REPORT ON RISK MANGEMENT OF AIR CANADA SUBMITTED TO : MRS. VANDANA MEHROTRA SUBMITTED BY: KUNAL KOTHARI MOHITA AGARWAL SAIMA AHMED APURV SHARMA NAINA SINGH SONAKSHI RATHI AIR CANADA- RISK MANAGEMENT INTRODUCTION: Colin Rovinescu, the Chief Executive Officer (CEO), for Air Canada was reviewing the Risk Management program of the company because the scheduled board meeting was approaching soon. He needed to deliver a comprehensive presentation in front of the board members. CHALLENGES FACED BY THE AIRLINE INDUSTRY: An Airline is a business providing a system of scheduled air transport.
Also called airway. Airline industry is the business of transporting paying passengers and freight by air along regularly scheduled routes, typically by airplanes but also by helicopter. The industry faced several challenges which it had to resolve. They are as follows: * Attack on WTC and Pentagon: The attacks on World Trade Centre and Pentagon, very well known as 9/11 led to decrease in confidence of people. The mindset of people changed to “if US can be attacked then nothing is safe in the world”. This mindset led to less number of people moving towards Air Transport. Increasing cost of operation: An increase in air traffic and number of new airport terminals drove up the landing fee of airlines impacting the overall operating cost and profitability of the Airline Industry. * Increasing fuel: Increase in prices of crude oil from $27 to $133 had a major impact on the profitability of the industry. The sudden increase in fuel prices left the industry in a fix and increased the cost of the industry by many folds as fuel accounts for around 30-40% of the total operating expenses. Health related issues: Health related concerns had also interrupted the international travel. SARS in 2003 and Influenza in 2009 created a fear in minds of travelers of being infected. As it is known that people from much demography fly together and apparently the risk of getting infected also increases. This also added to the woes of the Airline Industry. * High fixed cost: The nature of fixed cost in the sector also alluded to the woes of the Airline sector. The leasing cost for the equipment was 5 to 10% of the total expenses and labor accounted for another 30% of the expenses. Declining trend of projected consumer spending on Air travel: The projected yearly spending in us by consumer on Air travel by IBID provided a rare opportunity for optimism in the airline industry. The state of global economy also remained a major concern. AIR CANADA: A BRIEF DESCRIPTION: In 2001, Air Canada acquired its largest rival Canadian Airways to become the 8th largest Airline in the world. After the merger, there started the problems for Air Canada. The basic challenges were to integrate two types of fleets, labor relations and Information Technology Systems.
Over-all to integrate two types of companies. This resulted in the degradation of customer services and the problems became bigger than their anticipations. Air Canada was falling short of finance. Hence, it filed consumer protection in April, 2003. In September, 2004 it emerged from bankruptcy protection with the help of $850 million financing package from Deutsche Bank. There was a condition laid by the bank which was the further reduction in costs and the agreement on this condition made this package available to them.
Since, the years of restructuring Air Canada focused on customer service, cost cutting and improving revenue. Between 2004-07, Air Canada earned operating profits but due to deteriorating economy, they turned into losses. In 2010, finally came the time for improvement in result and then Air Canada started earning sufficient revenue. During this time the focus was shifted to four key initiatives for better future. They were: I. Expanding international operations- Operating globally II. Generating incremental revenue and significant cost savings- Optimal cost solutions III.
Refocusing on customer service and promoting premium cabin- Customer Satisfaction IV. Fostering a culture of change- During this time, the operating losses had turned into income and the primary reason was an increase in demand. The demand of premium cabin was near about half the $256million increase in sales. THE BOARD: The board consisted of the leaders of their own fields. It included physicians, lawyers, politicians and some of the former CEOs of airline industry. The board was relatively new and the most severe member had been there for four years.
The risk management was the major issue which attracted most attention of the board and they dedicated more time on attention n risk management since the financial collapse. TYPES OF RISK: Risk management is a much broader process in aviation industry. It includes basically solutions to the various risk factors. They are as follows: * Catastrophic Risk: Despite flying being the safest form of traveling, catastrophic risk is attached with the aviation industry because if any unforeseen circumstances take place then major monitory damages happen.
It lies in the LOW FREQUENY-HIGH SEVERITY zone. This type of risk is usually transferred to the third party through insurance. The entire commercial aircraft is insured in about $100 million to $250 million. * Operational Risk: It includes all the major and minor processes taking place in the company. It included: trained Human Resources, strong IT Infrastructure, management and repair of equipments. The risk involved has low severity. FREQUENCY SEVERITY ANALYSIS MATRIX: In Air Canada, Rovinescue was able to transfer the second quadrant risk through the aircraft insurance.
He was not much worried about the third and fourth quadrant risk. He was able to manage them. He was indeed concerned about the first quadrant risk of HIGH SEVERITY-HIGH FREQUENCY. Rovinescue believed they had no control over the changes in oil prices, stock prices, weather changes, foreign exchange and interest rates. The risk management program was based on dealing in such issues. RISK MANAGEMENT BY AIR CANADA: Fuel prices were the most commonly hedged expense within the airline industry.
Because fuel comprised between 20 to 30 per cent of all expenses, a small change in the expected fuel rates often meant a difference between profits and losses. For example an increase in the cost of fuel of $1 collectively cost the US Airline Industry $425 million as an additional cost per year and to overcome this problem the airlines that were well-financed and had strong cash flows hedged 86% of their Jet fuel needs. Air Canada also hedged 34% of its anticipated purchases of jet fuel. The second risk faced by Air Canada was the interest rate risk.
The problem occurred because Air Canada’s interest expense was greater than its operating income and any change in the rate of interest could help the company to generate profits or increase its losses. Therefore, Air Canada’s policy was to have 60% of its long term debt on a fixed interest rate and the rest 40% on floating rate. The third risk faced by Air Canada was the foreign exchange risk. Majority of the revenue of Air Canada were in Canadian Dollar whereas most of its expenses were in US dollars. To overcome this problem Air Canada used to convert all its Non- Canadian Dollars into US Dollars.
The fourth risk faced by Air Canada was that it had begun to purchase forward contract on its own stock to cover its exposure from Performance Share Units (PSUs). Each PSU entitled employees to receive a payment in the form of an Air Canada common share or cash on the basis of market value of share. CONCLUSION & ANALYSIS * Given the various approaches and policies followed by Air Canada to solve the various problems faced in the past, there arises a question whether Air Canada’s policies were appropriate. According to our study the past policies were not able to bring huge profit amounts to the company but were still able to bring the company’s position to a temporary stable point in the year2010. If the policies would have been wrong then the company would have been in jeopardy. * The policies focused on cost cutting, reducing capacity and managing the risk from pending labor contracts and the pension solvency deficit. * The current risk management policies at Air Canada allowed for the use of derivative financial instruments only for risk management purposes, not for generating profit. The acquisition of the company was not a problem but the company faced the problems because of the events of September 11, 2001, as they didn’t get sufficient time to establish the acquisition. * The company’s interest expense was greater than its operating income and any change in rates could help generate a profit or expand its losses. * As can be seen in the financial statement of the company, the company’s property and equipment grows from $5892 million to $6369 million, due to which the cash of the company decreased and there wasn’t enough profits to maintain the cash amount of the company.
SUGGESTIONS: * After mentioning the policies of the company, there are some measures to improve the position of the company. * At the time of acquisition, the most important point which the company ignored was the managerial differences among the two. The merger of the two airlines created a unique operational challenge as Air Canada attempted to integrate two very different fleets, two approaches of labor relations and two information technology systems. As a result, customer service quickly deteriorated.
In order to avoid this deterioration, the company should have focused on the training and orientation of the employees so as to train them the customer services methods followed by the company. * As the managerial situations of the companies differ they should have focused on bringing them together and maintain the trust of public in the company and its services. * Another point which should have been focused was while cost cutting, the company should keep in mind that the services to customers should not suffer and the level of the services should be maintained. To cover the foreign exchange exposure, the company converted all non-Canadian revenue to U. S. Dollars, but this strategy covered only 29 percent of the foreign exchange exposure. The company should have taken further steps to cover the maximum percent possible through a financial derivative. * Air Canada was to have 60% of its long term debt on fixed interest rate and 40% on floating rate, whereas to earn more profits the fixed interest rate should have been increased and the floating rate should be decreased.