As an international aviation company Lufthansa is exposed to both company and sector-specific risks. Our permanently updated management systems enable us to identify risks and opportunities at an early stage and act accordingly. The risk strategy remains unchanged
and allows us to take advantage of business opportun-ities as long as a risk-adjusted return can be realised on market terms and the risks are appropriate and acceptable.

 

The deliberate management of risks and rewards is an integral component of corporate leadership and decision making. There is, therefore, no independent organisational structure for risk management. The system enabling risks to be identifi ed and managed at an early stage is composed of several building blocks. These modules are systematically linked and embedded in the organisation.

 

The Risk management committee (RMC) ensures that risks are continuously identified and evaluated across functions and processes on behalf of the Executive Board. The RMC is responsible for the ongoing development of the risk management system and for maintaining its effectiveness and efficiency. The RMC's most important tool for doing so is the risk map. It documents all material risks which could endanger the results and the existence of the Company, and lists the instruments for managing risks. Risks count as material if they are capable of causing damage of at least one third of the earnings necessary for maintaining the value of the Company. For 2007, this value was put at EUR 260m.

 

The risk map is updated regularly and was fully revised in 2007. Its structure is now more closely oriented towards the risk management process: identification, coordination, communication and control.

 

Lufthansa has laid down comprehensive guidelines in order to guarantee uniform risk management standards across the Group. The managing directors of all Group companies also appoint risk managers in all business segments. They are responsible for implementing
the Group guidelines within their respective companies and are in close, regular contact with the RMC.

 

Opportunity and risk controlling in the course of the planning and coordination processes is a further component of the system. This primarily identifies the potential risks and opportunities which could impact earnings targets as part of an analysis of the market and
the competitive landscape.

 

The Opportunity and Risk Report, which was introduced in 2007, tracks recognised opportunities and risks throughout the year in relation to planned earnings. Potential departures from plan are quantified by the risk experts in order to focus attention on the most important risks. A discussion of risks and opportunities is also a fixed element of the regular meetings between Group controlling and the managing directors of Group companies.
Finally, risks and rewards are also examined in separate meetings with departments exposed to risk.

 

The risk management system for financial instruments is part of centrally coordinated financial management and is described in Notes to the consolidated financial statements. Pricewaterhouse-Coopers Aktiengesellschaft Wirtschaftsprüfungsgesellschaft
(PwC) has audited the early-warning system in place for risks at Deutsche Lufthansa AG. It conforms to the requirements to be made for such systems.

 

9.2 Risk categories and individual risks

The Lufthansa Group recognises the following risks, in particular, in accordance with the categories in the risk map.

 

9.2.1 Sector-specific opportunities and risks

 

Market & competitive risks affecting capacity and load factors The Lufthansa Group operates in a highly competitive environment. The pressure of competition has increased in all business segments over recent years. New competitors are coming onto the market with new business models and better cost structures, both in European and intercontinental traffic.

 

Lufthansa confronts this competition with a diversified and high-quality range of products and services, which are described in detail in the separate segments.

 

To combat deterioration of market share in the price-sensitive customer segment in Germany and Europe, Lufthansa expanded its "betterFly" products. Thanks to these special offers, we have been able to raise passenger numbers considerably and to achieve higher load factors for the available capacities, especially in times with less demand.

 

International competition is also developing into a competition between entire systems of airports, air traffic control and airlines, as these have a considerable effect on the location's effi ciency and thereby on the competitiveness of the airlines stationed there. Lufthansa has always emphasised the importance of infrastructure. The "German air transport initiative"
has created a common platform in collaboration with airports, air traffic control and public authorities. The planned extension of the runway and terminal system at Frankfurt Airport, for example, is a prerequisite for securing its current position as a leading air transport
hub in the future. For Lufthansa, the extension also represents the opportunity to implement extensive product and process improvements.

 

The new "Open Skies" agreement between the USA and the EU creates both opportunities and risks for Lufthansa . The decision to allow airlines from EU member states and the USA unfettered access to each other's airspace will add considerably to competition in transatlantic traffic and put greater pressure on prices. At the same time, it will give rise to new potential in neighbouring markets which Lufthansa intends to watch closely and use to the best advantage.

 

In this competitive environment alliances and more in-depth forms of cooperation play an increasingly important role. Star Alliance remains the leading association of its kind with the widest offering. Lufthansa adds to Star Alliance's global offering by developing targeted
regional cooperations. Air China and Shanghai Airlines joined Star Alliance at the end of 2007, for instance. A good example of a more in-depth form of cooperation including a capital investment is the successful integration of SWISS.

 

Finally, Lufthansa has the customer loyalty programme Miles & More, which has proven its worth over many years. Its range of offers is refined continuously, as evidenced not only by ever-growing membership figures but also by the attraction of the HONCircle.

 

In competition, constant improvements to the cost structure are vital. The Group initiative "Upgrade to Industry Leadership", among other things, develops and implements ways of achieving this. The new Group programme continues Lufthansa's policy of constant improvements, with the aim of making up for sinking prices by having lower costs.

 

Despite several years of uninterrupted growth, worldwide air traffic remains exposed to strong cyclical fluctuations in demand. Given the boom in new aircraft orders, we anticipate increasing overcapacities in many market segments in the years to come. The rocketing
growth planned in the Gulf region and additional longhaul capacities expected from the US carriers, who have now completed their turnarounds, will pile on further competitive pressure. A slowdown in the economy would exacerbate this trend. Competitiveness under these conditions depends, primarily, on how fast a company can react to changes in demand. Keeping costs variable is therefore extremely important and can be absolutely decisive. The fi rst point is the ability to adjust aircraft capacities to changes in demand. A far-sighted
order policy, with phased orders for new aircraft and the option of replacing a number of older aircraft at any time with new deliveries, gives Lufthansa the necessary flexibility to deal with cyclical variations.

 

We have also managed to make staff costs more flexible thanks to the wage settlements for ground, cockpit and cabin crew reached in the "concerted campaign" with the collective bargaining partners. In order to react rapidly to fluctuations in demand and better redress the financial consequences, the Group is still keen to agree on competitive wage settlements, tailored to the specificities of the segments and with new pay scales, for all its business segments.

 

Legal risks and contingencies New laws and changes to national and international regulations also have a major effect on Lufthansa's future business success. Air traffic rights, safety regulations as well as compliance, capital market and competition law all play an important
role. Current legal changes which could affect the course of Lufthansa's business are described in the "Regulatory and legal environment" chapter. In addition to existing regulations, Lufthansa has established a compliance programme. Information on
this can be found in the "Corporate governance".

 

Political, geopolitical and regulatory risks The aviation industry is subject, to a very high degree, to geopolitical events such as wars, terrorist attacks or pandemics. Lufthansa's earnings position can also be negatively affected by political decisions, for example, by eliminating or creating distortion of competition.

 

The planned introduction of an emissions trading scheme at EU level would have a considerable impact on the market and competitive position of the air transport industry in Europe, for example. Furthermore, the earnings positions of Lufthansa can be affected by a restrictive regulation of night flights at Frankfurt Airport. For available capacities to be used economically and in line with demand, a practicable arrangement for night flights is indispensable. The official approval of the plan on expanding airport capacity was taken in late 2007. It allows for substantial increases in capacity, but also restricts the number of flights taking place between 11 p. m. and 5 a. m. to 17. In contrast to other international hubs, this means that Frankfurt deprives itsself of long-term growth opportunities. On 8 February 2008, Lufthansa appealed against this decision in compliance with the statuary time limit.

 

The management of geopolitical risks must concentrate on dealing with the consequences after the event. Our emergency response programme Security and Reliability, forms the basis for minimising the consequences of an incident for all involved. The individual steps are adapted in response to ongoing developments and are laid down in an Emergency Response and Action Plan (ERAP).

 

Continued reluctance on the part of insurance companies makes it more difficult for aviation companies to insure themselves effectively against terrorist attacks. Specialised insurers now only offer limited insurance coverage for damage to aircraft. As this insurance cover is not obligatory for an airline's operating licence, there is no danger of planes being grounded because of it. Proposals for new terms in third-party liability insurance contracts have been developed in coordination with the aviation industry. These should ensure an acceptable
level of limited coverage for third-party liability instead of the current total exclusion.

 

The draft amendment to the Rome Convention, presented recently by the International Civil Aviation Authority in Montreal, is much more severe. The amendment is intended to govern the fundamental liability of an aircraft operator for damages to persons and property caused by terrorist attacks involving the use of an aircraft, as suffered by third parties not involved in air traffic. Particularly worrying is the attempt to make the aviation industry unilaterally liable for damages due to terrorist attacks by instituting a strict third-party liability regardless of fault. This is unacceptable, not least because the target of potential terrorist attacks is generally the community of states and the social community but not private aviation companies. Furthermore, it is not logical that aviation should be singled out among competing forms of transport and discriminated against.

 

9.2.2 Company-specific opportunities and risks

 

Strategic opportunities and risks A dense global network is a strategic success factor in the growth sector air transport. Together with their Star Alliance partners, the airlines in the Lufthansa Group have the largest network in the world. Systematic network and alliance management enable Lufthansa to identify risks at an early stage and make effective use of opportunities. The enlargement of the EU to the east gives all business segments the
chance for further growth and the Group also sees good prospects in the growth markets China and India.

 

Lufthansa intends to play an active role in the consolidation of the industry currently underway. The operating performance and financial profile of acquisition targets can also give rise to opportunities and risks.

 

To maintain Frankfurt's competitiveness as an air transport location in the future, Lufthansa and the airport operator Fraport have formed joint working groups to take specific action on influencing the development of airport charges. Fraport has continued the necessary
steps to improve performance at the airport terminals. Close cooperation between Lufthansa's station management and Fraport enables negative influences on flight operations to be reduced. These can still lead to temporary inconveniences in passenger check-in procedures, however.

 

Bottlenecks in the fragmented European air traffic control system are a serious problem. They still result in considerable delays to air traffic, unnecessary detours, holding periods, increased fuel consumption and avoidable emissions. These shortcomings depress the results of all European airlines and also jeopardise growth in air transport. Lufthansa and its competitors are, therefore, continuing to demand from the European Commission and national governments to create an effective European air traffic control system.

 

Staff For the Lufthansa Group to grow and improve its results it is vital to attract qualified new staff and strengthen the commitment and performance of our existing employees. Lufthansa has to compete ever more keenly for highly qualified specialists and managers.

 

One way in which we address this challenge is by maintaining close contacts to universities and using recruitment programmes specially tailored to our requirements. Attractive personnel development policies and performance-related pay form the basis for attracting
and retaining staff.

 

Given the cyclical nature of air transport, there are risks involved in wage settlements which restrict the Company's flexibility. Together with our collective bargaining partners, we are endeavouring to reach settlements in the upcoming round of negotiations which are  acceptable to all sides.

 

Information technology In many areas, Lufthansa's business processes are supported by the use of IT systems. The risks this engenders are controlled by active IT risk management. The security concepts and the need for protection are based on how critical the corporate processes are for the Company and the extent to which they are supported by IT.

 

Any identified defects are dealt with by organisational and technical means in order to reduce risk. The supporting of these means is being monitored by the corporate Audit department.

 

The Lufthansa Group's IT security policy recognises the new demands made of IT security management. These mainly arise from different threats and advances in IT technology. A corporate information security officer at Group level and information security officers within
the business segments are responsible for adapting the security regulations. The implementation of IT security regulations in the Group companies is carried out by the
information security offi ces. These precautions enable us to maintain an appropriate degree of IT security and to reduce risk to an economically viable extent.

 

Quality Factors such as brand image and product quality based on innovative new developments are becoming more and more important for achieving the desired price
level in the market. In the face of rising price pressure, it is absolutely vital to maintain Lufthansa's quality standards and to increase efficiency at the same time.

 

Communications Like any large company, Lufthansa is also exposed to communications risks. In the fields of public relations and capital market communications, specialised departments have been working professionally for many years to provide the right information to the appropriate parties at short notice. Furthermore, an overarching Ad Hoc Committee, made up of the general counsel and the heads of Investor Relations and Corporate Communication, reviews all events to determine their relevance for ad hoc publication.

 

Accounting Numerous national and European regulations and statutory provisions apply to the preparation of Lufthansa's financial statements, as for all publicly listed companies in Germany. More information on their application can be found in the Corporate governance.

 

Operational risks Like any airline, Lufthansa also has potential risks relating to flight and technical operations. A clear system of responsibility allocated throughout the Group enables these risks to be systematically identified, controlled, communicated and monitored. A
wide range of instruments are used for doing so, which are permanently refined in close collaboration with Lufthansa Flight Training GmbH.

 

9.2.3 Financial opportunities and risks

 

As an international aviation group, the Lufthansa Group is faced with the risk of changes in fuel prices, interest rates and exchange rates. The principally conservative approach towards fi nancial and commodity risks is reflected in a systematic risk management. We use suitable
management and monitoring systems to do this, with which we measure, control and monitor the risks. Lufthansa uses internal guidelines which are laid down by the Executive Board and permanently developed. The Group Financial Risk Controlling and Corporate Audit departments monitor compliance with the guidelines. Furthermore, the current hedging policies are also permanently discussed in management board meetings across the business units. The Supervisory Board is regularly informed of the amounts at risk. Detailed information on currency, interest rate and fuel price hedges can be found in Notes to the consolidated financial statements.

 

Derivative financial instruments are used exclusively for hedging underlying transactions. The market value of the derivatives must, therefore, be seen in connection with the hedged items. The primary aim of fuel price and exchange rate hedges is to reduce earnings volatility. This is achieved by forming average rates as part of a "layered hedging" approach. The aim of interest rate risk management is to reduce interest expenses while minimising their volatility at the same time. For the management of the general risk of changes in interest rates, Lufthansa uses the mostly contrary movements of the operating result (natural hedge) while at the same time minimising average long-term interest expenses.

 

All positions underlying hedging transactions are tracked in a treasury system and can be valued at any time. These transactions are only closed with banks that have at least a long-term "BBB" rating or similar. A limit is set for every bank dependent on its rating, and adherence to the limits is permanently monitored.

 

Fuel price risks The Lufthansa Group's annual fuel consumption amounts to some 8.3 million tonnes of kerosene. It is a major item of expense, making up around 17 per cent of operating expenses for the Group. Severe fluctuations in fuel prices can, therefore, have a
considerable effect on the operating result. Lufthansa applies a rule-based fuel price hedge with a time horizon of 24 months, in order to reduce these fluctuations. The diagram illustrates the Lufthansa Group's hedging policy.

 

Hedging transactions are predominantly for crude oil, supplemented, if possible, by the price difference between kerosene and crude oil.

 

Lufthansa uses standard market instruments such as forward contracts and options for its fuel price hedges. We hedge 5 per cent of planned consumption per month in Brent collars, up to a hedging level of 90 per cent and with a lead time of 24 months. The hedging transactions are, therefore, based on fixed rules and map the average of crude oil prices over time. The six months following a given date are therefore hedged to 90 per cent.

 

The hedging of crude oil prices is supplemented by hedges for the price difference between crude oil and kerosene, known as crack. The kerosene price is largely a function of the price for crude oil, but it is also subject to market movements of its own. These depend mainly
on changes in refinery capacities and variations in prices between different petroleum products. The market for crack is not liquid, however, which makes hedging crack expensive. The system has therefore been refined in such a way that, in the ideal scenario, the regular
crude oil hedges are combined with short-term hedging for crack by means of spread options. In this model a crack hedge for 7.5 per cent of consumption per month is added for months 1 – 6, which leads to a hedging level of 45 per cent. Due to the high fuel prices and
low market liquidity in recent months, the rule-based minimum hedging amount for crack has currently been suspended.

 

At the reporting date there were crude oil hedges for 81 per cent of the forecast fuel requirement for 2008, in the form of spread options and other hedging combinations.
For 2009, around 23 per cent of the forecast fuel requirement was hedged at the reporting date.

 

The fuel surcharge has established itself in the market as a further means of reducing risk. It is uncertain, however, to what extent the fuel surcharge can be maintained if fuel prices continue to rise, or the economy slows down markedly.

 

If fuel prices were to drop by 20 per cent below their year-end 2007 level, expenses for the Lufthansa Group would be reduced by EUR 520m. This benefi t would, however, be partly forfeited due to the put options sold and fuel surcharges reduced as part of the hedging policy.

 

As fuel is priced in US dollars, fluctuations in the euro / US dollar exchange rate can have a positive or a negative effect on fuel prices in euros. This is accounted for under Currency risks (see Note 48 to the consolidated financial statements).

 

Currency risks International ticket sales, fuel purchases, the procurement of aircraft and spare parts, and other transactions give rise to foreign currency risks for the Lufthansa Group. All subsidiaries report their currency exposures to the Group over a time horizon of 24 months. At Group level, a net position is aggregated for each currency in order to take advantage of "natural hedging". Of the 56 currencies in use within the Lufthansa Group, 16 are actively managed. The most important currencies are USD, JPY and GBP. Currencies highly correlated with the US dollar are set off against operating USD exposure.

 

Operating exposure and other information on hedging general currency positions and hedging currency risks from aircraft investments can be found in Note 48 to the consolidated financial statements.

 

Liquidity and interest rate risks Having sufficient liquidity at all times is of crucial importance for Lufthansa. We therefore use a financial reporting system which provides all companies majoritarily owned by the Lufthansa Group with centralised information on the actual financial status and expected cash flows. To safeguard our payment obligation, we maintain a strategic liquidity reserve of EUR 2bn, available at any time.

 

Financing the Group's business also gives rise to interest rate risks. The total amount financing outstanding is EUR 3,345m. Lufthansa aims to have 85 per cent of its borrowings at variable interest rates. This reduces interest expenses and minimises earnings volatility.

 

Additional information can be found in Note 48 to the consolidated financial statements.

 

Financing risks Growth plans and the accompanying capital expenditure require financing, the availability of which can be limited by the borrower’s credit rating or external factors (e.g. a liquidity crunch).

 

Lufthansa has investment-grade credit ratings from both rating agencies Standard & Poor's and Moody's. These ratings mean that Lufthansa meets a key requirement for accessing capital markets. Lufthansa is currently one of only two European airlines to hold an
investment-grade rating.

 

In addition, a high position of 70 per cent of the Lufthansa Group's aircraft are unencumbered, which enables them to be used as collateral for other financing arrangements. Lufthansa also has long-term relationships with a large number of banks and has used its creditor relations activities to build even greater confidence with banks and the capital markets. In past crises these banks have already been reliable partners for
Lufthansa . This also meant that the general liquidity and banking crisis of 2007 did not affect Lufthansa in terms of aircraft financing.

 

Credit risks The sale of passenger travel and freight documents mostly takes place via third parties. The creditworthiness of the third parties involved is continually reviewed and, in some cases, is secured by guarantees or similar instruments.

 

The aim of the counterparty limit methodology in place at Lufthansa is to assess and control the default risk of counterparties. A maximum acceptable risk is determined for each counterparty. This is primarily derived from the rating given by recognised rating agencies. For oil companies without a rating the maximum credit limit is generally EUR 20m.

 

The extent to which counterparty limits are taken up by existing financial market transactions is calculated and reported daily. If limits are exceeded, an escalation procedure comes into play, requiring decisions to be taken on the action needed. Additional information and the credit risk positions existing at year-end 2007 can be found in Notes to the consolidated financial statements.

 

Market risk from capital investments Capital investments are made in the course of the strategic minimum liquidity, the operational liquidity and the Lufthansa Pension Trust.

 

The risks from capital investments made to ensure strategic minimum liquidity result mainly from market risks for interest rates, credits and shares. In order to maximise the return for a given risk, the structure of the investment portfolio has been determined with the help
of an optimisation study. The basic assumptions and parameters are Lufthansa's conservative general investment principles as approved by the Executive Board. The aim of the study was to determine a portfolio with a diversified risk profile.

 

As a result of the study the majority of the strategic minimum liquidity was invested in low-risk products. Part of the investments was secured by capital guarantees. The investments are divided into different investment horizons, so that the products have a differentiated risk
profi le. The entire strategic minimum liquidity can be liquidated within four weeks. All investments are made by external managers, primarily via a special fund vehicle with mandates for various asset classes and by means of promissory notes. There are precisely defined investment guidelines for each asset class, which take account of the general investment principles. Lufthansa monitors the investments by means of daily and monthly
performance and risk reports.

 

Capital investments to ensure operational liquidity are made in accordance with the Group financial guidelines. The maximum investment horizon is twelve months. At least EUR 300m must be held for withdrawal on a daily basis. Assets can be held in overnight and fixed-term deposit accounts, daily realisable money market funds and short-term securities. Direct investments in securities require that the issuer is rated BBB or better. Up to 20 per cent of investments may be rated below A –.

 

Investments of the Lufthansa Pension Trust (CTA) are also subject to the Company's general investment principles.

 

Lufthansa has not invested directly in the American subprime mortgage market. Nevertheless, Lufthansa's strategic liquidity portfolio does include asset-backed securities (ABS, approx. 11 per cent), which suffered markdowns in connection with the financial crisis. None of the instruments in which Lufthansa has invested has reported defaults, however. Lufthansa's pension fund and its operational liquidity reserve are not invested in ABS or similar investment products.

 

For the Lufthansa Group, there is no major change in the risk situation and in potential opportunities compared with the previous year. Opportunities and risks are essentially determined by macroeconomic factors and ever-increasing competition in all sectors.

 

In agreement with most financial institutions, we are assuming that the global economy will continue to grow despite the property crisis in the USA, but that growth will be at lower rates. Given these prospects, we expect demand for Lufthansa's services to remain on high levels. At the same time, overcapacities and, therefore, price pressure are anticipated in the medium term, which could be accompanied by high fuel prices or more extreme swings in the economy. Lufthansa endeavours to make up for any resulting loss of income by cost reductions beyond the relative savings expected as a result of growth.

 

Lufthansa is a financially sound company and, therefore, has good chances of benefiting from further growth in the air transport sector. A high degree of financial flexibility also allows us to address the changes that competition will bring and to use them.

 

Taking all known facts and circumstances into account, there are currently no risks which could jeopardise the Group's existence in the foreseeable future.