Risk management

The Managing Board is responsible for risk management in the Company and has designed and implemented a risk management system. It is the aim of the system to ensure that the extent to which the strategic and operational objectives of the Company are being achieved is understood, that the Company’s reporting is reliable and that the Company complies with relevant laws and regulations.

The most important risks identified, as well as the structure of the aforesaid risk management system and aspects of its further development are discussed below and in the section on risk management in the Annual Report.

Internal representations received from management, regular management reviews, reviews of the design and implementation of the Company’s risk management system and reviews in audit committees are integral parts of the Company’s risk management approach. On the basis of these, the Managing Board confirms that internal controls over financial reporting provide a reasonable level of assurance that the financial reporting does not contain any material inaccuracies, and confirms that these controls functioned properly in the year under review and that there are no indications that they will not continue to do so. The financial statements fairly represent the financial condition and result of operations of the Company and provide the required disclosures.

It should be noted that the above does not imply that these systems and procedures provide absolute assurance as to the realization of operational and strategic business objectives, nor that they can prevent all misstatements, inaccuracies, errors, fraud and non-compliances with rules and regulations.

In view of all of the above the Managing Board believes that it is in compliance with recommendation II.1.4. of the Dutch corporate governance code, taking into account the recommendation of the Corporate Governance Code Monitoring Committee on the application thereof.

All risks that were identified during the strategy development and implementation planning phases were addressed in 2006, and a renewed risk assessment was performed at corporate level. The possible erosion of the profitability of existing businesses as a result of intense global competition was seen as the main risk that needs to be given due attention in the strategy implementation process. Risks that were identified at the operational level are listed in the Risks section below.

In 2006, the implementation of the Corporate Requirements as a basis for risk management in the operational units was continued. The focus of this so-called True Blue project was on the Requirements that relate to the flows of goods and money. This year the focus was on China and on service and staff units in the Netherlands. The True Blue project was completed at the end of the year. The risk management framework for the total company is now being maintained by a newly created Corporate Risk Management function on behalf of the Managing Board.

The following section contains a selection of important risks that have been identified and for the management of which strategies, controls and mitigating measures have been put in place as part of our risk management practices. They nevertheless involve uncertainty that may lead to the actual results differing from those projected. There may also be current risks that the company has not yet fully assessed and that are currently qualified as ‘minor’ but that could have a material impact on the company’s performance at a later stage. The company’s risk management and internal control system has been designed to timely identify and respond to these developments, but 100% assurance can never be achieved, of course.

Macroeconomic trends
Being a global company, DSM is subject to the usual business risks associated with macroeconomic trends and events. The projected results from the Vision 2010 strategy are sensitive to deviations from the assumed and defined economic scenario on which the strategy is based.

General market developments
DSM operates in many different business segments with contingent risk profiles reflecting the different business environments, the diverse nature of the businesses and the distinctive competitive positions those businesses target for. DSM’s Vision 2010 strategy aims at further reducing the cyclical element, but a substantial portion of its activities may still experience material fluctuation in sales and results due to changes in general market conditions, supply-driven overcapacity, economic conditions, currency exchange rate fluctuations or other factors.

Low-cost competition
Counteracting the influence of low-cost competitors and seizing opportunities in low-cost areas (especially China) is one of the centerpieces of DSM’s strategy. There is always the risk, however, that such low-cost competitors may penetrate in DSM’s core markets.

Political risks
DSM has subsidiaries in more than 35 countries. These subsidiaries can be exposed to changes in government regulations and potentially unfavorable political developments that might hamper the exploitation of certain opportunities or might impair the value of the local business.

Currency risks and interest risk
All DSM sales that are priced in currencies other than the euro are subject to economic transaction and/or translation risks that may significantly impact on the financial results, as the company’s reporting unit is the euro.

DSM’s aim is to mitigate its currency exposure by developing sales in certain regions, through product mix improvements, by focusing manufacturing activities and through increased dollar-based purchasing. However, these ‘natural hedges’ are never fully balanced. The volatility of the US dollar in relation to the euro and the Swiss franc can have a significant impact on the company’s results. Although the production base still has its center of gravity in Europe, a large portion of DSM’s product sales are in US dollars or are based on US-dollar-denominated world-market prices. Consequently, from a currency perspective there is a mismatch between revenue and costs. In the 2006 business mix a 1% change in the euro-US dollar rate and the US dollar-Swiss franc rate has on aggregate a € 8 -10 million impact on gross margin level (=sales minus variable costs). Fluctuations in the relative values of other currencies (such as the yen or the pound sterling) have a limited impact on DSM’s results.

DSM companies are obliged to hedge their open currency positions via the DSM In-house Bank in order to protect the operating result against effects of currency fluctuations. Only under strict conditions are DSM companies allowed to hedge firm commitments in order to protect the cash flow of the contract value against currency fluctuations. Hedging of forecast transactions is only allowed after the approval of the Managing Board.

Due to the fact that a portion of the borrowings are floating interest bearing, fluctuations in the interest rates have an impact on the net result. The impact on the DSM result is capped by the company’s policy of not allowing the floating interest position to exceed 60% of net debt. DSM uses financial derivatives to hedge various currency and interest rate risks. Under IFRS, all derivatives are recognized as either assets or liabilities. In line with IAS 39 financial derivatives are recognized at fair value. Changes in fair value go to the income statement either contemporaneously or, if hedge accounting is applied, at the moment that the hedged item impacts on the income statement. These changes normally consist of a currency and an interest rate component. To limit the volatility deriving from the use of derivatives, hedge accounting is applied in certain cases. Hedge accounting is only allowed under strict conditions, which are different per hedge type.

DSM applies the following hedge accounting models: fair value hedge accounting, cash flow hedge accounting and net investment hedge accounting.

The goal of a fair value hedge is to fix the value of an asset/liability (hedged item). Changes in fair value of a designated derivative that is highly effective as a fair value hedge, together with the change in fair value of the corresponding asset, liability or firm commitment attributable to the hedged risk, are included directly in earnings. So both fair value changes are offset in the income statement.

The goal of a cash flow hedge is to limit the variability of highly probable future cash flows due to foreign currency or interest rate movements. Changes in fair value of a designated derivative that is highly effective as a cash flow hedge are included in equity and reclassified into income in the same period during which the hedged forecast cash flow affects income. In this way volatility in the income statement is avoided.

The goal of a net investment hedge is to fix the value of an investment in a foreign entity. Changes in fair value of a designated derivative that is highly effective as a net investment hedge are included in equity. So volatility of the hedged part of the net investment is offset in equity.

Under IFRS hedge accounting through combined derivatives is not allowed. For this reason DSM has chosen to hedge the interest and foreign currency risk with separate derivatives and not to use combined derivatives to hedge both risks.

Any ineffectiveness of hedges is reflected directly in income. DSM aims to mitigate these risks by closely monitoring the effectiveness of the hedges through effectiveness testing. Ineffectiveness only occurs when fair value changes of the hedging instrument compared to fair value changes of the underlying risk are outside a 80 – 125 % bandwidth. All hedges in 2006 have proven to be effective.

Acquisitions, divestments and joint ventures
The success of DSM’s strategy is partly dependent on the company’s ability to spot and implement opportunities for acquisitions, divestments and joint ventures. Risks in this field are connected to the company’s failure to identify relevant acquisitions or alliances, or its failure to do so in time, or its lack of success in bid processes or in the integration of acquired businesses needed to safeguard its path of growth. DSM uses joint ventures and other strategic alliances whenever it is beneficial to do so (for example to combine strengths and to share investments and inherent risks). Although joint ventures and strategic alliances are always intended to add value, situations can arise that result in a conflict of interests that could potentially damage the business.

New markets, products and technologies
In its Vision 2010 strategy, DSM is increasing its focus on innovation in order to develop new technologies and products and explore new markets. To this end, the company will strengthen its market intelligence and enhance its market and customer orientation. Nevertheless, the actual developments in the targeted markets, the speed with which new products and technologies are accepted and the emergence of new competition will always constitute risks to the success of the chosen strategy.

Innovation risks
Within DSM’s strategy there is an extra focus on innovation. A multitude of actions are being taken to ensure success in the R&D and market development processes. There is a risk that goals may nevertheless not be achieved and that the company may have to abandon a project on which it has already spent substantial sums of money. The company may reach a point where its overall sales volume does not, on a longer-term basis, justify the company’s related R&D expenditure.

A certain portion of the company’s financial results is based on legally protected intellectual property. When these protection mechanisms expire and the company is unable to follow up these situations appropriately, e.g. through new valuable patents, there is a risk that the financial results might deteriorate.

Human resource risks
DSM’s ability to retain highly specialized and committed technical staff as well as talented staff working in sales, R&D, manufacturing, finance, general management and human resources is critical to the company’s future success. Within the limits of its strategic direction, the company is making huge and ongoing efforts to manage the required processes. The company may have to adjust the timing of its growth path due to constraints or opportunities in this field.

Corporate reputation risks
Any failure by any of its business units to meet production safety, social, environmental and/or ethical standards could harm DSM’s corporate reputation and thereby impact on its business and results. DSM values such as good corporate citizenship, open communication and transparency should reasonably assure appropriate employee conduct. Moreover, the company mitigates its reputation risk by making substantial efforts to reduce the probability that any of its units might fail to comply with internal requirements and/or external laws and regulations.

In 2006 DSM was ranked No. 1 worldwide in the global chemical sector of the Dow Jones Sustainability Index for the third year running, reflecting among other things the enormous efforts the company continues to make in the area of production processes and their potential impact on the environment and on the safety and well-being of its employees.

Customer risks
The company makes considerable efforts to delight its customers. Compliance with customer agreements and commitments is measured regularly. Appropriate process and product quality checks and balances are in place to mitigate the risk of non-compliance with customers’ and DSM’s sales conditions.

No DSM customer represents more than 3% of DSM’s total sales.

Production process risks
DSM tries to mitigate production process risks by spreading production where possible, but concentration is necessary in order to achieve economies of scale. The design of any new facilities and/or production processes is required to include state-of-the-art safety and security facilities. Plants are regularly and systematically inspected against predefined risk and engineering standards. Nevertheless, certain risks and the degree to which SHE elements are managed may not be sufficiently well known.

Product liability risks
As a result of the progress made towards DSM’s current strategic corporate goals following from Vision 2010, the company’s product portfolio has shifted and is still shifting. This has been accompanied by a correspondiong shift in DSM’s risk profile. DSM is aware of this ongoing process. From a product liability point of view the life science business is more exposed than other businesses. This holds in particular for the pharmaceutical industry, which today has to face the situation that certain product liability exposures cannot be insured against, or only at prohibitively high costs and very high retentions. To protect itself against these risks, DSM has put in place highly demanding process and product requirements and is putting in a great deal of effort on an ongoing basis to assure that all its units comply with internal and external regulatory requirements (e.g. FDA).

ICT risks
In order to control potential ICT risks DSM employs a policy of using the latest proven hardware and software solutions. Group-wide DSM works with integrated and standardized ICT infrastructures, backup, encoding and encryption systems, replicated databases, virus and access protection and a fully compatible global network and intranet. Regular local ICT security assessments should assure adequate local applications. External ICT service providers have been contracted in and are required to report regularly on the measures they are taking to reasonably assure that DSM’s ICT processes are not disrupted.

Although DSM has applied strict measures with regard to the security and reliability of its IT systems, incidents regarding for example back-up recovery, hot failover systems, virus attacks and international network connections may still occur, and this can have a material impact on business operations.

Project risks
The company is currently undertaking some major projects whose success is important to the overall business results and exposure. In general these fall into three categories: pricing reinforcement projects, reorganization projects and ICT projects. Apollo is a project that assures uniform application of standard business processes designed in SAP-R3 throughout DSM worldwide.

DSM has extensive experience in project management. It seconds its best people to projects that are considered critical. Moreover, direct Board involvement and monitoring are in place to mitigate the risk of project failure.

Financial risks
Additional financial risks include commodity risk, credit risk, interest rate risk, tax risk, pension risk and country risk. The major credit rating institutions may change their assessments of DSM’s creditworthiness, thereby affecting the company’s borrowing capacity and/or the conditions under which it can borrow money and causing fluctuations in the cost of finance. The company aims to keep its single-A credit rating.

The low effective rate of corporation tax may come under pressure under the new harmonized European and Dutch tax legislation. In addition, the outcomes of ongoing disputes with tax authorities could impact on the company’s tax position with retroactive effect. Although tax assets have been recognized at fair value, future profits may not suffice to realize all tax-loss carry-forwards.

Insurable risks
Global insurance policies are in place to reduce the risk of damage to property, business interruption loss and general liability exposures, including the liability risks related to the products produced. Especially the recent and still ongoing change in our product portfolio makes product liability an issue that needs careful monitoring. At the moment, none of the products in DSM's total product portfolio is excluded from cover under our corporate insurance programs.

Uninsured losses in 2006 for any one incident will not exceed about € 30 million per occurrence with an annual aggregate of € 45 million, the possible excess being transferred to external insurers.

Control failures
In our Triple P Report some of the control failures are mentioned that occurred in spite of our risk management efforts. They can be found in the section “What still went wrong”. All failures are extensively analyzed and lessons learnt are implemented.