedged 48% of its jet fuel purchases for the first six months of 2005 and 29% for the second half. The hedging policy varies between scheduled and leisure traffic. Thanks to the change in the contractual structure of leisure traffic, the hedging requirement is lower than before. The jet fuel price risk is shared with the tour operators.
In the financial year 2004, jet fuel used in flight operations accounted for 12% of the Group's operating costs. Fuel costs depend on fluctuations in the oil market and the value of the US dollar.
A rise of ten per cent in the world market price of jet fuel - without hedging - increases annual jet fuel costs by 20 million euros. At year end - hedging included - the ten per cent increase raises costs by 13 million euros.
Interest rate risk
In order to manage interest rate risks, the Group's loans and investments are diversified into fixed and variable interest-rate instruments, yet so that most of the Group's interest-bearing loans have floating interest rates. At the end of financial year 2004, the average interest rate on the Group's interest-bearing loans was 3.35%. The average maturity of Finnair's money market investments is below 12 months.
Credit risk
The Group is exposed to counterparty risk when investing its cash reserves and in using derivative instruments. The credit risk is managed by making contracts, within the framework of counterparty risk limits, only with financially sound domestic and foreign banks, financial institutions and brokers. Liquid assets are also invested in promissory notes and commercial paper issued by conservatively selected companies.
Liquidity risk
The goal of the Finnair Group is to maintain good liquidity. Liquidity is ensured by cash reserves, bank account limits, liquid money market investments and committed credit facilities. With respect to aircraft purchases, the company's policy is to secure financing, for example through credit facilities, at least 6 months before delivery.
The Group's liquid assets were 291,4 million euros at the end of financial year 2004. Furthermore, Finnair Plc had the following unused credit facilities at the closing of the accounts: a domestic commercial paper programme of 100 million euros and a committed 200 million euro revolving credit facility. The credit facility contains a financial covenant which is based on adjusted gearing. The covenant level of the adjusted gearing is 175 per cent, at year end the ratio is 95.5%. The maximum level set by the Board of Directors is 140 per cent. |