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Risks and uncertainties

Set out below are those risks which could have a material impact on the Group’s future performance and cause financial results to differ materially from expected and historical performance. Additional risks not currently known or which are currently regarded as immaterial could also adversely affect future performance.

The current global economic recession has magnified existing risks and created new ones. The Group has an extensive risk management structure in place designed to identify and assess the likelihood and consequences of these risks and to manage the actions necessary to mitigate their impact. A detailed description of the Group’s procedures to manage risk is given in the corporate governance report.

Financial risk

The Group is exposed to a variety of market related risks, including refinancing risks and the effects of changes in foreign currency exchange rates and interest rates. In the normal course of business, the Group also faces risks that are either non-financial or non-quantifiable, including country and credit risk.

Refinancing risk

Committed revolving credit facilities totalling £350 million mature in July 2010 and all or part of these facilities would normally be refinanced during 2009. The terms of the refinancing, including the time frame, cost and quantum, are expected to be more onerous given the current credit market conditions. This is likely to be further exacerbated by the downgrade of the Group’s credit rating to sub-investment grade in January 2009.

Currency risk

The Group has transactional currency exposures arising from sales or purchases by operating subsidiaries in currencies other than the subsidiaries’ functional currency, the most significant being the US dollar and the euro. Under the Group’s foreign exchange policy, transaction exposures are hedged, once they are known, mainly through the use of forward foreign exchange contracts.

The Group has a significant investment in overseas operations, particularly in continental Europe and the Americas. As a result, the sterling value of the Group’s balance sheet can be affected by movements in exchange rates. In prior years, the Group sought to mitigate the effect of these translational currency exposures by matching the net investment in overseas operations with currency borrowings, synthetically created using forward foreign exchange contracts. This policy was suspended at the end of 2008 due to the continuing volatility of foreign currencies against sterling.

Interest rate risk

The Group operates an interest rate policy designed to minimise interest cost and reduce volatility in reported earnings. To achieve this, it maintains a target range of fixed and floating rate debt for discrete annual periods. Interest rates on all debt capital market issues remain at fixed rates whilst the balance of debt is at floating rates. At 31 December 2008, 83% of the Group’s gross financial liabilities were at fixed rates of interest, whilst the weighted average period in respect of which interest has been fixed was 7 years.

Credit risk

The Group is exposed to credit-related losses in the event of non-performance by counterparties to financial instruments, which include trade debtors.

Credit risk relating to financial institutions is mitigated by the Group’s policy of selecting only counterparties with a strong investment graded long term credit rating, normally at least AA– or equivalent, and assigning financial limits to individual counterparties.

With the concentration of customers noted below, the financial failure of any one of them could have a material impact on performance. Increasing emphasis is placed on the monitoring of credit exposures in the current economic climate, with regular reporting to divisional management and the Executive Committee. In addition, credit terms and overdue debtors are closely monitored and appropriate action taken. At 31 December 2008 the largest individual debtor balance was 0.7% of Group sales. (For further information see note 19 to the financial statements.)

In addition to the inherent specific financial risks and their management referred to above, there are other, more general, financial risks that could have a material adverse effect on the business, its financial condition or results of its operations.

Pension and retiree medical risk

We operate both defined benefit (DB) and defined contribution (DC) pension plans, together with retiree medical and life insurance arrangements. The majority of the DB plans are in the UK, North America and continental Europe. Retiree medical arrangements are limited to North America and the UK, where all schemes are closed. Funded obligation deficits, mostly in the US and UK, increased by £402 million to £435 million at 31 December 2008. Unfunded obligation deficits, primarily in continental Europe, increased by £101 million to £399 million.

Deterioration in asset values, changes to real long term interest rates or the strengthening of longevity assumptions could lead to a further increase in the deficit or give rise to an additional funding requirement. Furthermore, foreign exchange rate volatility can impact pension fund values.

Taxation risk

The Group operates in over 30 countries and as a consequence is subject to many complex tax laws and tax authority audit procedures.

Amounts accrued for tax liabilities are based upon management’s judgement taking into account their interpretation of tax law in each country and the likelihood of settlement where there is a tax dispute. Actual tax liabilities could differ from the accruals made by management and the difference would give rise to an adjustment in a subsequent period, which could have a material impact on the Group’s income statement and/or cash position.

Market and customer related risk

Global economic and political risk

GKN operates in a number of emerging markets including Asia Pacific and Latin America. Whilst exposed to a wide range of risks including political, regulatory, environmental and socio-economic, it is also in a position to benefit from potentially significant growth opportunities and a diversified business base.

Cyclical nature of markets

Approximately 57% of 2008 sales of subsidiaries were to automotive vehicle manufacturers and 23% for original equipment on aircraft or aircraft components.

The automotive industry, in common with other capital goods industries, is affected by macro-economic conditions and consumer demand and preferences. Economic conditions became extremely challenging in many of the world’s economies in 2008. There has been a material deterioration in the number of vehicles manufactured and sold, which is likely to continue throughout 2009 and potentially beyond.

The military aircraft element of our business is affected by political and budgetary considerations, particularly in the US. Civil demand is affected by the number of passenger miles flown and revenue per seat which, in turn, is a function of economic growth, fuel costs, personal spending power and perceived security risk. In the civil aerospace market, the current economic conditions are beginning to impact demand with a further softening anticipated during 2009 and 2010.

The availability of credit to consumers and airlines could impact purchases of vehicles and aircraft with a consequential effect on the level of build rates and orders in all of our businesses.

The Group seeks to mitigate these risks by acting aggressively to reduce its cost base when demand for its products fall, through plant rationalisations, short-time working, Lean manufacturing techniques and other cost base reduction initiatives.

Competitive markets and competition

The Group’s markets are very competitive and our ability to compete for contracts depends on the effectiveness of our products and our ability to manage costs and maintain customer relationships.

Customer concentration and relationships

The Group portfolio is built around a broad-based, diversified business across a wide range of geographic, customer and product offerings. The nature of the automotive and aerospace industries does mean, however, that a significant degree of customer concentration exists. Approximately 60% of our sales revenue is from 25 major global customers. The loss of, or damage to, certain of these relationships, particularly in the light of the rapid decline in automotive volumes seen in the latter part of 2008, or a significant worsening of commercial terms with these customers could have a material impact on the Group’s results. The Group is not dependent on contractual or other arrangements with any individual customer.

Technological change

The markets for our products and services are characterised by evolutionary change driven by consumer preference for increased safety and environmentally friendly vehicles and aircraft. Many of the Group’s products are technologically advanced or use leading edge processes in their manufacture. In order to maintain the competitiveness of our products, we make focused investment in research and development to achieve technological leadership in our key businesses and retain the competitive advantage which this leadership provides.

Acquisitions

The Group has grown both organically and through acquisition. Capturing the value and integrating the operations and people of acquired businesses is a complex process. The Group manages the associated risks by carrying out extensive pre-acquisition due diligence, carefully managing the integration process and carrying out post-acquisition audits.

Manufacturing and operational risk

Manufacturing strategy

Strategies are developed with the objective of manufacturing in the most competitive locations for our customers’ requirements. Failure to meet customer requirements upon relocation of production could impact upon both short and longer term customer relationships. We have considerable experience of implementing operational change and a wealth of experience to draw on to minimise this risk. In the current economic climate, the Group is undertaking strenuous efforts to align its cost base through the flexing of variable costs (labour and material) as well as fixed cost reductions to lower our breakeven point.

Product quality and liability

The nature of our products means that we face an inherent risk of product liability claims if failure results in any claim for injury or consequential loss. However, our customers require high levels of quality assurance and manufacturing systems in place to ensure that our quality record is world class in both Automotive and Aerospace. Appropriate levels of insurance are in place covering product liability, although the Group does not generally insure against the cost of product warranty or recall.

Supply chain

The Group’s manufacturing processes may have dependencies on the availability of specific equipment and raw materials. An inability to supply because of their non-availability would affect sales and relationships with customers. Active monitoring of the financial viability of our suppliers is undertaken and contingency plans exist, including second sourcing of key materials, to ensure continuity of supply. In most cases this would result in additional costs which may or may not be recoverable. Furthermore, close relationships with our supply base and clear communication of movements in demand help to support continuity of supply. GKN’s sales to original equipment manufacturers could also be adversely affected by the failure of other tier one suppliers.

Commodities

The Group has ongoing exposure to the price of a number of commodities, in particular steel, titanium, aluminium, copper, nickel and molybdenum. This exposure is managed by entering into supply contracts to reduce short term volatility of price and supply. In addition, where commodity costs increase, agreements are in place to surcharge customers in order to protect the Group’s profitability.

IT systems reliability, security and change

Our IT systems and networks are secured by back-up systems, hardware, virus protection and other measures but any interruption could lead to disruption in service. A breakdown of security or damage arising from any cause could affect our operational performance or revenue.

Management resources

Active management of our people around the world is critical to the success of our business. Training and development initiatives and reward systems are in place to support the recruitment and retention of appropriately qualified and skilled personnel. It is also essential that key technical staff remain in place to support the Group’s engineering skill base. Furthermore, as restructuring takes place, we ensure that we do not diminish the overall capability of the Group.

Environmental risk

The environmental laws of various countries and our customers’ requirements impose obligations on our businesses to operate in an environmentally friendly way. Failure to do so could result not only in financial consequences but also in damage to our reputation and may impact shareholder value as well as our employees and communities in which we operate. In environmental terms, our manufacturing processes are not inherently high risk, nevertheless, great care is taken to prevent any adverse impact arising. Further details of how this is managed are given within the GKN Way section of the Business Review.

Insurance

The Group insures against the impact of a range of unpredicted losses associated with business assets such as buildings, plant, machinery and ensuing financial impact arising from interruption to the business, as well as its liabilities (whether statutory or not) arising from employees, products and services supplied or the public at large. For non aviation products, insurance takes the form of a significant level of capped self-insured retention at the Group level (within GKN’s own captive insurance company, Ipsley Insurance Ltd (Ipsley), which does not insure the risks of any other entity) and a much lower level of self-insurance or deductible at the subsidiary level. Catastrophe insurance is then purchased in the commercial insurance market over and above these levels of retention. Ipsley’s current participation in GKN’s principal insurance programme is £10 million per incident capped at £20 million in any one year. Due to the nature of the risk, the Group’s aviation products liability insurance is placed solely in the commercial market.

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