The market for occupant restraint systems has undergone a significant consolidation during the past ten years and Autoliv has strengthened its position in this passive safety market. However, in the future, the best growth opportunities may be in active safety systems, which is likely to include other and often larger companies than Autoliv's traditional competitors.
Autoliv is reducing the risk of this trend by utilizing its leadership in passive safety to develop a strong position in active and especially integrated safety, (see pages 14-15).
Intangible risks
Product Warranty and Recalls
The Company is exposed to product liability and warranty claims in the event that our products fail to perform as expected and such failure results, or is alleged to result, in bodily injury and/or property damage. There can be no assurance that the Company will not experience any material warranty or product liability losses in the future or that the Company will not incur significant costs to defend such claims.
In addition, if any of the Company's products are or are alleged to be defective, the Company may be required to participate in a recall involving such products. Each vehicle manufacturer has its own practices regarding product recalls and other product liability actions relating to its suppliers.
As suppliers become more integrally involved in the vehicle design process and assume more of the vehicle assembly functions, vehicle manufacturers are increasingly looking to their suppliers for contribution when faced with recalls and product liability claims.
A recall claim or a product liability claim brought against the Company in excess of the Company's available insurance may have a material adverse effect on the Company's business. Vehicle manufacturers are also increasingly requiring their external suppliers to guarantee or warrant their products and bear the costs of repair and replacement of such products under new vehicle warranties. A vehicle manufacturer may attempt to hold the Company responsible for some or all of the repair or replacement costs of defective products under new vehicle warranties when the product supplied did not perform as represented.
Accordingly, the future costs of warranty claims by the Company's customers may be material. However, we believe our established reserves are adequate to cover potential warranty settlements.
The Company's warranty reserves are based upon management's best estimates of amounts necessary to settle future and existing claims. Management regularly evaluates the appropriateness of these reserves, and adjusts them when appropriate. However, the final amounts determined to be due could differ materially from the Company's recorded estimates.
The Company's strategy is to follow a stringent procedure when developing new products and technologies and to apply a proactive "zero-defect" quality policy (see page 20).
In addition, the Company carries product liability and product recall insurance with limits that management believes are sufficient to cover the risks. Such insurance may not always be available, however, in appropriate amounts.
A substantial recall or liability in excess of coverage levels could therefore have a material adverse effect on the Company.
Patents and Proprietary Technology
The Company's strategy is to protect its innovations with patents, and to vigorously protect and defend its patents, trademarks and know-how against infringement and unauthorized use. At present, the Company holds more than 3,500 patents covering a large number of innovations and product ideas. These patents expire on various dates during the period 2006 to 2025. The expiration of any single patent is not expected to have a material adverse effect on the Company's financial results.
Although the Company believes that its products and technology do not infringe upon the proprietary rights of others, there can be no assurance that third parties will not assert infringement claims against the Company in the future. There can also be no assurance that any patent now owned by the Company will afford protection against competitors that develop similar technology.
Environmental
The Company has no pending material environmental-related issues, and it does not incur (or expect to incur) any material costs or capital expenditures associated with maintaining facilities compliant with U.S. or non-U.S. environmental requirements. Since most of the Company's manufacturing processes consist of the assembly of components, the environmental impact from the Company's plants is generally modest.
To reduce environmental risk, the Company has implemented an environmental management system (see page 19) and has adopted an environmental policy (see corporate website www.autoliv.com) that requires, for instance, that all plants should be ISO-14001 certified.
However, environmental requirements are complex, change and have tended to become more stringent over time. Accordingly, there can be no assurance that these requirements will not change or become more stringent in the future, or that the Company will at all times be in compliance with all such requirements and regulations, despite its intention to be.
Financial Risks
The Company is exposed to financial risks through its international operations and debt-financed activities. These financial risks are caused by variations in the Company's cash flows resulting from changes in exchange rates and interest rate levels, as well as from refinancing and credit risks.
The Company defines the financial risks as currency risk, interest-rate risk, refinancing risk and credit risk. In order to reduce these risks and to take advantage of economies of scale, the Company has a central treasury function supporting operations and management. The Treasury Department handles external financial transactions and functions as the Company's in-house bank for its subsidiaries.
The Board of Directors monitors compliance under the financial policy on an on-going basis. The Company was compliant with its financial policy at December 31, 2005, with the exception of the interest rate policy due to the Jobs Act distribution (see Interest Rate Risk on page 31).
Currency Risk
Transaction Exposure
Transaction exposure arises because the cost of a product originates in one currency and the product is sold in another.
The Company's gross transaction exposure is approximately $1,150 million annually. Part of the flows have counter-flows in the same currency pair, which reduces the net exposure to approximately $1,090 million per annum.
In the three largest net exposures, Autoliv sells USD against MXN for the equivalent of $190 million, EUR against SEK for $129 million and USD against CAD for $98 million. Together these account for more than 38% of the Company's net exposure.
Hedging these flows postpones the impact of fluctuations but does not reduce the impact. In addition, the net exposure only relates to 18% of sales and is made up of 43 different currency pairs with exposures in excess of $1 million. Autoliv therefore does not hedge these flows.
Currency Risk
Translation Exposure in the
Income Statement
Another effect of exchange rate fluctuations arises when the income statements of non-U.S. subsidiaries are translated into U.S. dollars. Outside the U.S., the Company's most significant currency is the Euro. Close to 60% of the Company's sales is denominated in Euro or other European currencies, while approximately one-fourth of net sales is denominated in U.S. dollars.
The Company estimates that a one-percent increase in the value of the U.S. dollar versus the European currencies would have decreased reported U.S. dollar net annual sales in 2005 by approximately $40 million or by roughly 0.6%. The reported operating income for 2005 would also have declined by 0.6% or by approximately $3 million. The fact that both sales and operating income is impacted at the same rate (i.e. 0.6%) is due to the fact that most of the Company's production is local and most revenues and costs are matched in the same currencies.
The Company's policy is not to hedge this type of translation exposure.
Currency Risk
Translation Exposure in the Balance Sheet
A translation exposure also arises when the balance sheets of non-U.S. subsidiaries are translated into U.S. dollars. The policy of the Company is to finance major subsidiaries in the country's local currency. Consequently, changes in currency rates relating to funding have a small impact on the Company's income.
The Jobs Act distributions also decreased this exposure significantly since non-U.S. dollar assets at year-end are better matched by non-dollar debt.
Interest Rate Risk
Interest rate risk refers to the risk that interest rate changes will affect the Company's borrowing costs.
Autoliv's policy is that an increase in floating interest rates of one percent should not increase the annual net interest expense by more than $5 million in the following year and not by more than $10 million in the second year.
Given that the American Jobs Creation Act distributions changed the denomination of a significant portion of the net debt in the second half of December, the Company is not compliant with this policy at year-end. The Company therefore intends to fix additional interest flows in 2006.
The Company estimates, given its debt structure at the end of 2005, that a one-percent interest rate increase would increase net interest expense in 2006 and 2007 by $7 million and $8 million, respectively.
The fixed rate debt is achieved both by issuing fixed rate notes and through interest rate swaps. The table above shows the maturity and composition of the Company's net borrowings.
Net borrowings    
 % of% of fixed% of floatingMaturity of
December 31, 2005totalinterestinterestfixed rate part
SEK620100n/a
USD2110001 year
JPY1061394 years
Other 711895 years
Total1004159 
Given this interest rate profile, a 1% change in interest rates on the Company's floating rate debt would change net interest cost by approximately $7 million during the first year and by $8 million during the second year.
Refinancing Risk
Refinancing risk or borrowing risk refers to the risk that it could become difficult to refinance outstanding debt.
In order to protect against this risk, the Company has a syndicated revolving credit facility with a group of banks, which backs its short-term commercial paper programs. The committed facility of $1.1 billion matures in November 2012.
The Company's policy is that total net debt shall be issued as or covered by long-term facilities with an average maturity of at least three years and with a target maturity of four years.
At December 31, 2005, net debt was $877 million and total available long-term facilities were $1,187 million with an average life of 6.6 years.
Credit Risk in Financial Markets
Credit risk refers to the risk of a counterpart being unable to fulfill an agreed obligation. In the Company's financial operations, this risk arises in connection with the investment of liquid assets and when entering into forward exchange agreements, swap contracts or other financial instruments.
The policy of the Company is to work with banks that have a high credit rating and that participate in the Company's financing.
In order to reduce credit risk, deposits and financial instruments can only be entered into with a limited number of banks up to a risk amount of $75 million per bank. In addition, deposits can be made in U.S. government short-term notes as approved by the Company's Board.
Debt Limitation Policy
To manage the inherent risks and cyclicality in the Company's business, the Company maintains a relatively conservative financial leverage. At the same time, it is important to have a capital structure, which is optimal for shareholders.
The Company's policy is to always maintain a leverage ratio significantly below three and an interest coverage ratio significantly above 2.75. At the end of 2005, these ratios were 1.1 and 14.1, respectively. For details on leverage ratio and interest-coverage, refer to the tables below which reconcile these two non-GAAP measures to GAAP measures.
In addition, it is the objective of Autoliv to maintain a strong investment grade rating. Autoliv's current long-term credit rating from Standard and Poor's is A-, after being upgraded in 2005 from BBB+.
Reconciliation to U.S. GAAP
Interest Coverage Ratio Leverage Ratio
Full Year 2005 December 31, 2005
Operating income $512.7   Net debt2) $876.9
Amortization of intangibles Pension liabilities $49.6
(incl. impairment writeoffs) 15.5 Net debt per the Policy 926.5
Operating profit per the Policy $528.2 Income before income taxes 482.0
Interest expense net1): $37.4 Plus: Interest expense net1) 37.4
Depreciation 293.4
Interest coverage ratio 14.1 Amortization of intangibles
(incl. impairment writeoffs) 15.5
EBITDA per the Policy $828.3
Net debt to EBITDA ratio 1.1
1) Interest expense net is interest expense less interest income.
2) Net debt is short- and long-term debt and debt-related derivatives (see Note 12) less cash and cash equivalents.