Risk Management

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Risk Management

Icelandair Group’s objective is to manage and control risk exposures and keep them within acceptable limits, subject to optimised returns, by using derivatives and other available means. All risk management is carried out within guidelines set by the Board of Directors.

Various, macroeconomic, sector-specific, financial and enterprise-related risks can impact Icelandair Group’s operations. The Board of Directors is responsible for defining policy measures to reduce exposure to financial and enterprise risk. These measures outline the parameters and framework which need to be considered when managing risk, especially risk arising from price volatility and liquidity fluctuations.

An internal Risk Management Committee, chaired by the CEO, endeavours to reduce risk exposure to the maximum feasible extent within the Board’s policy limits. The main policy objectives determine the methods to be used to reduce costs and disadvantages arising from any instability and uncertainty in the Company’s operating environment. The policy is reviewed on a regular basis and modified when improvements are needed

 

Foreign currency risk

The Group seeks to reduce its foreign exchange exposure arising from its business dealings in diverse currencies through a policy of matching receipts and payments in each individual currency to the extent possible. Any mismatch is dealt with using currency trades within the Group before turning to outside parties. Historically, the biggest currency mismatch has been a USD deficit, where the annual USD cash inflow falls short of the USD outflow, mainly due to investment, maintenance, fuel costs, and funding-related payments, which are to a large extent denominated in USD. This mismatch has been shrinking, however, in both relative and absolute terms due to USD revenue growth and lower fuel and funding costs. The gap is expected to shrink still further in 2016 due to lower fuel prices and larger USD inflows resulting from increased US sales via marketing and the USD appreciation. In recent years the ISK deficit has emerged and expanded from being trivial to a significant and growing ISK shortfall since 2009. This trend stems from the revenue growth in foreign markets, whilst the consequential added operations are domestic and need to be covered by ISK. This shortage is financed by a surplus of European currencies, most importantly the EUR, CAD and Scandinavian currencies. The Group follows a policy of hedging 50–80% of the net currency exposure 9–12 months forward. In addition to the impact on cash flow, risk exposure of this nature affects the balance sheet. The risk committee monitors on a monthly basis the net balance sheet currency mismatch and mitigates the exposure through shortterm management of assets and loans to the extent feasible and within the scope of the cash flow objectives.

Fuel price risk

The Group’s risk policy requires a hedge ratio between 40 and 60%, 9–12 months forward. Account is taken of the ratio of forward ticket sales as a minimum cover if it exceeds the 40% lower band. The policy entails a mixture of swaps and options, which are allocated in accordance with the degree of risk exposure. The policy and hedge strategy take account of several supporting factors which are eligible to counter the fuel risk exposure. These factors are acknowledged as hedge proxies and evaluated to some extent as substitutions for hedge contracts. First, contractual risk transfer is used where possible and the benefits of a correlation between jet fuel and the USD are monitored and calculated on a regular basis. Second, ticket pricing is a very important and effective tool in the medium term to offset fluctuations in fuel prices. Third, production management is a longer-term option, which can become relevant when coping with fuel price trends over longer periods. Hedge strategies are subject to IFRS hedge accounting standards, but the embedded instrument quality requirements align importantly with policy guidelines of sufficient effectiveness, reporting clarity and the transparency of scenario analysis. Thus, basis risk is avoided and hedge effectiveness sustained by choice of instruments.

Interest rate risk

The Group follows a policy of hedging 40–80% of the interest rate exposure of long-term financing with up to a 5-year horizon. Currently, foreign loans are hedged against interest rate fluctuations using fixed-rate loan contracts or swap contracts, where the floating rate is exchanged for fixed interest rates. When evaluating the interest risk exposure and the optimal level of contractual protection, account is taken of the Group’s level of cash and marketable securities and various other offsetting economic factors. As a result of repayments and prepayments of loans in 2014 and 2015 the capital structure has changed considerably and interest payments are currently of little significance. However, due to future investments steps have been taken to prepare for future funding and to contemplate rate protection measures to meet the consequential growth in interest rate exposure. Various strategies and instruments to cover future interest risks have been evaluated, but these still fall outside the policy framework in terms of tenor. In light of the recent attractive low-rate environment the issue has deserved close attention, and policy exemptions provide some scope for action when or if desirable.

Carbon price risk

Since the beginning of 2012 all airlines offering European destinations have been required to comply with the EU Emissions Trading Scheme (ETS), which commits them to raise their carbon permits in proportion to their emissions of carbon. Icelandair Group is already hedged against roughly 50% of its 2016 exposure through the EU allocations of emissions quotas. In November 2012 the EU decided to offer airlines flying to and from European destinations an exemption from the Scheme with respect to international flights. Icelandair accepted this offer and its commitment was therefore reduced to covering internal European flights. Again, in April 2014, the EU extended this exemption to 2016 and has therefore relieved airlines temporarily from the uncertainty of the carbon exposures within this time frame. Emission permits are mainly purchased with spot and forward contracts, and carbon exposure is subject to the same scrutiny and risk management as jet fuel. However, while the consequences of the ETS compliance is economically trivial in comparison with the magnitude of fuel cost volatility, the emission allowances will not be embedded into the fuel hedge strategies yet, but instead procured on a rolling 3-6 month basis in relation to fuel consumption.

Liquidity risk

Liquidity risk reflects the Group´s ability to fulfil its payment obligations associated with financial liabilities. The liquidity risk management is based on a policy of minimum cash target levels deemed adequate under both normal and stressed conditions. Imbedded in the policy are guidelines concerning the quality of the cash equivalents and financial assets. Through risk analysis and based on past experience the Group has used an estimation of three month operating costs as a benchmark for the preferred minimum cash positions, where 30% can be in the form of unused lines of credit. Cash flow requirements and their effects on the cash levels are monitored by using rolling currency flow forecasts which are updated on regular basis.

Credit risk

Credit risk is dependent on the likelihood of the counterparty’s default and the loss of their financial obligations. The greatest part of the exposure is concentrated in the form of cash and cash equivalents. Secondly there are considerable commitments through trade and other receivables from services rendered. The relative spread of claims across counterparties is a relevant factor contributing to the credit risk exposure in addition to the composition of asset classes. The risk is countered by the choice of counterparties and dealt with in the accounts with allowances for impairment. The Group maintains an awareness of potential losses relating to credit risk exposure and chooses its counterparties based on business experience.

Industry-related risk factors

At group and subsidiary levels, management monitors and assesses the airline industry’s risk exposure, which has historically posed uncertainty, even in normal operating conditions. A part of the Company’s culture stems from its long history, including a general recognition of the value of learning from past experience. Yet, in addition to the retrospective view, management systematically focuses attention on potential threats from a prospective viewpoint, as the environment is extremely cyclical. The Group operates and thrives in well-established and defined markets which, as such, can be regarded as valuable intangible assets that require attention. Icelandair’s credibility and reputation are crucial for its market status and growth, but the markets are also sensitive to external factors, such as the macroeconomic elements governing aggregate demand. An economic downturn will usually reduce the general purchasing power of potential customers and thereby the demand for air travel. Airlines are prone to even greater vulnerability when it comes to other types of shocks which are more sudden and forceful. Abnormal weather conditions and volcanic eruptions in recent years have caused costly and unanticipated threats of disruptions. Terrorist incidents and pandemics are also examples of events which need to be considered at all times. Factors that can be analysed and monitored with respect to reasonable risk of occurrence and impact call for close monitoring and readily available contingency plans. The ash cloud experience of Eyjafjallajökull Glacier in 2010 and Grímsvötn in 2011 put the contingency planning and operational flexibility of Icelandair Group to the test and they proved successful. This experience benefits the Group now in light of the recent Holuhraun eruption and geological unrest in Bárðarbunga Glacier, which calls for constant monitoring and scenario analysis. The Company owes its adaptive potential and flexibility of operations chiefly to its capable human resources, contingency policies and economies of scale. The quality of the Company’s responsive processes enables us to cope with other adverse circumstances and industry factors, such as seasonality, competition, insurance and new taxes.

Operational risk

The Group distinguishes between industry-related risks and those which expose the subsidiaries at individual company level. Embedded in the Group’s operations is a natural spread of business risk, not only in terms of market diversification, but also between the subsidiary business models themselves. This dispersion of interests has delivered rewards during periods of economic turbulence. Methods of coping with threats of disruptions and disturbances are also decentralised when it comes to operational hazards. Again, the long and successful history of Icelandair Group and its companies is a valuable asset, which serves both as the foundation and the benchmark for many of the policies and contingency plans used across the Group. The Group’s computer and communication systems are crucial for sales and market activities, but also for undisrupted internal operations. Equipment maintenance is needed to guarantee airworthiness. Third-party services may become bottlenecks in the production chain, whether in catering, ground services or flight control. Human resources need to be managed, labour disputes resolved and work stoppages prevented. Wage negotiations were extensive in 2014 and 2015, involving a number of different unions covering a large majority of the Company´s work force. These were favourably resolved after extensive efforts on both sides. Management constantly evaluates the risks involved and the potential consequences of individual events. Scenarios are projected, charted and contemplated and action plans launched based on possible outcomes, where collaboration is maintained between the Group and its individual companies.

Enterprise risk management

Risk management needs access to a secure and steady flow of information about all enterprise-related risks at the Group level and thus requires centralised mapping and detailed registration of risk factors and their estimated inherent financial value and potential consequences. The Group’s Risk Management Committee has focused on enterprise-related risk assessment in collaboration with Internal Audit and concentrated on aligning risk records across all subsidiaries to achieve consistency and compliance. The key objective of Enterprise Risk Management is to enhance motivation in risk analysis and improve risk awareness, standardise the quantification of risk and establish the Company culture that is needed to promote everyday risk awareness and risk-reduction measures. Cash-flow stress testing is now performed with enterprise risk inputs by simulating events and scenarios induced by the factors defined in the risk registry. Although based on sensitive and qualitative assumptions, this practice has the merit of shedding light on the possible operational and financial consequences of external and internal disturbances. Semi-annual results are submitted to the Audit Committee for evaluation and support.