Bayer's Annual Report, section on Risk Management, for year ended December 31, 2012

From Bayer's Annual Report, section on Risk Factors, for year ended December 31, 2012.

Number of words in 17.1.4: 3481
Compulsory licensing of patents: 0

17.1.4 Risks
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

The Bayer Group is 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, disputes, tax assessments and environmental matters. The outcome of any current or future proceedings cannot be predicted. 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.

Investigations into possible legal or regulatory violations, such as potential infringements of antitrust law or certain marketing and / or distribution methods, may result in civil or criminal sanctions – including substantial monetary penalties – and / or other adverse financial consequences, may harm Bayer‘s reputation and ultimately detract from the company‘s success.

To ensure that laws and regulations are observed, Bayer has established a global corporate compliance program that forms an integral part of its corporate culture. This program comprises the Corporate Compliance Policy, which serves as the framework for the observance of laws and regulations, a dedicated compliance organization and intensive communication and training activities. Legal proceedings currently considered to involve material risks are described in Note [32] to the consolidated financial statements.

Industry-specific 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. Changes regarding governmental price controls in our key markets are continuously monitored. If necessary, we adjust our business plans depending on the extent of such price controls. The Group‘s sales and earnings are affected by the economic circumstances of our customers. At MaterialScience, a downturn in the business cycle would result in weak demand and overcapacities, putting pressure on prices and heightening competition. 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.

However, even our detailed analyses may not ensure that a massive economic downturn can be predicted. 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 Bayer Group’s consolidated statement of financial position has increased significantly in recent years as a result of acquisitions. 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. Suitably experienced personnel resources are provided to support the integration processes. Teams of experts also provide support for any divestiture projects.

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.

In addition, 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 earnings. To ensure an effective and efficient use of resources in research and development, the Bayer Group has implemented an organizational structure and process organization comprising functional departments, working groups and reporting systems that monitor 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. 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-science 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. Sometimes a generic version of a product may even be launched “at-risk” prior to the issuance of a final patent decision. 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 system in place. In addition, our patents 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 events such as 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 processes. 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 wherever possible through long-term contracts and / or by purchasing from multiple suppliers. Furthermore, all stages of our production processes and our material inputs are continuously monitored by the respective expert function within the company.

The manufacturing of chemical products is subject to risks associated with the production, filling, storage and transportation of raw materials, products and waste. These risks may result in personal injury, property damage, environmental contamination, production stoppages, business interruptions and liability for compensation payments.

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 adopting suitable quality assurance measures. An integrated quality, health, environmental and safety management system ensures process stability. Our sustainability strategy and sustainability management are driven by our commitment to the international Responsible Care and Global Product Strategy initiatives of the chemical industry.

Personnel Risks

Skilled and dedicated employees are essential for the success of our growth-oriented corporate strategy. Particularly in the emerging markets of Asia and Latin America, the number of people with the technical and language skills needed for demanding positions in an international industrial enterprise remains relatively small. Accordingly, those who possess these skills are highly sought after by companies operating there. Should we be unable to recruit a sufficient number of employees in these countries and retain them for the long term, this could have considerable adverse consequences for our future success.
We are addressing this risk by globally positioning the company as an attractive employer and carrying out comprehensive personnel marketing to convince our target groups of the benefits of working for Bayer. These include competitive compensation with performance-related components as well as an extensive range of training and development opportunities. We also pursue a diversity-based human resources policy to tap the full potential of the employment market.

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, issuing regulations that define the relevant roles and responsibilities, and implementing a periodic reporting system. For this purpose a committee has been established at the Group level to resolve upon the basic strategy, architecture and IT security features, which are implemented accordingly by the subgroups and service companies in consultation with this central organization. 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 postemployment 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 costs for pension plans or diminish 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 adversely affect the future fair value of plan assets. This in turn 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 risks, liquidity risks and various market price risks that may materially affect its net assets, financial position and results of operations. In line with company policy, a central risk management process is applied to identify and analyze the market price risks arising from operating activities and from the resulting financing requirements. Our use of derivatives to eliminate or minimize these risks relates almost entirely to hedge recorded or forecasted transactions and 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. Further details on derivatives are given in Note [30.3].
The following section explains the various risks associated with financial instruments and how these
risks are managed.

Credit and country risks

Credit risks arise from the possibility of the value of receivables or other financial assets being impaired because counterparties cannot meet their payment or other performance obligations. The Bayer Group does not conclude master netting arrangements with its customers for non-derivative financial instruments; here, the total of financial assets represents the maximum credit risk exposure. In the case of derivatives, positive and negative market values may be netted under certain conditions. 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. Each invoicing company has appointed a responsible credit manager who regularly analyzes customers’ creditworthiness. Some of these receivables are collateralized, and the collateral is used according to local conditions. It includes credit insurance, advance payments, letters of credit and guarantees. Reservation of title is generally agreed with our customers. Credit limits are set for all customers. All credit limits for debtors where total exposure is €10 million or more are evaluated by local credit management and submitted to the Group’s Central Financial Risk Committee. To minimize credit risks, financial transactions are only conducted within predefined exposure limits and with banks and other partners that have investment-grade ratings. All risk limits are based on methodical models. Adherence to the risk limits is continuously monitored. Country risks relating to trade receivables, intra-Group loans and the creditworthiness of the countries themselves are continuously monitored, systematically evaluated and centrally managed.

Liquidity Risks

Liquidity risks – those arising from the possibility of not being able to meet current or future payment obligations because insufficient cash is available – are centrally managed in the Bayer Group. The Group holds sufficient liquidity to ensure the fulfillment of all planned payment obligations at maturity. Payment obligations result both from operating cash flows and from changes in current financial liabilities. 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 held 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 2013 out of liquidity and free operating cash flow.

Market Risks

Market risks relate to the possibility that the fair value or future cash flows of financial instruments may fluctuate due to variations in market prices. They include currency, interest-rate and other price risks, especially commodity price risks. We estimate market price risks by performing a sensitivity analysis for each category (such as interest rates) on the basis of hypothetical changes in risk variables (such as interest curves) to determine the potential effects of market price fluctuations on equity and earnings. We employ sensitivity analysis because it provides readily understandable risk estimates using straightforward assumptions (for example, an increase in interest rates). We continue to use market information and additional analytics to manage our risk exposure and mitigate the limitations of our sensitivity analysis. The assumptions and parameters used in sensitivity analysis are regularly reviewed. The sensitivity analyses provided in the following sections relate to the hypothetical loss in cash flows from the derivative and non-derivative financial instruments that we held as of December 31, 2012 and December 31, 2011. The range of sensitivities that we chose for these analyses reflects our view of the 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 eurozone, 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, the Canadian dollar and the Chinese renminbi. Recorded operating items, receivables and payables in liquid foreign currencies are normally fully hedged. The anticipated foreign currency exposure from forecasted transactions in the next twelve 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. We applied a hypothetical adverse scenario in which the euro simultaneously depreciates by 10% against all other currencies compared with the year-end exchange rates. Under this scenario the estimated hypothetical loss of cash flows from derivative and non-derivative financial instruments as of December 31, 2012 would be €256 million (December 31, 2011: €305 million). Of this €256 million, €127 million is related to the U.S. dollar, €32 million to the Japanese yen, €31 million to the Canadian dollar and €66 million to other currencies. Of the €256 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 equity under other comprehensive income (OCI). The offsetting position of €40 million is primarily attributable to account balances in foreign currencies.

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 or decrease in the future. Interest-rate risks are managed via 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 liabilities including derivatives as of December 31, 2012 amounted to €9,528 million (December 31, 2011: €11,663 million). The sensitivity analysis was performed on the basis of our floating-rate debt position at year end 2012, taking into account the interest rates relevant to our liabilities in all principal currencies. A hypothetical increase of 100 basis points, or 1 percentage point, in these interest rates (assuming constant currency exchange rates) as of January 1, 2012 would have raised our interest expense for the year ended December 31, 2012 by €46 million (2011 based on our floating-rate debt position at year end 2011: €68 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 may 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. The procurement departments of the subgroups are responsible for managing commodity price risks on the basis of centrally set requirements and limits. The operation of our production facilities requires large amounts of energy, mostly in the form of electricity and steam. To minimize our exposure to energy price fluctuations, we aim for a balanced diversification of fuels for steam production and a mix of external procurement and captive production for power generation.

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.