Risk Management In The Airline Industry - Essay Example

British Airways and Easy Jet: The airline was originally launched in 1919 and was nationalised in 1993 to form the British Overseas Airways Corporation. The airline was privatised in February 1987 and entered into mergers with various companies. At the end of 2008, the total revenues earned were 15,012 million dollars. As opposed to British Airways which is a larger corporation and a major fleet carrier, EasyJet is the largest low fare airline for leisure and business passengers, operating all over Europe (www.rati.com). It was incorporated in March 2000 and after a reorganization process in April 2000, it acquired the interests in the group subsidiaries of its parent company, Easyjet Holdings Ltd. The element of risk in the airline industry could include aspects such as the single loss of aircraft or a collision between two aircraft and insurers need to plan for such events. This is done through risk assessments carried out in-house by insurance firms or by Lloyds of London.(Elkasaby et al, 2003). For example, the Company carries out risk assessments by drawing up Realistic Disaster Scenarios, which specifically discuss the risks associated with aviation. Assumptions may be made, such as the assumption of a collision between two 747s occurring over a major U.S. city, the assumption of liability losses in amounts such as $1 billion US dollars per airline, which has recently been increased to a total of $4 billion. The scenario then computes that if such a disaster were to actually occur, it would produce losses which are equivalent to two and a half times the gross premium income of $1.5 billion from all the airline business worldwide (Aon, 2007). One of the most significant risks in the airline industry is the incidence of accidents, which have caused property damages and a high incidence of fatalities. The strategic and financial consequences of aviation accidents have been examined in several studies (Chance and Ferris, 1987; Walker et al, 2005). The risks associated with accidents are also attached to financial consequences such as insurance, operating on the principle that “the premiums of the many will pay the losses of the few.”(Viccars, 2001:xxxi). The insurance market functions in such a manner that the financial risks associated with accidents and the damages that occur, both to property and people, among insurers and re-insurers such that the extent of risk an individual insurer is exposed to is kept within acceptable limits. The trend towards consolidation has also meant that the number of participants in an insurance deal is limited. Aviation insurance differs from other kinds of insurance. First, only a limited number of risks are to be insured. For example, after several years of lacklustre growth, there was some expansion in growth rates in the industry in the year 2007 of about 11%, but even then the total insurable fleet values were about $670 billion (Flouris et al, 2009). Second, the insurance class is comparatively small in size as compared to other kinds of non-life insurance; for example, one example cited is that the cost of insuring all the airlines all around the world would approximately equal the cost of insuring plate glass in New York state (Viccars, 2001:xvi). One important characteristic of the airline industry is that it has a higher-than-average exposure to catastrophic events that could lead to accidents. (Viccars, 2001: xvi). As a result, the airline industry is characterized by risk insurance in large amounts for a single unit such as an individual jet airplane. Climate change is also expected to make insurance more expensive and much harder to get and this is also likely to affect the airline industry, because insurers would need to hold more capital in reserve in order to cover potential losses, which in turn could lead to a loss in availability of cover (www.dailyrecord.co.uk). British Airways versus Easyjet: As defined in British Airways’ annual report, the highly regulated and competitive atmosphere within which the airline industry functions has given rise to risks such as terrorist acts, pandemics and changes in government regulation (www.britishairways.com). The risk assessment group in the Company carries out detailed risk management reviews to ensure that wherever possible, those risks are mitigated. In the notes appended to its annual report of 2007/2008, the British Airways group has identified a series of risks the Company is exposed to. One of these is market risk, which includes foreign currency risks, interest rate risks and price risks, as well as credit risks and liquidity risks. The overall objective of the risk management program of British Airways is to understand the unpredictability of the financial markets and to minimise the potential adverse effects that could result to the group’s financial performance. In order to manage market risks, the Company enters into derivative transactions, all of which are carried out in accordance with guidelines that are set out and approved by the Board of Directors of the Company (www.britishairways.com). The Board sets out written principles according to which overall risks are to be managed and these principles also cover specific areas such as the use of derivative instruments and investments. Financial risk management is carried out by the Group treasury which identifies financial risks and takes the time and effort to evaluate them and then hedge them accordingly. The Annual report also sets out a table that demonstrates how sensitive financial instruments are to fuel price changes on profits before tax and equity, when other variables are kept constant. This table is provided below as follows: Group   Company 2008 2007   2008 2007 Increase/decrease in fuel price per cent Effect on profit before tax £ million Effect on equity £ million Effect on profit before tax £ million Effect on equity £ million   Increase/decrease in fuel price per cent Effect on profit before tax £ million Effect on equity £ million Effect on profit before tax £ million Effect on equity £ million 10 14 166 6 70   10 14 166 6 70 (10) (11) (163) (11) (59)   (10) (11) (163) (11) (59) The price risk management strategy provides the airline with protection against sudden increases in oil prices, while also ensuring that the airline is not placed at a disadvantage in any serious way if prices tend to fall. As a part of this strategy, the risk management programme allows for the use of derivatives that are available over the counter. The British Airways group may also be exposed to foreign currency risks on revenues that are set out in currencies other than sterling, such as euros, U.S. dollars or Japanese yen, although the and the Company has been able to generate a surplus in most of the currencies in which it does business. Foreign exchange rate movements can give rise to either beneficial or adverse effects. Therefore, in order to mitigate the effects of foreign exchange fluctuations arising out of individual transactions, both receipts as well as payments are matched in the individual currency. If any surpluses of convertible currencies are available, then they can be sold either as spot or forward, for U.S. Dollars or for sterling. A large part of the liabilities of the Company are denominated in yen and U.S. dollars, however these liabilities and yen repayments of debt are used as a hedge against future yen and dollar revenues. The report has also set out a table identifying the sensitivity of financial instruments to changing currency rates: Strengthening/ (weakening) in US dollar rate per cent Effect on profit before tax £ million Effect on equity £ million Strengthening/ (weakening) in Japanese yen rate per cent Effect on profit before tax £ million Effect on equity £ million Strengthening/ (weakening) in euro rate per cent Effect on profit before tax £ million Effect on equity £ million Group                   2008 10 (4) (42) 10 (7) (57) 10 (2) (26)   (10) 3 32 (10) 5 47 (10) 2 22 2007 10 (8) (49) 10 (8) (49) 10   (11)   (10) 7 36 (10) 6 40 (10)   10 Company                   2008 10 (6) (42) 10 (7) (57) 10 (2) (26)   (10) 5 32 (10) 5 47 (10) 2 22 2007 10 (10) (49) 10 (8) (48) 10   (11)   (10) 8 36 (10) 6 40 (10)   10 Easy Jet: In the case of EasyJet, most of its holdings held by its subsidiary companies are functionally assessed in terms of U.S. dollars because this is the currency of funding and aircraft that are acquired are sold approximately within a seven year period. When the accounts are prepared, these dollar amounts are converted into pounds sterling and the overflow amounts at the end of each financial period are transferred into consolidated reserves (www.easyjet.com). Similarly, the net assets of all overseas subsidiaries are also converted into pound sterling and differences arising as a result of foreign currency exchange rate fluctuations are passed into the consolidated reserves. Amounts borrowed in foreign currency that hedge on foreign currency assets are also transferred into the consolidated reserves. In cases where the borrowing in foreign currency is used for the purpose of funding foreign equity transactions, then any overflows after currency conversions have taken place at existing rates are transferred into the consolidated profit and loss account. Hence, it may be noted that Easyjet’s policy with regard to foreign currency fluctuations is to transfer surpluses and overflows into consolidated reserves or a consolidated profit and loss account and held in storage until the time they are needed. British Airways on the other hand, does not generally store its overflows from foreign exchange conversions, but tends to sell them immediately as spot or forward payments, except for yen and dollar debts which are used as a hedge against future revenues in the same currencies. In the case of Easyjet, most assets held by the Company, i.e., up to 70%, are in U.S. dollars, as a result, the Company’s balance sheet is affected by fluctuations in exchange rates. In order to avoid the repercussions and losses arising out of such currency fluctuations, all borrowing activity of the Company is also retained in the same currency as the assets, i.e, in U.S. dollars. In the case of British Airways, the risk assessment program provides for losses incurred as a result of rise in fuel prices by using derivatives available over the counter. Easyjet however, follows the same principle it uses in dealing with foreign currency fluctuations. i.e., it works predominantly with U.S. dollars. Since international fuel prices are denominated in U.S. dollars, easyjet’s fuel pricing is subject to both fuel price fluctuations as well as exchange rate fluctuations. But the Company does not resort to hedging to manage these risks. References: AON, 2007. “Airline insurance market review: Pre renewal season 2007”, London: Aon Global aviation. Chance, D., and S. Ferris, 1987. “The Effect of Aviation Disasters on the Air Transport Industry: A Financial Market Perspective”, Journal of Transport Economics and Policy, 21: 151-165 “Climate change risk to insurance premiums”, Retrieved November 10, 2009 from: http://www.dailyrecord.co.uk/news/business-news/2009/11/04/climate-change-risk-to-insurance-premiums-86908-21796697/ “Easyjet plc: Directors report and consolidated financial statements”, retrieved Novembver 11, 2009 from: http://www.easyjet.com/en/news/1999-2000results.pdf “Easy Jet”, Retrieved November 10, 2009 from: http://www.rati.com/frameset/frameset_f.asp?u=rzG4K4yJJEG&p=HJr4FDzy3G&target=../news/news.asp Flouris, Triant, Hayes, Paul, Pukthuanthong-Le, Kuntara, Thiengtham, Dolrudee and Walker, Thomas, 2009. “Recent developments in the aviation insurance industry”, Risk management and Insurance Review, 12(2): 227-250 British Airways Annual report 2008: Notes to the accounts. Retrieved November 11, 2009 from: http://www.britishairways.com/cms/global/microsites/ba_reports/notes/note30.html “Principal risks and uncertainties”, Retrieved November 11, 2009 from: http://www.britishairways.com/cms/global/microsites/ba_reports0809/pdfs/Risks.pdf Viccars, P., 2001. “Aviation Insurance - A PlaneMans Guide”, London: Witherby & Co Walker, T., D. Thiengtham, and Y. Lin, 2005. “On the Performance of Airlines and Airplane Manufacturers Following Aviation Disasters”, Canadian Journal of Administrative Sciences, 22: 21-34 Read More