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Risk Report
Risk management
Business operations necessarily involve opportunities and risks. Effective risk management is therefore a key factor in sustainably safeguarding a company’s value.
The management of opportunities and risks at Bayer is an integral part of the Group-wide corporate governance system, not the task of one particular organizational unit. Key elements of the risk management system are the planning and controlling process, Group regulations and the reporting system. In regular conferences the company’s results and its potential opportunities and risks are discussed, and targets and necessary actions are agreed upon. The principles of the Bayer Group’s risk management system are set forth in a Group directive.
The subgroups, service companies and the units of the holding company have nominated persons responsible for risk management at the upper managerial level and risk management coordinators to ensure that an effective system for early identification of risks is implemented and maintained.
Corporate Auditing is responsible for coordinating the identification and documentation of risk areas throughout the Group, enhancing the risk management system and monitoring its effectiveness at regular intervals. In addition, during the year-end audit the external auditor issues an opinion on the risk management system and informs the Group Management Board and the Supervisory Board of the outcomes of these evaluations. These outcomes are taken into account in the continuing enhancement of our risk management system.
Risk exposure
As a global company with a diverse business portfolio, the Bayer Group is exposed to numerous risks. We have purchased insurance coverage – where it is available on economically acceptable terms – in order to minimize related financial impacts. The level of this coverage is continuously re-examined.
Significant risks for the Bayer Group are outlined in the following sections. The order in which the risks are listed is not intended to imply any assessment as to the likelihood of their materialization or the extent of any resulting damages.
Legal risks
We are exposed to numerous legal risks from legal disputes or proceedings to which we are currently a party or which could arise in the future, particularly in the areas of product liability, competition and antitrust law, patent disputes, tax assessments and environmental matters. The outcome of any current or future proceedings cannot be predicted with certainty. It is therefore possible that legal or regulatory judgments could give rise to expenses that are not covered, or not fully covered, by insurers’ compensation payments and could significantly affect our revenues and earnings.
Legal proceedings currently considered to involve material risks are described in Note [32] to the consolidated financial statements.
Overall business risks
Pharmaceutical product prices are subject to regulatory controls in many markets. Some governments intervene directly in setting prices. In addition, in some markets major purchasers of pharmaceutical products have the economic power to exert substantial pressure on prices. Price controls, as well as price pressure from generic manufacturers as a result of government reimbursement systems favoring less expensive generic pharmaceuticals over brand-name products, diminish earnings from our pharmaceutical products and could potentially render the market introduction of a new product unprofitable. We expect the current extent of regulatory controls and market pressures on pricing to persist or increase.
Regulatory changes are continuously monitored, especially in our key markets. If necessary, we adjust our business plans according to the significance of governmental intervention.
Some of our products, particularly medicines, are marketed by third parties. The success of such products therefore depends on the quality of these partners’ marketing and sales efforts.
Sales of the Bayer Group are subject to seasonal fluctuations. This applies particularly in the CropScience business, which is affected by factors such as weather conditions. The performance of our MaterialScience subgroup is affected by cyclicality in customer industries. A downturn in the business cycle, characterized by weak demand – especially from key customers – and overcapacities, may lead to price pressure and more intense competition. Expectations of growth, especially in Asian economies, encourage producers to increase their production capacities. Future growth in demand may not be sufficient to absorb those capacity additions without significant downward pressure on prices.
The early identification of trends in the economic or regulatory environment and active portfolio management are important elements of our business management. Our analyses of the global economy and forecasts of medium-term economic development are documented in detail on a quarterly basis and used to support operational business planning. For a summary forecast, see “Future Perspectives – Economic Outlook and Market Opportunities.”
Where it appears strategically advantageous we may acquire a company or part of a company and combine it with our existing business. The amount of goodwill and other intangible assets reflected in the consolidated balance sheet of the Bayer Group has increased significantly in recent years. Failure to successfully integrate a newly acquired business or unexpectedly high integration costs could jeopardize the achievement of quantitative or qualitative targets, such as synergies, and adversely impact earnings.
The integration processes associated with our acquisitions are steered by integration teams. Appropriate resources are provided to support the integration processes.
Product development risks
The Bayer Group’s competitive position, sales and earnings depend significantly on the development of commercially viable new products and production technologies. We therefore devote substantial resources to research and development. Because of the lengthy development processes, technological challenges, regulatory requirements and intense competition, we cannot assure that all of the products we will develop in the future or are currently developing will actually reach the market and achieve commercial success as scheduled or at all.
Furthermore, adverse effects of our products that may be discovered after regulatory approval or registration despite thorough prior testing may lead to a partial or complete withdrawal from the market, due either to regulatory actions or our voluntary decision to stop marketing a product. Also litigations and associated claims for damages due to negative effects of our products may materially diminish our net income.
To ensure an effective and efficient use of resources, the Bayer Group has implemented an organizational structure and process organization comprising functional departments, working groups and reporting systems to monitor internal research and development projects.
Regulatory risks
Our life science businesses, in particular, are subject to strict regulatory regimes relating to the testing, manufacturing and marketing of many of our products. In some countries regulatory controls have become increasingly demanding. We expect this trend to continue, particularly in the United States and the European Union. Increasing regulatory requirements, such as those governing clinical or (eco-)toxicological studies, may increase product development costs and/or delay product (re-)registration.
To counter risks arising from legal or other requirements, we make our decisions and engineer our business processes on the basis of comprehensive legal advice provided both by our own experts and by acknowledged external specialists. Projects have been initiated to coordinate the implementation of new regulatory controls and mitigate any negative implications for the business.
Patent risks
A large proportion of our products, mainly in our life sciences businesses, is protected by patents. We are currently involved in lawsuits to enforce patent rights in our products. Generic manufacturers and others attempt to contest patents prior to their expiration. When a patent defense is unsuccessful, or if one of our patents expires, our prices are likely to come under pressure because of increased competition from generic products entering the market. Details of related litigation are provided as part of the description of legal risks in Note [32] to the consolidated financial statements.
In some areas of activity we may also be required to defend ourselves against charges that products infringe patent or proprietary rights of third parties. This could impede or even halt the development or manufacturing of certain products or require us to pay monetary damages or royalties to third parties.
Our life science businesses, in particular, have a comprehensive product life cycle management in place. In addition, our legal department, in conjunction with the relevant functional departments, regularly reviews the patent situation. Potential infringements of our patents by other companies are carefully monitored so that legal action can be taken if necessary.
Production, procurement market and environmental risks
Production capacities at some of our manufacturing facilities could be adversely affected by, for instance, technical failures, natural disasters, regulatory rulings or disruptions to supplies of key raw materials or intermediates, as in the case of dependence on a single source for critical materials. This applies particularly to our biotech products because of the highly complex manufacturing process. If in such cases we are unable to meet demand by shifting sufficient production to other plants or drawing on our inventories, we may suffer declines in sales revenues.
The supply of strategically important raw materials is ensured on the basis of long-term contracts with multiple suppliers wherever possible. Furthermore, all stages of our production processes and our material inputs are continuously monitored by the respective expert function within the company.
Moreover, the manufacturing of chemical products is subject to risks associated with the production, filling, storage and transportation of raw materials, products and wastes. These risks may result in personal injury, property damage, environmental contamination or business interruptions and liability for compensation payments.
Furthermore, the possibility of accidental cross-contamination among our crop protection products or the presence of unintended trace amounts of genetically modified organisms in agricultural products and/or foodstuffs cannot be completely excluded.
We address product and environmental risks by way of suitable quality assurance measures. An integrated quality, health, environmental and safety management system ensures process stability. In addition, we are committed to the international Responsible Care initiative of the chemical industry, have initiated a special Bayer Climate Program and report regularly on our own safety and environmental management system.
IT risks
Business and production processes and the internal and external communications of the Bayer Group are increasingly dependent on information technology systems. Major disruptions or failure of global or regional business systems may result in loss of data and/or impairment of business and production processes.
The foundations for a continuous and sustainable IT risk management system have been laid by establishing a comprehensive organization, enacting rules and regulations that define the relevant roles and responsibilities, and implementing a periodic reporting system. Technical precautions such as data recovery and continuity plans have been established together with our internal IT service provider to address this risk.
Risk to pension obligations from capital market developments
The Bayer Group has obligations to current and former employees related to pensions and other post-employment benefits. Changes in relevant valuation parameters such as interest rates, mortality and rates of increases in compensation may raise the present value of our pension obligations. This may lead to increased pension costs or diminish stockholders’ equity due to actuarial losses being recognized directly in equity. A large proportion of our pension and other post-employment benefit obligations is covered by plan assets including fixed-income securities, shares, real estate and other investments. Declining or even negative returns on these investments may negatively impact the future fair value of plan assets. This again may diminish equity, and/or it may necessitate additional contributions by the company. Further details are given in Note [25] to the consolidated financial statements.
We address the risk of market-related fluctuations in the fair value of our plan assets through prudent strategic investment, and we constantly monitor investment risks in regard to our global pension obligations.
Financial risks
Management of financial and commodity price risks
As a global enterprise, Bayer is exposed in the normal course of business to credit risk, liquidity risk and various market risks that could materially affect its net assets, financial position and results of operations.
As a global enterprise, Bayer is exposed in the normal course of business to credit risk, liquidity risk and various market risks that could materially affect its net assets, financial position and results of operations.
It is company policy to use derivatives to minimize or eliminate the risks associated with operating activities and the resulting financing requirements. Derivatives are used almost exclusively to hedge realized or forecasted transactions. The use of derivatives is subject to strict internal controls based on centrally defined mechanisms and uniform guidelines. The derivatives used are mainly over-the-counter instruments, particularly forward exchange contracts, foreign currency options, interest-rate swaps, cross-currency interest-rate swaps, commodity swaps and commodity option contracts concluded with banks. We set counterparty limits for such banks depending on their creditworthiness.
The various risks associated with financial instruments are outlined below together with the relevant risk management systems.
Credit risks
Credit risk arises from the possibility of the value of receivables or other financial assets being impaired because counterparties cannot meet their payment or other performance obligations. Since the Bayer Group does not conclude master netting arrangements with its customers, the total amounts recognized in assets plus the total potential contribution to the effective initial fund of Bayer-Pensionskasse represent the maximum exposure to credit risks. Thanks to comprehensive credit management, the Bayer Group so far has not registered an increase in defaults on trade receivables despite the current situation on the capital markets.
Credit risk arises from the possibility of the value of receivables or other financial assets being impaired because counterparties cannot meet their payment or other performance obligations. Since the Bayer Group does not conclude master netting arrangements with its customers, the total amounts recognized in assets plus the total potential contribution to the effective initial fund of Bayer-Pensionskasse represent the maximum exposure to credit risks. Thanks to comprehensive credit management, the Bayer Group so far has not registered an increase in defaults on trade receivables despite the current situation on the capital markets.
To effectively manage the credit risks from trade receivables, Bayer has put in place a standardized risk management system, which is the subject of a Group directive. Regular creditworthiness analysis takes place in relation to exposures; these receivables are partly secured. Credit limits are set for all customers. All credit limits for debtors where total exposure is €10 million or more are evaluated by operational credit management and submitted to the Group’s Central Financial Risk Committee.
To minimize credit risks, financial instrument transactions are only conducted with banks and other partners of first-class credit standing in line with predefined exposure limits. All risk limits are based on methodical models and are continuously monitored.
Country risks relating to trade receivables and intra-Group loans are continuously monitored, systematically evaluated and centrally managed.
Liquidity risks
Liquidity risk, i.e. the risk of not being able to fulfill current or future payment obligations because insufficient cash is available, is centrally managed in the Bayer Group. Sufficient liquid assets are held to meet all of the Group’s payment obligations when they fall due, thereby ensuring solvency at all times. Payment obligations result both from operating cash flows and from changes in current financial liabilities and are included in liquidity planning. In addition, a reserve is maintained for unbudgeted shortfalls in cash receipts or unexpected disbursements. For this purpose, budget deviation analyses are performed on the basis of historical time series, adjusted for variations in business structure. The liquidity reserve is then determined which, with a defined probability, will cover a negative deviation from budgeted cash flows. The size of this reserve is regularly reviewed and adjusted as necessary to current conditions. Liquid assets are kept mainly in the form of overnight and term deposits. Credit facilities also exist with banks. These include, in particular, a €3.5 billion syndicated credit facility, which is undrawn.
Liquidity risk, i.e. the risk of not being able to fulfill current or future payment obligations because insufficient cash is available, is centrally managed in the Bayer Group. Sufficient liquid assets are held to meet all of the Group’s payment obligations when they fall due, thereby ensuring solvency at all times. Payment obligations result both from operating cash flows and from changes in current financial liabilities and are included in liquidity planning. In addition, a reserve is maintained for unbudgeted shortfalls in cash receipts or unexpected disbursements. For this purpose, budget deviation analyses are performed on the basis of historical time series, adjusted for variations in business structure. The liquidity reserve is then determined which, with a defined probability, will cover a negative deviation from budgeted cash flows. The size of this reserve is regularly reviewed and adjusted as necessary to current conditions. Liquid assets are kept mainly in the form of overnight and term deposits. Credit facilities also exist with banks. These include, in particular, a €3.5 billion syndicated credit facility, which is undrawn.
We intend to service the bonds maturing in 2009 out of liquidity and free operating cash flow. The maturation of the mandatory convertible bond in June 2009 will not result in a cash outflow because the bond will be converted into equity.
Market risks
Market risks relate to the possibility that the fair value or future cash flows of a financial instrument could fluctuate due to variations in market prices. Market risks include currency risk, interest-rate risk and other price risks, especially commodity price risk.
Market risks relate to the possibility that the fair value or future cash flows of a financial instrument could fluctuate due to variations in market prices. Market risks include currency risk, interest-rate risk and other price risks, especially commodity price risk.
Sensitivity analysis is a widely used risk measurement tool that allows our management to make judgments regarding the potential loss in future earnings, fair values or cash flows of market-risk-sensitive instruments resulting from one or more selected hypothetical changes in interest rates, foreign currency exchange rates, commodity prices or other relevant market rates or prices over a selected period of time. We use sensitivity analysis because it provides reasonable risk estimates using straightforward assumptions (for example, an increase in interest rates). The risk estimates we provide below assume:
- a simultaneous, parallel foreign exchange rates shift in which the euro depreciates against all currencies by 10%;
- a simultaneous, parallel commodity price increase of 20% in all relevant commodities with respect to which we hold derivatives; and
- a parallel shift of 100 basis points in the interest rate yield curves of all currencies.
We use market information and additional analytics to manage our risk exposure and mitigate the limitations of our sensitivity analysis. We have found sensitivity analysis to be a useful tool in achieving some of our specific risk management objectives. Sensitivity analysis offers an easy-to-understand risk exposure estimate that allows an approximation of the effect changing market conditions could have on our business. Additionally, it allows our management to take the necessary steps to address such risks.
We continually refine our risk measurement and reporting procedures. This includes periodically re-examining the underlying assumptions and parameters utilized.
The sensitivity analyses included in the following sections of this Risk Report present the hypothetical loss in cash flows of financial instruments and derivatives that we held as of December 31, 2008 and December 31, 2007. The range of sensitivities that we chose for these analyses reflects our view of changes in foreign exchange rates, commodity prices and interest rates that are reasonably possible over a one-year period.
Currency risks
Since the Bayer Group conducts a significant portion of its operations outside the euro currency zone, fluctuations in currency exchange rates can materially affect earnings. Currency risks from financial instruments exist with respect to receivables, payables, cash and cash equivalents that are not denominated in a company’s functional currency. In the Bayer Group these risks are particularly significant for the U.S. dollar, the Japanese yen and the Canadian dollar.
Since the Bayer Group conducts a significant portion of its operations outside the euro currency zone, fluctuations in currency exchange rates can materially affect earnings. Currency risks from financial instruments exist with respect to receivables, payables, cash and cash equivalents that are not denominated in a company’s functional currency. In the Bayer Group these risks are particularly significant for the U.S. dollar, the Japanese yen and the Canadian dollar.
Currency risks are identified, analyzed and managed centrally and systematically. The scope of hedging is evaluated regularly and defined in a corporate directive. Recorded foreign currency operating items, receivables and payables are normally fully hedged.
The anticipated foreign currency exposure from forecasted transactions in the next 24 months is hedged on a basis agreed between the Group Management Board, the central finance department and the operating units. A significant proportion of contractual and foreseeable currency risks is hedged, mainly through forward exchange contracts and currency options.
Our Board of Management has provided clear guidance on how to limit and monitor cash flow risks that result from this approach.
We applied a hypothetical adverse scenario in which all currencies simultaneously appreciate by 10% against the euro compared with their year-end exchange rates. Under this scenario the estimated hypothetical loss of cash flows from derivatives and non-derivatives as of December 31, 2008 would be €293 million (2007: €119 million). Of this €293 million, €236 million is related to the U.S. dollar, €36 million to the Japanese yen and €21 million to other currencies. Of the €293 million estimated hypothetical loss of cash flow, €296 million results from derivatives used to hedge anticipated exposure from planned sales denominated in foreign currencies. Such transactions qualify for hedge accounting, and the respective changes in value are recognized in other comprehensive income. The impact of exchange-rate fluctuations on our anticipated sales in foreign currencies is not included in this calculation. The offsetting position of €3 million is primarily attributable to unhedged currency derivatives embedded in supply contracts.
Interest-rate risks
The Bayer Group’s interest-rate risks arise primarily from financial assets and liabilities with maturities exceeding one year. In the case of fixed-rate financial instruments, such as fixed-rate bonds, the risk of fluctuations in capital-market interest rates results in a fair-value risk because the fair values fluctuate as a function of interest rates. In the case of floating-rate instruments, a cash flow risk exists because interest payments could increase in the future.
The Bayer Group’s interest-rate risks arise primarily from financial assets and liabilities with maturities exceeding one year. In the case of fixed-rate financial instruments, such as fixed-rate bonds, the risk of fluctuations in capital-market interest rates results in a fair-value risk because the fair values fluctuate as a function of interest rates. In the case of floating-rate instruments, a cash flow risk exists because interest payments could increase in the future.
Interest-rate risks are analyzed centrally in the Bayer Group and managed by the central finance department. This is done in line with the duration set by the Board of Management, which implicitly also includes the ratio of fixed-rate to floating-rate debt. The duration is subject to regular review. Derivatives – mainly interest-rate swaps, cross-currency interest-rate swaps and interest options – are employed to preserve the target structure of the portfolio.
Financial debt including derivatives amounted to €16,647 million as of December 31, 2008 (December 31, 2007: €14,198 million). The sensitivity analysis was performed on the basis of our floating-rate debt position at year end 2008, taking into account the interest rates relevant to our liabilities in all principal currencies. A hypothetical increase of 100 basis points, or 1% per annum, in these interest rates (assuming constant currency exchange rates) as of January 1, 2008 would have raised our interest expense for the year ended December 31, 2008 by €75 million (2007 based on liabilities at year end 2007: €65 million).
Other price risks (especially commodity price risks)
The Bayer Group requires significant quantities of petrochemical feedstocks and energy for its various production processes. The prices of these inputs may fluctuate considerably depending on market conditions. As in the past, there will be times when it is not possible for us to pass on increased raw material costs to customers through price adjustments. This applies particularly to our MaterialScience business.
The Bayer Group requires significant quantities of petrochemical feedstocks and energy for its various production processes. The prices of these inputs may fluctuate considerably depending on market conditions. As in the past, there will be times when it is not possible for us to pass on increased raw material costs to customers through price adjustments. This applies particularly to our MaterialScience business.
We have addressed this risk by concluding long-term contracts with multiple suppliers. In addition, derivatives are employed where possible to hedge against commodity price risks by smoothing variations in income-statement items due to changes in commodity prices – and the resulting changes in stockholders’ equity – over the long term. The procurement departments of the subgroups are responsible for managing these price risks on the basis of internal directives and centrally determined limits, which are subject to constant review.
Commodity swaps and commodity options, in particular, are employed to hedge changes in the prices of utilities, especially gas, and of crude oil, naphtha and benzene feedstocks. These instruments are also used in the case of long-term, fixed-price supply contracts.
We applied a hypothetical adverse scenario in which all commodity and energy prices simultaneously decrease by 20%. Under this scenario the estimated hypothetical loss of cash flows from derivatives as of December 31, 2008 would be €30 million (2007: €34 million). Of this €30 million, €1 million would be directly disclosed in the income statement and €29 million would be recognized as a value adjustment in other comprehensive income according to hedge accounting rules. In considering sensitivities for commodity futures and commodity option contracts, we have made a small allowance for the fact that forward rates are less volatile than spot rates. The stated long-term contract volumes are therefore based on somewhat smaller price changes. The derivatives used by the Bayer Group to mitigate the risk of changes in exchange rates, interest rates and commodity prices are described in Note [30.3] to the consolidated financial statements.
Assessment of the overall risk situation
Compared with the previous year, the overall risk situation did not change significantly in the reporting period. The overall risk assessment is based on a consolidated view of all significant individual risks. At present, no potential risks have been identified that either individually or in combination could endanger the continued existence of the Bayer Group.
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