24. Financial Instruments

24.1 Financial Instruments by Category

The following tables show the carrying amounts and fair values of financial assets and liabilities as of December 31, 2018, based on IFRS 9 and as of December 31, 2017, based on IAS 39. The effects of the changes in the classification and measurement of financial instruments resulting from the introduction of IFRS 9 are outlined in note 2.

The fair values of financial instruments are determined and reported in accordance with IFRS 13 (Fair Value Measurement) on the basis of the fair value hierarchy described below:

Level 1 covers fair values determined on the basis of unadjusted prices which exist in active markets.

Level 2 comprises fair values determined on the basis of parameters which are observable in an active market.

Level 3 applies to fair values determined using parameters whose input factors are not based on observable market data.

The following table shows the assignment of the financial instruments to the three-level fair value hierarchy:

During the fiscal year, no transfers were made between the levels of the fair value hierarchy.

Because of the generally short maturities of cash and cash equivalents, loans, trade accounts receivable and payable, and other receivables and liabilities, their carrying amounts do not significantly differ from the fair values.

The fair value of the bonds issued by Covestro AG is based on quoted, unadjusted prices in active markets and therefore assigned to Level 1 of the fair value hierarchy. The fair value of some of the other investments is also based on quoted prices in active markets (Level 1).

The fair values stated for noncurrent financial assets and liabilities are the present values of the respective future cash inflows or outflows. These are determined by discounting the cash flows at a reporting-date interest rate that takes into account the term of the assets or liabilities and the creditworthiness of the counterparty. For this reason, these values are assigned to Level 2 of the fair value hierarchy.

The fair values of derivatives for which no publicly quoted market prices exist are determined using valuation techniques based on observable market data as of the reporting date (Level 2). Credit value adjustments and debt value adjustments are determined to allow for both the contracting party’s credit risk and Covestro’s own credit risk. The currency forward contracts are measured individually at their forward rates or forward prices as of the reporting date. These depend on spot rates or prices including time spreads.

Fair values measured using unobservable inputs are categorized within Level 3 of the fair value hierarchy. The fair values of noncurrent leasing receivables, reported for information purposes, are calculated on the basis of interest curves observable in the market. Additionally, a discount for cash flows that are very far in the future was applied as an unobservable factor.

As of January 1, 2018, other investments comprising exclusively equity instruments are accounted for at fair value directly in other comprehensive income because they are held for the long term for strategic reasons. The fair value of some of the other investments is based on quoted prices in active markets (Level 1). Where there are no quoted, unadjusted prices in an active market for identical or similar instruments, and there is no suitable valuation method where all major input factors are based on observable market data, the fair value of the other investments is determined using a valuation method where the main input factors are not based on observable market data (Level 3). The valuation of certain other investments is based on available performance indicators. In the previous fiscal year, other investments were classified under the measurement category of “available-for-sale finacial assets”.

Further, the fair values of embedded derivatives are determined on the basis of unobservable input factors (Level 3). They are separated from their respective host contracts, which are purchase agreements relating to the operational business. The embedded derivatives cause the cash flows from the contracts to vary with fluctuations in exchange rates, or regional and industry-specific price indices, for example. The internal measurement of embedded derivatives is mainly performed using the discounted cash flow method, which is based on unobservable inputs. These include prices or price indices derived from market data.

The table below shows the reconciliation of Level 3 financial instruments:

Gains and losses from Level 3 financial instruments recognized in profit or loss result primarily from embedded derivatives and are reported in other operating expenses or income.

Other financial investments amount to €7 million, of which €3 million is attributable to Hi-Bis GmbH, Bitterfeld-Wolfen (Germany) and €1 million to Salzgewinnungsgesellschaft Westfalen mbH & Co. KG, Hanover (Germany). In fiscal 2018, the Covestro Group received dividends of €1 million from other financial investments, all of which was attributable to the two previously mentioned companies.

The following table shows income, expenses, gains and losses from financial instruments assigned to the measurement categories in accordance with IFRS 9 for 2018 and in accordance with IAS 39 for 2017:

24.2 Financial Risk Management and Information on Derivatives

Capital management

The main purpose of financial management is to ensure solvency at all times, continuously optimize capital costs and reduce the risks of financing measures. Financial management for the Covestro Group is performed centrally by Covestro AG.

Moody’s Investors Service, London (United Kingdom), currently assigns Covestro AG an investment-grade rating of Baa1 with a stable outlook. Covestro uses the debt ratios published by prominent rating agencies in managing its capital and pursues a conservative debt policy along with a balanced financing portfolio. This is based for the most part on bonds, syndicated credit facilities and bilateral loan agreements.

Credit risk

Credit risk is the risk of a loss for the Covestro Group when a counterparty is unable to meet its payment obligations arising from a financial instrument as contractually stipulated. The payment obligations to the Covestro Group primarily comprise trade accounts receivable, debt instruments, other financial assets and contract assets.

The carrying amount of the financial assets and the contract assets represents the maximum credit risk exposure.

The impairment loss for financial assets and contract assets recognized during the year amounted to €1 million net. Impairment losses for trade accounts receivable make up nearly all of this amount.

Trade accounts receivable and contract assets

The credit risk the Covestro Group is exposed to through its trade accounts receivable and contract assets depends largely on the creditworthiness of the customer. In order to manage this risk, the Covestro Group’s Credit Management implemented a process that uses internal and external data to assess each customer in terms of its creditworthiness. Quantitative and qualitative data are evaluated during the assessment process. The assessment reflects financial data, ratings, payment history and data on the customer’s environment. The customer is allocated to one of five risk categories on the basis of the final assessment. The categories range from A to E, with risk category A representing the most creditworthy companies and risk category E the least.

Meaningful data is used to determine an expected loss rate for each risk category. Data such as default probabilities from rating agencies and credit insurance firms, historical impairment losses recognized by the Covestro Group and the empirical data from Credit Management are used to determine the expected loss rates. In addition, forward-looking information such as the country rating is also used in determining the expected loss rates. Every year, the expected and actual losses are compared (backtesting).

The following table presents the gross carrying amounts and the expected losses for trade receivables and contract assets as of December 31, 2018:

The accumulated impairment losses amounted to €33 million for those customers that the Covestro Group considers credit impaired on the basis of this assessment. The corresponding gross carrying amount amounted to €35 million. Indicators that trade accounts receivable and contract assets are at risk of credit impairment include significant financial difficulties of the customer and breach of contract such as overdue payments. Determining that a customer is credit impaired does not occur automatically when payments are overdue for more than 90 days, but is instead always based on the individual assessment conducted by Credit Management.

Total impairment losses for trade accounts receivable and contract assets changed as follows during the fiscal year:

The Covestro Group limits the credit risk exposure from trade accounts receivable by stipulating the shortest payment terms possible. In addition, the Covestro Group has a widely diversified customer portfolio. In order to avoid concentration of risk, customer limits are set, regularly monitored and exceeded only in agreement with Credit Management.

Receivables of €44 million (previous year: €50 million) are secured mainly by letters of credit.

Comparative disclosures in accordance with IAS 39

Changes in impairment losses on trade accounts receivable in the previous year were as follows:

As of December 31, 2017, trade accounts receivable amounting to €1,880 million were not impaired. As of the reporting date, €182 million of these unimpaired trade accounts receivable was past due or due immediately.

The gross carrying amount of impaired trade accounts receivable was €43 million. The impairment losses recognized on these assets totaled €41 million, resulting in a net carrying amount of €2 million.

The following table summarizes the breakdown of trade accounts receivable according to the criteria of impairment and past-due status:

Debt instruments

The Covestro Group pursues a conservative investment policy based on a strategy of maintaining liquidity and safeguarding value. Consequently, the investments are limited to counterparties with investment grade ratings, simple debt instruments and short-term investment horizons. Credit risks, particularly concentration of risk with individual counterparties, are managed by means of a Group-wide limit system in conjunction with ongoing monitoring.

The general approach for calculating and recording impairment losses in accordance with IFRS 9 applies to all debt instruments, loan commitments and financial guarantees recognized at amortized cost or at their fair values directly in equity. Covestro uses a general, three-stage approach for measuring the risk provision for expected credit losses as follows:

• Stage 1: The risk provision is calculated as the 12-month expected credit loss, whereby the default probability is derived from historical data published by prominent rating agencies. The Covestro Group assumes that investment grade ratings imply a low level of credit risk.
• Stage 2: The amount of the risk provision is the expected credit loss over the lifetime of the debt instrument if the credit risk has increased significantly since its initial recognition. Changes in credit risk are assessed using the actual payment history and external information. Whenever available, Covestro uses credit default swap prices and other forward-looking information such as ratings outlooks in addition to external ratings.
• Stage 3: If Covestro determines that the collectability of a debt instrument has deteriorated, it is reclassified to stage 3. This is the case, for instance, when a counterparty has obtained insolvency status; when there is sufficient information available to show that the counterparty has applied for insolvency proceedings; or when debt instruments are more than 90 days overdue.

No reclassification between the stages of the general impairment approach took place during the fiscal year. The Covestro Group holds no collateral to secure its debt instruments.

Because of the low credit risk profile, the Covestro Group is not exposed to significant credit risk from debt instruments. The risk provision calculated using the general approach is immaterial both overall and for the individual stages.

Currency risks

Currency opportunities and risks for the Covestro Group result from changes in exchange rates and the related changes in the value of financial instruments (including receivables and payables) and of anticipated payment receipts and disbursements in foreign currencies. Material receivables and payables in liquid currencies from operating and financial activities are generally fully hedged through forward exchange contracts. A value-at-risk approach is used to manage foreign currency exposures arising from planned receivables and liabilities. Anticipated foreign currency exposures were not hedged in 2018 since they did not exceed the limit defined for the Group. They will be rehedged using forward contracts if the foreign currency risk increases significantly. The extent of the currency risk is represented below by a sensitivity analysis.

The currency risk shown in the sensitivity analysis results from the following:

• The unsecured portion of receivables and payables in nonfunctional currencies
• Unsecured bank deposits and liabilities to banks in nonfunctional currencies
• Currency risks from embedded derivatives

Sensitivities were determined based on a hypothetical scenario in which the euro depreciates by 10% against all other currencies compared with the year-end exchange rates. Under this scenario, the estimated hypothetical gains recognized in profit or loss as of December 31, 2018, would have totaled €18.1 million (previous year: gains of €7.9 million). The table below shows the distribution of these effects among the individual currencies:

Liquidity risk

Liquidity risk is the risk of not being able to meet existing or future payment obligations. The liquidity status of all material Group companies is continuously planned and monitored. Liquidity is secured by cash pooling agreements as well as internal and external financing. A syndicated revolving credit facility offers additional financial flexibility.

The liquidity risks to which the Covestro Group was exposed from its financial instruments can be divided into obligations for interest and repayment installments on financial liabilities and payment obligations arising from derivatives. The following tables show the maturity structure of the nondiscounted contractually agreed payments arising from these line items:

In addition to the primary financial liabilities and derivative financial instruments, there was an obligation under certain conditions to make a loan of €208 million (previous year: €208 million) to the effective initial fund of Bayer-Pensionskasse VVaG, which may result in payments by Covestro AG in subsequent years. This is reflected in the loan commitments shown in the table above. Further information is given in note 25.

In this analysis, foreign currencies were translated at the closing rates. Derivative financial instruments are reported as net amounts.

Interest rate risks

Interest rate opportunities and risks for the Covestro Group result from changes in capital market interest rates, which could lead to changes in the fair value of fixed-rate financial instruments and in interest payments in the case of floating-rate instruments. To minimize adverse effects, interest rate risk is managed centrally based on an optimized debt maturity structure.

A sensitivity analysis based on our net floating-rate receivables and payables position at year end 2018, taking into account the interest rates relevant for our receivables and payables in all principal currencies, produced the following result: A hypothetical increase of 100 basis points, or one percentage point, in these interest rates (assuming constant currency exchange rates) would have raised our interest expense by €0.0 million (previous year: €0.2 million).

Raw material price risks

The Covestro Group requires significant quantities of energy and petrochemical feedstocks for its production processes. Procurement prices for energy and raw materials may fluctuate significantly. Important raw materials are procured on the basis of long-term supply agreements and an active supplier management to minimize substantial price fluctuations. In steam and electricity generation, we aim for market-based price indexing, a diversification of fuels and a mix of external procurement and captive production to minimize the price fluctuation risk for energies. During the past fiscal year, derivative financial instruments were not used to hedge raw material price risks.

Derivatives

As of the reporting date, the nominal volume of the forward exchange contracts used to hedge currency risk amounted to €1,608 million (previous year: €1,633 million). Other market risks are not hedged as of the reporting date.

Covestro has entered into master netting agreements or similar agreements for derivative financial instruments. These take effect in particular in the event of the insolvency of one of the contractual partners involved. The derivative financial instruments covered by netting agreements from the perspective of the Covestro Group are presented in the table below: