20-F 1 b822558-20f.htm Prepared and filed by St Ives Financial

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 20-F

(Mark One)

REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE
SECURITIES EXCHANGE ACT OF 1934
OR
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
for the fiscal year ended December 31, 2005
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
OR
SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Date of event requiring this shell company report

For the transition period from           to

Commission file number: 333-1-276-2

Royal & Sun Alliance Insurance Group plc

(Exact name of Registrant as specified in its charter)
Not Applicable

(Translation of Registrant’s name into English)
England and Wales

(Jurisdiction of incorporation or organization)
9th Floor, One Plantation Place
30 Fenchurch Street
London EC3M 3BD
England

(Address of principal executive offices)

Securities registered or to be registered pursuant to Section 12(b) of the Act.

Title of each class
  Name of each exchange on which registered
American Depositary Shares (as evidenced by American Depositary Receipts), each representing five (5) ordinary shares, nominal value 27.5p per share
  New York Stock Exchange
Ordinary shares, nominal value 27.5p per share*
  New York Stock Exchange
*
Not for trading, but only in connection with the listing of American Depositary Shares, pursuant to the requirements of the Securities and Exchange Commission

Securities registered or to be registered pursuant to Section 12(g) of the Act.
None

(Title of Class)
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act.
8.95% Subordinated Guaranteed Bonds due October 15, 2029

(Title of Class)

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report.

   
As of December 31, 2005, there were outstanding:
     
   
2,935,117,294 ordinary shares, nominal value 27.5p per share including 22,402,911 American Depositary Shares (as evidenced by American Depositary Receipts), each representing five (5) ordinary shares
     
   
125,000,000 preference shares, nominal value £1 per share
   
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
   
Yes
  No

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

Yes
  No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes
  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 
Large accelerated filer
Accelerated filer Non-accelerated filer

Indicate by check mark which financial statement item the registrant has elected to follow.

Item 17
  Item 18

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes
  No

 

TABLE OF CONTENTS

        Page  
       
 
Presentation of Information   ii  
Forward-Looking Statements   iii  
           
PART I
         
Item 1.
  Identity of Directors, Senior Management and Advisors   Not applicable  
Item 2.
  Offer Statistics and Expected Timetable   Not applicable  
  Key Information   1  
  Information on the Company   15  
  Operating and Financial Review and Prospects   72  
  Directors, Senior Management and Employees   102  
  Major Shareholders and Related Party Transactions   118  
  Financial Information   119  
  The Offer and Listing   121  
  Additional Information   123  
  Quantitative and Qualitative Disclosures About Market Risk   128  
Item 12.
  Description of Securities Other Than Equity Securities   Not applicable  
           
PART II
         
Item 13.
  Defaults, Dividend Arrearages and Delinquencies   Not applicable  
Item 14.
  Material Modification to the Rights of Security Holders and Use of Proceeds   Not applicable  
  Controls and Procedures   135  
  Audit Committee Financial Expert   136  
  Code of Ethics   136  
  Principal Accountant Fees and Services   136  
  Exemptions From Listing Standards for Audit Committees   137  
  Purchases of Equity Securities by the Issuer and Affiliated Purchasers   137  
           
PART III
         
Item 17.
  Financial Statements   Not applicable  
  Financial Statements   138  
  Exhibits   139  
           
Consolidated Financial Statements and Schedules   F-1  
Glossary of Selected Insurance Terms   G-1  
Signatures   Sig-1  

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PRESENTATION OF INFORMATION

In this annual report on Form 20-F, unless the context otherwise requires, “Royal & SunAlliance,” “Group,” “we,” “us” and “our” refer to Royal & Sun Alliance Insurance Group plc and its consolidated subsidiaries. Please refer to the glossary beginning on page G-1 for definitions of selected insurance terms.

We publish consolidated financial statements prepared in accordance with International Financial Reporting Standards as adopted by the European Union (“IFRS”). IFRS are issued by the International Accounting Standards Board (“IASB”) and decisions regarding their adoption for use by European companies are taken in accordance with Regulation (EC) No. 1606/2002 of the European Parliament and of the Council of July 19, 2002 on the application of international accounting standards (“the IAS Regulation”). Article 4 of the IAS Regulation requires that the consolidated accounts of the Group are prepared in conformity with IFRS as adopted by the European Union. The accounting policies that we have adopted in the financial statements also comply with IFRS as issued by the IASB.

Unless we note otherwise, financial information contained in this annual report is presented in accordance with IFRS. IFRS differ from accounting principles generally accepted in the United States (“U.S. GAAP”). See notes 38 and 39 to our consolidated financial statements for a description of the significant differences between IFRS and U.S. GAAP, a reconciliation of net income and shareholders’ equity from IFRS to U.S. GAAP and condensed consolidated U.S. GAAP financial statements.

We publish our consolidated financial statements in British pounds. Unless we note otherwise, all monetary amounts in this annual report are expressed in British pounds. As used herein, references to “U.S. dollars,” “dollars” or “$” and “cents” or “c” are to U.S. currency, references to “British pounds,” “pounds sterling” or “£” and “pence” or “p” are to U.K. currency, references to “Canadian dollars” or “C$” are to Canadian currency and references to “euro” or “€” are to the currency introduced at the start of the third stage of European economic and monetary union pursuant to the Treaty establishing the European Community, amended by the Treaty on European Union. For your convenience, unless otherwise stated, this annual report contains translations of British pound amounts at the rate of £1.00 per $1.72, the Noon Buying Rate in New York City for cable transfers in British pounds as certified for customs purposes by the Federal Reserve Bank of New York (the “Noon Buying Rate”) on December 31, 2005. On May 17, 2006, the Noon Buying Rate was £1.00 per 1.88. See “Item 3—Key Information” for certain historical exchange rate information regarding the Noon Buying Rate. You should not construe these translations as representations that the amounts referred to actually represent converted amounts or that you could convert these amounts into the translated currency at the rates indicated.

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FORWARD-LOOKING STATEMENTS

The following cautionary statements identify important factors that could cause our actual results to differ materially from those projected in forward-looking statements made in this annual report. Any statements about expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These statements are often, but not always, made through use of words or phrases such as “will likely result,” “are expected to,” “will continue,” “believe,” “is anticipated,” “estimated,” “intends,” “plans,” “seeks,” “projection” and “outlook.” Forward-looking statements include statements regarding profit, underwriting and capital improvements, expense reductions, our projected capital surplus and our combined ratio and insurance result targets. Forward-looking statements are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed in such forward-looking statements. Any forward-looking statements are qualified in their entirety by reference to the factors discussed throughout this annual report. Among the key factors that have a direct bearing on our results of operations are those identified in “Item 3—Key Information—Risk Factors” and:

 
general economic conditions, including in particular economic conditions in the United Kingdom;
     
 
the frequency, severity and development of insured loss events, as well as catastrophes;
     
 
policy renewal and lapse rates;
     
 
fluctuations in interest rates;
     
 
returns on and fluctuations in the value of fixed income investments, equity investments and properties;
     
 
fluctuations in foreign currency exchange rates;
     
 
changes in laws and regulations, including changes related to capital and solvency requirements in the United Kingdom;
     
 
the results of ongoing and future litigation; and
     
 
general competitive factors.

Because these and other factors referred to in this annual report could cause actual results or outcomes to differ materially from those expressed in any forward-looking statement made by us, you should not place undue reliance on any of these forward-looking statements. Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict what will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those described in any forward-looking statements.

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PART I

ITEM 3. KEY INFORMATION
 
Selected Financial Data

As stated in the “Presentation of Information”, the Group adopted IFRS for the year ended December 31, 2005. Previously the Group’s consolidated financial statements were prepared in accordance with applicable U.K. accounting standards and the Statement of Recommended Practice issued by the Association of British Insurers in November 2003. The previously reported 2004 consolidated financial statements have been restated to comply with IFRS. The impact of the adoption of IFRS, which materially affected the consolidated financial statements, is described in note 1 to our consolidated financial statements included herein.

We have applied International Financial Reporting Standard No. 1 (“IFRS 1”), First Time Adoption of International Financial Reporting Standards, in preparing our consolidated financial statements. The Group’s transition date is January 1, 2004 and an opening IFRS Balance Sheet has been prepared at that date.

IFRS 1 allows some exemptions from full retrospective application of certain standards. In preparing these consolidated financial statements in accordance with IFRS 1, the Group has applied the following mandatory exceptions and certain of the optional exemptions from full retrospective application of IFRS.

Mandatory exceptions

We have applied the following mandatory exceptions from retrospective application:

 
Derecognition of financial assets and liabilities exception.
   
 
Financial assets and liabilities derecognized before January 1, 2004 are not rerecognized under IFRS.
     
 
Hedge accounting exception.

We have applied hedge accounting from January 1, 2004 only if the hedge relationship meets all the hedge accounting criteria under International Accounting Standard No. 39 (“IAS 39”), Financial Instruments: Recognition and Measurement.

 
Estimates exception.

Estimates under IFRS at January 1, 2004 are consistent with estimates made for the same date under U.K. GAAP.

Optional exemptions

We have elected to apply the following optional exemptions from full retrospective application:

 
Business combinations exemption.

We have applied the business combinations exemption in IFRS 1. It has not restated business combinations that took place prior to the January 1, 2004 transition date.

 
Cumulative translation differences exemption.

We have elected to set the previously accumulated cumulative translation differences to zero at January 1, 2004. This exemption has been applied to all subsidiaries in accordance with IFRS 1.

 
Designation of financial assets and financial liabilities exemption.

We have reclassified various securities as available for sale investments with fair value movements recognized in equity.

The following selected consolidated financial data is derived from and should be read in conjunction with our audited IFRS consolidated financial statements, including the notes thereto, contained elsewhere in this annual report. Under SEC rules relating to the adoption of IFRS, such IFRS financial data is presented for the year ended December 31, 2005 and the year ended December 31, 2004, only.

 

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U.S. GAAP differs from IFRS. A description of the significant differences between IFRS and U.S. GAAP and reconciliations of our shareholders’ equity to U.S. GAAP as of December 31, 2005 and 2004, and of our net income for the two years ended December 31, 2005, are included in note 38 to our consolidated financial statements included herein. We have included a translation of the data as of and for the year ended December 31, 2005 from British pounds into U.S. dollars solely for your convenience at the rate of £1.00 per $1.72, the Noon Buying Rate on December 31, 2005.

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Consolidated Profit and Loss Account Data
 
    Year Ended December 31,  
   
 
      2005     2005     2004  
      $ (1)   £     £  
   

 

 

 
    (in millions, except per ordinary share amounts)  
Amounts in accordance with IFRS
                   
Net premiums written
    9,288     5,400     5,082  
   

 

 

 
Underwriting result (2)
    203     118     (277 )
Investment income
    1,060     616     551  
Realized gains
    222     129     113  
Unrealized gains/(losses), impairments and foreign exchange
    21     12     (2 )
Unwind of discount
    (105 )   (61 )   (71 )
                     
Investment result
    1,198     696     591  
                     
   

 

 

 
Insurance result
    1,401     814     314  
Other activities (3)
    (200 )   (116 )   (56 )
   

 

 

 
Operating result
    1,201     698     258  
Total interest costs
    (184 )   (107 )   (75 )
Amortization
    (29 )   (17 )   (22 )
Reorganization costs
    (148 )   (86 )   (118 )
Profit on change in pension scheme design
    310     180      
Profit/(loss) on disposals (4)
    339     197     (109 )
Discontinued life (5)
            104  
   

 

 

 
Profit before tax
    1,489     865     38  
Taxation
    (447 )   (260 )   (118 )
   

 

 

 
Profit/(loss) after tax
    1,042     605     (80 )
   

 

 

 
Attributable to:
                   
Equity holders of the Company
    956     555     (125 )
Minority interests
    86     50     45  
   

 

 

 
Profit/(loss) after tax
    1,042     605     (80 )
   

 

 

 
Earnings per ordinary share, basic
    32.5 c   18.9 p   (5.0 )p
Earnings per ordinary share, diluted
    32.3 c   18.8 p   (5.0 )p
Dividends per ordinary share (6)
    8.00 c   4.65 p   4.55 p

 

      2005     2005     2004     2003     2002     2001  
      $ (1)   £     £     £     £     £  
   

 

 

 

 

 

 
    (in millions, except per ordinary share amounts)  
Amounts in accordance with U.S. GAAP
                                     
Net premiums written and policy fees (5)
    9,582     5,571     5,244     6,679     8,640     9,082  
Net investment income
    1,156     672     488     1,005     991     1,073  
Unrealized gains/(losses) on trading assets
    (24 )   (14 )   91     80     (278 )   (47 )
Net (loss)/income
    380     221     (279 )   (572 )   (726 )   (280 )
Net (loss)/income per ordinary share, basic
    12.56 c   7.3 p   (10.0 )p   (29.1 )p   (41.6 )p   (16.4 )p
Net (loss)/income per ordinary share, diluted
    12.56 c   7.3 p   (10.0 )p   (29.1 )p   (41.6 )p   (16.4 )p

 
(1)
Amounts stated in U.S. dollars have been translated from British pound amounts at the rate of £1.00 per $1.72, the Noon Buying Rate on December 31, 2005.
(2)
The underwriting result includes the following expenses:
        2005     2004  
     

 

 
      (£ in millions)  
  Claims and benefits incurred     3,595     4,261  
  Underwriting and policy acquisition costs     1,751     1,816  
(3)
Other activities include central expenses, income from associated undertakings, expenses related to investment activities and net gains on derivatives for contracts not treated as insurance contracts under IFRS.
(4)
Profit on disposals in 2005 has predominantly arisen on sale of our nonstandard automobile insurance business in the U.S., our Japanese operation and our holding in Rothschilds Continuation Holdings AG. The loss in 2004 predominantly arose on sale of our U.K. and Scandinavian life and asset accumulation businesses.

 

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(5)
During 2004 we disposed of our U.K. and Scandinavian life and asset accumulation businesses. All income and expenses relating to these businesses are included in the result for discontinued life operations.
(6)
The payment of dividends on outstanding ordinary shares is subject to the recommendation of our Board and, with respect to the final dividend, the approval of our shareholders at a general meeting. The interim dividend is generally paid in November of each year. The declaration of the interim dividend is subject to the discretion of our Board. The final dividend is proposed by our Board after the end of the year and is not reflected in our consolidated financial statements for that year in accordance with IFRS. The final dividend is generally approved at, and paid after, our annual general meeting held generally in May of the following year.

 

    Year Ended December 31,  
   
 
      2005     2005     2004  
      $ (1)   £     £  
   

 

 

 
    (in millions)  
Amounts in accordance with IFRS
                   
Additional information—segmental results (2)
                   
Insurance result (management basis)
                   
United Kingdom
    785     456     368  
Scandinavia
    310     180     145  
International
    356     207     173  
   

 

 

 
Core Group insurance result
    1,451     843     686  
USA
    (50 )   (29 )   (372 )
   

 

 

 
Total segmental results
    1,401     814     314  
Other activities (3)
    (200 )   (116 )   (56 )
   

 

 

 
Total operating result
    1,201     698     258  
   

 

 

 

 
(1)
Amounts stated in U.S. dollars have been translated from British pound amounts at the rate of £1.00 per $1.72, the Noon Buying Rate on December 31, 2005.
(2)
See “Item 5—Operating and Financial Review and Prospects—Consolidated Results of Operations” for a discussion of our operating segments.
(3)
Other activities includes central expenses, income from associated undertakings, expenses related to investment activities and net gains on derivatives for contracts not treated as insurance contracts under IFRS.

Operating result is a measure used for internal purposes in the management of our business segments. Operating result includes the pre-tax profits of our property and casualty business and other activities including the Group’s share of the results of investments accounted for under the equity method. The insurance result for the United States segment is determined by including actual investment return. For the United Kingdom, Scandinavia and International segments the insurance result for each segment is determined by allocating aggregate actual investment return, based upon technical reserves, working capital and local regulatory capital requirements. Investment return includes investment income, realized gains and other investment movements reported within the IFRS Consolidated Profit and Loss Account.

Operating result is before charging the following unallocated corporate items: interest costs, reorganization costs (including losses on terminated business) and amortization of intangibles other than goodwill. It also excludes the profit or loss on disposal of subsidiaries and branches. This measure differs from the profit or loss on ordinary activities before tax, which includes each of the above items. For a reconciliation of operating result to group profit or loss on ordinary activities before tax, see “Item 5 – Operating and Financial Review and Prospects”.

We use Operating result to measure the financial performance of our segments and believe that under IFRS it represents an appropriate measure of the performance of the Group.

Operating result may not be comparable from one U.K. company to another as the elements of the result that are included and excluded may differ between companies.

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Consolidated Balance Sheet Data
 
    As of December 31,

 
      2005     2005     2004  
      $ (1)   £     £  
   

 

 

 
    (in millions, except shares and per ordinary share amounts)  
Amounts in accordance with IFRS
                   
Assets
                   
Goodwill and intangible assets
    774     450     322  
Property, plant and equipment
    705     410     418  
Investments
                   
Investment property
    748     435     417  
Investment in associated undertakings
    50     29     29  
Equity securities
    2,895     1,683     1,657  
Debt and fixed income securities
    19,967     11,609     11,158  
Other
    415     241     320  
                     
Total investments
    24,075     13,997     13,581  
Reinsurers’ share of insurance contract liabilities
    7,578     4,406     4,424  
Insurance and reinsurance debtors
    4,381     2,547     2,684  
Deferred acquisition costs
    800     465     487  
Other debtors and other assets
    1,151     669     791  
Cash and cash equivalents
    2,781     1,617     1,866  
   

 

 

 
Assets associated with continuing business
    42,245     24,561     24,573  
Assets associated with discontinued business
    62     36     81  
   

 

 

 
Total assets
    42,307     24,597     24,654  
   

 

 

 
Equity, reserves and liabilities
                   
Equity and reserves
                   
Shareholders’ funds
    4,718     2,743     2,321  
Perpetual notes
            444  
Minority interests
    672     391     368  
   

 

 

 
Total equity and reserves
    5,390     3,134     3,133  
Loan capital (2)
    1,842     1,071     607  
   

 

 

 
Total equity, reserves and loan capital
    7,232     4,205     3,740  
   

 

 

 
Liabilities (excluding loan capital)
                   
Insurance contract liabilities
    29,591     17,204     17,191  
Insurance and reinsurance liabilities
    817     475     778  
Borrowings
    432     251     349  
Provisions and other liabilities
    4,235     2,462     2,519  
   

 

 

 
Liabilities associated with continuing business
    35,075     20,392     20,837  
Liabilities associated with discontinued business
            77  
   

 

 

 
Total liabilities (excluding loan capital)
    35,075     20,392     20,914  
   

 

 

 
Total equity, reserves and liabilities
    42,307     24,597     24,654  
   

 

 

 
Number of shares (in thousands) (3)
    2,935,117     2,935,117     2,912,319  
Net assets pre ordinary share (3)
    155 c   90 p   76 p

 

      2005     2005     2004     2003     2002     2001  
      $ (1)   £     £     £     £     £  
   

 

 

 

 

 

 
    (in millions, except shares and per ordinary share amounts)  
Amounts in accordance with U.S. GAAP
                                     
Total investments
    23,571     13,704     13,368     11,240     11,690     13,131  
Total assets (4)
    42,567     24,748     25,263     55,134     59,860     68,014  
Property and casualty liabilities
    30,954     17,997     18,064     19,233     20,907     21,362  
Shareholders’ equity (5)
    3,550     2,064     2,472     2,522     2,600     4,377  
Number of shares (in thousands)
    2,935,117     2,935,117     2,912,319     2,880,199     1,782,789     1,781,824  
Net assets per ordinary share (6)
    120 c   70 p   85 p   88 p   146 p   246 p

 
(1)
Amounts stated in U.S. dollars have been translated from British pound amounts at the rate of £1.00 per $1.72, the Noon Buying Rate on December 31, 2005.
(2)
Loan capital consists of our subordinated guaranteed bonds and a subordinated guaranteed loan as shown in note 19 to our consolidated financial statements.

 

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(3)
The net asset value per share is based on total shareholders’ funds of £2,743 million, with adjustments of £370 million for the pension deficit and £125 million for preference shares, and shares in issue at the year end of 2,910,996,128 excluding those held in the ESOP trusts.
(4)
The difference between 2003 and 2004 arises principally from the disposal in 2004 of our life and asset accumulation operations in the United Kingdom and in Denmark. The difference between 2002 and 2001 arises principally from the disposal in 2002 of our life and asset accumulation operation in the Isle of Man.
(5)
The move to IFRS identified that a restatement was required to the opening equity to correct for a misstatement in the year 2000. Consequently, as stated in note 39 to our consolidated financial statements, an amount of £290 million was transferred from retained earnings to net unrealized gains on investments. There was no impact on either Shareholders’ equity or the net (loss)/income.
(6)
Net assets per ordinary share is calculated on shareholders’ funds (after excluding minority interest) and the number of ordinary shares issued at the end of the year, as restated for the rights issue – see note 18 to our consolidated financial statements.
 
Exchange Rate Information

The following tables set forth, for the periods indicated, certain information concerning the Noon Buying Rate in New York City for cable transfers in British pounds as certified for customs purposes by the Federal Reserve Bank of New York, expressed in U.S. dollars per £1.00. On May 17, 2006, the Noon Buying Rate was $1.88 per £1.00.

Last Six Months
    High     Low  
   

 

 
    (U.S. dollars per British pound)  
2006
             
May (through May 17, 2006)
    1.89     1.83  
April
    1.82     1.74  
March
    1.76     1.73  
February
    1.78     1.73  
January
    1.79     1.74  
2005
             
December
    1.78     1.72  
November
    1.78     1.71  

 

Year Ended December 31,
    High     Low     Average (1)   End of Period  
   

 

 

 

 
    (U.S. dollars per British pound)  
2005
    1.93     1.71     1.82     1.72  
2004
    1.95     1.75     1.83     1.92  
2003
    1.78     1.55     1.65     1.78  
2002
    1.61     1.41     1.51     1.61  
2001
    1.50     1.37     1.44     1.45  

 
(1)
The average of the Noon Buying Rate on the last business day of each month during the relevant period.

We publish our financial statements in British pounds. Because a substantial portion of our revenues and expenses is denominated in U.S. dollars and other currencies, we have a financial reporting translation exposure attributable to fluctuations in the value of these currencies against the British pound. In respect of the major overseas currencies the rates of exchange used in our 2005 consolidated financial statements to translate balance sheet items are U.S. Dollar 1.72 (2004: 1.92), Canadian Dollar 2.01 (2004: 2.30) and Danish Kroner 10.86 (2004: 10.51). In respect of the major overseas currencies the rates of exchange used to translate profit and loss account items not denominated in British pounds in our 2005 consolidated financial statements are U.S. Dollar 1.82 (2004: 1.83), Canadian Dollar 2.20 (2004: 2.38) and Danish Kroner 10.90 (2004: 10.95).

See also “Item 5—Operating and Financial Review and Prospects” for information regarding the effects of currency fluctuation on our financial results.

Dividends

The payment of dividends on outstanding ordinary shares is subject to the recommendation of our Board and, with respect to the final dividend, the approval of our shareholders at a general meeting. The interim dividend is generally paid in November of each year. The declaration of the interim dividend is subject to the

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discretion of our Board. The final dividend is proposed by our Board after the end of the year and is not reflected in our consolidated financial statements for that year in accordance with IFRS. The final dividend is generally approved at, and paid after, our annual general meeting held generally in May of the following year.

The table below presents dividends per ordinary share in each year indicated.

    Year Ended December 31,

 
      2005     2004  
   

 

 
Pence
             
Final paid in respect of prior year (1)
    2.96 p   2.90 p
Interim paid in respect of current year
    1.69     1.65  
   

 

 
Total
    4.65 p   4.55 p
   

 

 
Cents (2)
             
Final paid in respect of prior year (1)
    5.37 c   5.34 c
Interim paid in respect of current year
    2.92     3.15  
   

 

 
Total
    8.29 c   8.49 c
   

 

 

 
(1)
The dividends presented above are reported in accordance with IFRS. Under IFRS final dividends are recorded when approved by the shareholders, at which time the dividends are declared and subsequently paid. At the Annual General Meeting on May 22, 2006 a final dividend in respect of 2005 of 3.05p per share was declared. Interim dividends are recorded when paid.
(2)
Solely for the convenience of U.S. investors, we have translated the historical dividend amounts per ordinary share into U.S. dollars at the Noon Buying Rates on the respective dividend payment dates, or on the following business day if such date was not a business day in the United Kingdom or the United States.
 
Risk Factors
 
Our results are subject to fluctuations in both the fixed income and equity markets

Investment returns are an important part of our overall profitability, and fluctuations in the fixed income or equity markets could have a material adverse effect on our consolidated financial condition, results of operations and cash flows.

Fluctuations in interest rates affect returns on and the market values of our fixed income investments. Generally, investment income will be reduced during sustained periods of lower interest rates as higher yielding fixed income securities are called, mature or are sold and the proceeds reinvested at lower rates. During periods of rising interest rates, prices of fixed income securities tend to fall and realized gains upon their sale are reduced. As at December 31, 2005, the fixed income investment assets backing our general insurance liabilities and shareholders’ funds were £11.6 billion. If interest rates were to rise by 100 basis points, the fair value of the fixed income portfolio would fall by approximately £300 million.

We invest a portion of our assets in equities, which are generally subject to greater risks and more volatility than fixed income securities. General economic conditions, stock market conditions and many other factors beyond our control can adversely affect the equity markets. As at December 31, 2005, the equity investment assets backing our general insurance liabilities and shareholders’ funds were £1.7 billion. If world equity markets decreased by 15 per cent, the fair value of the equity portfolio would fall by approximately £250 million.

Our investment returns are susceptible to changes in general economic conditions, including changes that impact the general creditworthiness of the issuers of debt securities and equity securities held in our portfolios. The value of our fixed income securities may be affected by changes in the investee’s credit rating. Where the credit rating of the issuer of a debt security drops, the value of the security may also decline. Should the credit rating of the issuer fall, a resulting disposal of the securities may lead to a significant loss on our investment.

Fluctuations in interest rates and returns from equity markets also impact consumer behavior. More specifically, the demand for general insurance, particularly commercial lines, can vary with the overall level of economic activity.

 

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In addition, the funding requirements of the Group’s defined benefit plans and our contributions to those plans will be dependent upon, among other things, fluctuations in interest rates and in the equity markets. As at December 31, 2005, our defined benefit pension funds had an estimated deficit of £370 million (net of tax) (of which £131 million related to pension funds in the United States), a decrease from £544 million (net of tax) at year end 2004. At March 31, 2006 our defined benefit pension funds had an estimated deficit of £127 million (net of tax) (of which £114 million related to pension funds in the United States). This valuation uses assumptions in accordance with International Accounting Standard No. 19, Employee Benefits (“IAS 19”). IAS 19 compares, at a given date, the current market value of a pension fund’s assets with its long term liabilities, using a discount rate in line with yields on “AA” rated bonds of suitable duration and currency. As such, the financial position of a pension fund on this basis will be highly sensitive to changes in bond rates and equity markets. In the United Kingdom we have an agreed deficit funding program which viewed today we believe will enable us to meet our obligations over the duration of the U.K. pension fund. We also a have funding program in place for the U.S. pension deficit. If these programs prove to be inadequate, because of the performance of the equity or fixed income portions of the pension funds’ portfolios or other factors, it is possible that we may be required to make further contributions or take other appropriate actions.

We have exposures to financial enhancement products, which provide surety to banks, lending institutions and credit facilities that insure principal and interest repayment on debt securities. We no longer write such business. Within the financial enhancement portfolio of Financial Structures Limited, a U.S. subsidiary, are a variety of credit default products, including collateralized debt obligations (“CDO”) and credit enhancement and residual value insurance contracts. As of December 31, 2005, the gross and net CDO exposure aggregated approximately $241 million. In February 2006, one of the remaining two contracts was terminated for a net pre tax gain of $4 million. The fair value of the remaining contract at March 31, 2006, was a liability of $71 million.

Our loss reserves may not adequately cover actual losses

Our loss reserves may prove to be inadequate to cover our actual losses experience. We maintain loss reserves to cover our estimated ultimate liability for losses and loss adjustment expenses for reported and unreported losses incurred as of the end of each accounting period. Loss reserves do not represent an exact calculation of liability, but rather are estimates of the expected cost of the ultimate settlement of losses less losses paid to-date. These estimates are based on actuarial and statistical projections. In making the projections we consider facts and circumstances about our reported claims, trends in claim frequency and loss severity, emerging bases of liability, general economic conditions and other factors. Changes in these trends or other factors could result in claims in excess of loss reserves. For example, our assumptions concerning future loss cost inflation could prove to be insufficient at a time of rising interest rates, resulting in higher losses combined with a reduction in asset values in our investment portfolio to meet these losses. For some types of losses, most significantly asbestos-related and environmental pollution, it has been necessary, and may over time continue to be necessary, to revise estimated potential loss exposure and, therefore, the related loss reserves. Consequently, actual losses, and related expenses paid may differ from estimates reflected in the loss reserves in our financial statements. To the extent loss reserves are insufficient to cover actual losses, loss adjustment expenses or losses arising from changes in the legal environment we would have to add to these loss reserves. This could have a material adverse effect on our future consolidated financial condition, results of operations and cash flows.

We have significant exposure arising from insurance contracts underwritten in previous years. Contracts covering liability issues, for example, create risks in the fact that their loss projections are subject to actuarial calculations based on accepted methodologies used within the insurance industry worldwide which may not prove accurate. In particular, we have exposure to asbestos and environmental claims in the United States and the United Kingdom, other employer liability claims in the United Kingdom, personal accident claims in Scandinavia and workers’ compensation claims in the United States. We maintain significant reserves for these exposures and all are subject to specific actuarial calculations. These actuarial models and calculations are tested by external independent consultants but there are nonetheless residual risks in that the assumptions within the models which may not reflect future experience. Reserving for asbestos and environmental claims is subject to a range of uncertainties that are generally greater than those presented by other types of claims. These include long reporting delays, unresolved legal issues on policy coverage, and the identity of the insureds. As a consequence, traditional loss reserving techniques cannot wholly be relied on and we have employed specialized techniques to determine reserves in a prudent manner using the extensive knowledge of both internal asbestos and environmental experts and external legal and professional advisors. In addition, the prevalence of asbestos-related

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claims is a more recent development in the United Kingdom than in the United States. As such, there is less data and information relating to asbestos claims in the United Kingdom available to conduct our U.K. asbestos reserving analysis and thus more potential for variability in ultimate outcomes.

We use a discount factor of 5% to discount certain long tail reserves. While we believe 5% is a reasonable long term discount factor to use, the fact that current long term interest rates in our main markets may be below that level, and the fact that we may not have fully matched our assets to long term liabilities, creates a risk that our loss reserves for these long tail claims may not be sufficient.

See “Item 4—Information on the Company—Property and Casualty Reserves” for a fuller discussion of our property and casualty loss reserves including a discussion of the uncertainties around asbestos loss reserves.

Our restructuring plans in the United States are subject to particular risks

Our restructuring plans in the United States are complex and are subject to particular risks. Although we have reduced the number of lead regulatory states, our U.S. subsidiaries are subject to government regulation in their states of domicile and also in each of the jurisdictions in which they are licensed or authorized to do business. In the United States, the conduct of insurance business is regulated at the state level and not by the federal government and our subsidiaries are subject to state supervision of their regulatory capital and surplus positions. As of December 31, 2005, our consolidated U.S. regulatory capital and surplus capital position was 2.2 times the National Association of Insurance Commission risk-based capital, or RBC amount. Our objective is to reduce or eliminate the Group’s exposures in relation to our U.S. business and we continue to review all options.

Some events or transactions contemplated by our restructuring plans may give rise to risks and liabilities which, individually or taken together, are sufficiently material to create the need for the provision of additional capital or put at risk existing capital allocated to the U.S. We estimate the cost of implementing our restructuring program in the United States to total £300 million. We believe this is a prudent estimate of costs but the final level of expenses will depend on the precise actions taken to restructure the business, and potential developments that are not within our control including regulatory, employee and customer responses. At the end of 2005 the majority of this £300 million had been incurred.

Insurance regulatory agencies in the United States have broad administrative power to regulate many aspects of a company’s insurance business, including trade and claims practices, accounting methods and capital adequacy. These agencies are concerned primarily with the protection of policyholders rather than shareholders or creditors. Moreover, insurance laws and regulations, among other things, establish solvency requirements, including minimum reserves and capital and surplus requirements, limit the amount of dividends, intercompany loans and other payments our U.S. subsidiaries can make without prior regulatory approval, impose restrictions on the amounts and types of investments held, and require assessments to pay claims of insolvent insurance companies.

Insurance regulatory agencies in the United States also have broad power to institute proceedings to take possession of the property of an insurer and to conduct the business of such insurer under rehabilitation and liquidation statutes. Among the reasons for instituting such proceedings may be that the insurer is found, upon examination, to be in such condition that further transaction of business will be hazardous to its policyholders, creditors or the public. The regulators in our domiciliary states continuously examine existing laws and regulations. We cannot predict the effect any proposed or future legislation or rulemaking in the United States or elsewhere may have on the financial condition or operations of our U.S. subsidiaries.

In addition to the regulatory risks described above, our restructuring plans in the United States are subject to operational risks. For example, our plans are dependent in part upon significant management attention, which could adversely affect our ability to carry out the day-to- day functions of the business. In addition, we may not have or be able to retain personnel with the appropriate skill sets for the tasks associated with our restructuring, which could adversely affect the implementation of our plans.

Litigation outcomes could adversely affect our business

We are involved in, and may become involved in, legal proceedings that may be costly if we lose and that may divert management’s attention. In common with the industry generally, the Group in the United States receives notifications and approaches from, and on behalf of, insureds who previously had peripheral or

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secondary involvement in asbestos litigation indicating that they may be seeking coverage under Group policies. One such approach received during 2004 from General Motors Corporation is now subject to ongoing litigation.

In addition we are involved in litigation in the United States in connection with a series of credit risk insurance policies covering loans made to students in various post-secondary trade schools in the United States, primarily truck driving schools. The original loan portfolio had a face value to approximately $501 million. In 2002, a U.S. subsidiary of the Group filed lawsuits seeking, among other things, rescission of these policies. The foregoing rescission actions gave rise to other related lawsuit filed in Delaware seeking to enforce the credit risk insurance policies. In April 2005 and October 2005 respectively, PNC Bank and Wilmington Trust, two of the plaintiffs in the Delaware actions, agreed to discontinue their part of the legal action following agreed settlements. The other plaintiffs were granted summary judgment which calculated through to March 31, 2006, was approximately $388 million. The summary judgment was overturned on appeal and the case returned to the District Court to determine coverage and whether the policies cover all of the losses claimed. The case is now proceeding through the District Court. Any losses on the student loan portfolio, to the extent not offset by reinsurance, recoveries from the original borrowers under the defaulted loans, any remaining reserves established under the loan programs or recoveries from other third parties, will ultimately be borne by the Group’s U.S. subsidiary.

In the ordinary course of our insurance activities, we are routinely involved in legal or arbitration proceedings with respect to liabilities which are the subject of policy claims. For example, we have estimated the cost of insurance losses associated with the terrorist actions of September 11, 2001 to be £280 million as at December 31, 2005, net of reinsurance. The final cost may be different from the current estimate due to the uncertainty associated with the ongoing appeals and the valuation and allocation process which is currently underway in respect of the Twin Towers complex. Appraisal hearings are scheduled to continue until December 2006. As a consequence, there is uncertainty as to the eventual cost of the insurance losses associated with this event.

As insurance industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues can have a negative effect on our business by either extending coverage beyond our underwriting intent or by increasing the number and size of claims.

In addition, to the extent that legal decisions in any of the jurisdictions in which we operate world-wide increase court awards, the impact of which may be applied prospectively or retrospectively, claims and benefits reserves may prove insufficient to cover actual losses, loss adjustment expenses or future policy benefits. In such event, or where we have previously estimated that no liability would apply, we would have to add to our loss reserves and incur a charge to our earnings. Such insufficiencies could have a material adverse effect on our future consolidated financial condition, results of operations and cash flows.

The U.K. insurance market is currently subject to changes arising from the compensation framework relating to non-pecuniary loss, including pain and suffering, and loss of amenity. At present, although a number of decisions have been rendered, their full impact has yet to be reflected in court awards. In addition, a number of matters have not yet been ruled on. These changes to the compensation framework could have a material adverse effect on our future consolidated financial condition, results of operations and cash flows.

For a further discussion on litigation risks, see “Item 8—Financial Information—Legal Proceedings”.

We are subject to regulatory inquiries in the normal course of our business

The Group, in common with the insurance industry, is subject to regulatory inquiries in the normal course of its business in many of the jurisdictions in which it operates. In recent years we have seen an increase in the number of inquiries being initiated by regulators, particularly in the United Kingdom, European Union and the United States, which may give rise to threatened litigation or disputes.

There can be no assurance that any losses resulting from future regulatory inquiries may not have an adverse effect on our financial condition.

 

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Regulatory changes could adversely affect our business and may have significant implications for our capital position

Our insurance subsidiaries worldwide are subject to government regulation in each of the jurisdictions in which they conduct business. Regulatory agencies have broad administrative power over many aspects of the insurance business, which may include premium rates, marketing and selling practices, advertising, licensing agents, policy forms, capital adequacy and permitted investments. Government regulators are concerned primarily with the protection of policyholders rather than our shareholders or creditors. Insurance laws, regulations and policies currently affecting us and our subsidiaries may change at any time in ways having an adverse effect on our business. Furthermore, we cannot predict the timing or form of future regulatory initiatives.

The U.K. regulatory environment has been over the past few years, and continues to be, the subject of significant change in particular including solvency requirements. This is in part attributable to the implementation of European Union (“EU”) directives but is also the response of the regulators to the challenging market conditions that have prevailed. Until the requirements are finalized, there will be uncertainty as to the implications for the Group’s solvency. In particular, the following developments, which are described elsewhere in this annual report, are relevant:

 
The Financial Services Authority (“FSA”) has established a new requirement from December 31, 2005 for U.K. insurers, where it is the lead European Economic Area (“EEA”) regulator, to publicly disclose the group capital calculation of its ultimate EEA insurance parent undertaking. At December 31, 2005, the Group had a surplus over the EU Insurance Groups Directive (“IGD”) requirement of £1.0 billion, an increase of £0.4 billion in the year.
     
 
The Integrated Prudential Sourcebook for Insurers (“PRU”), which came into force on December 31, 2004, requires a general insurance company to calculate an Enhanced Capital Requirement (“ECR”) although for the time being this will remain a target level of capital as opposed to a regulatory minimum. The ECR is based on the principle of there being a capital charge for the various types of risk that an insurer faces, such as underwriting, adverse claims development and credit risk. The ECR sets out capital charge percentages for particular lines of insurance business and for particular assets and liabilities.
     
 
PRU also introduced an additional requirement for companies to make their own Individual Capital Assessment (“ICA”) that is more specifically related to the risk profile of the particular company. The new FSA rules require a U.K. insurer to assess its own capital requirement based upon its circumstances and risk appetite and this is to be reviewed by the FSA. If the FSA considers the firm’s capital assessment to be insufficient they are empowered to issue Internal Capital Guidance (“ICG”), which could require the firm to maintain a capital buffer.
     
   
The Group has adopted a dynamic financial analysis model in developing its ICA, which incorporates the generation of statistical distributions for our insurance, market and credit risk. This modeling has been supplemented by a number of other techniques in order to assess operational risk and to incorporate stress and scenario tests to fully assess its capital requirement. The results provide the Group with an indication of how much capital is needed. The Group has agreed its ICA with the FSA. On this new regulatory basis the Group has adequate capital but at the request of the FSA, and in common with the rest of industry, the final agreed capital requirement remains confidential. The Group monitors the ICA on a regular basis and continues to embed the application of the capital model into the Group’s business processes.
     
 
Solvency II, the European Commission’s project to reform the prudential regulation of European life and non-life insurance companies is now well underway with a draft Framework Directive scheduled for release in mid to late 2006. The final Directive is scheduled to be adopted by the European Commission in July 2007 for implementation in 2010. Solvency II will replace the current Solvency I regime which does not reflect the developments in financial markets and risk management techniques that have taken place over the past twenty years. Current solvency requirements differ across Europe and tend to be based on arbitrary formulaic calculations with little assessment of the variety of risks which an insurance company may face. Although these current measures provide a degree of policyholder protection, they create opportunities for

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regulatory arbitrage between jurisdictions and lead to a disconnect between an insurer’s economic capital needs and regulatory capital requirements. Solvency II seeks to address these issues by creating a more risk sensitive approach to measuring an insurance company’s capital requirements.

The Group maintains a close dialogue with the FSA to gain as good an understanding as possible of the likely developments and, wherever possible, maximize the time available to plan for them.

For a further discussion of these U.K. regulatory changes, see “Item 4—Information on the Company—Regulation”.

Proposed U.S. legislation regarding U.S. asbestos liability could adversely affect our business

Following recent debate in the Senate, the prospects of some form of asbestos reform, including a no fault Trust Fund, have substantially diminished during the first quarter 2006. However, the risk remains of reform progressing in a way that does not ensure finality and allows claims for individuals who have failed to establish genuine medical criteria.

Our proposed program of strategic and operational improvements in the Core Group is large and challenging to implement

Our program of strategic and operational improvements is complex. It involves a restructuring of, and the implementation of substantial changes to, a significant portion of the Group’s operations. Successful implementation of this program will require a significant amount of management time and, thus, may affect or impair management’s ability to run the business effectively during the period of implementation. In addition, we may not have, or be able to retain, personnel with the appropriate skill sets for the tasks associated with our improvement program, which could adversely affect the implementation of our plans.

The estimated expense savings and the claims and underwriting improvements contemplated by the program are significant. Achieving our operational improvement goals will also require improvement in the pricing of our products, which is dependent in part on factors beyond our control, including general market conditions and in a number of jurisdictions regulatory controls on pricing. The Group currently anticipates that the total costs associated with the implementation of the expense savings program will amount to approximately £300 million of which the majority had been incurred by the end of the 2005. There can be no assurance that the costs will not exceed this amount.

In addition certain of our intended operational improvements and expense savings are anticipated to arise from the selective use of outsourcing and the piloting of some outsourcing initiatives offshore. These initiatives and our existing outsourced operations may entail additional operational or control risks arising from the performance by third party contractors or consultants of functions or processes which were formerly carried out within the Group. These risks may result in additional requirements for supervision, audit or intervention by employees of the Group and potential costs in the event of the failure of systems or controls or a breach by a contractor or consultant of its obligations.

There can be no assurance that the Group will realize the benefits planned in the time scheduled, or to the level expected. In the event that we are unable to successfully implement our strategy, our financial performance and results of operations could be adversely affected.

Changes in our ratings may adversely affect us

Financial strength ratings are an important factor in our competitive positioning. Rating organizations periodically review the financial performance and condition of insurers, including our insurance subsidiaries. Any lowering of our ratings could have a material adverse effect on our ability to market our products and retain our current policyholders. These consequences could, depending upon the extent thereof, have a material adverse effect on our liquidity and, under certain circumstances, net income.

Rating organizations assign ratings based upon several factors. While most of the factors relate to the rated company, some of the factors relate to general economic conditions and circumstances outside the rated company’s control.

 

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Standard & Poor’s Rating Services rate the Group’s financial strength as A- stable outlook. This rating represents their third highest category of nine. Moody’s Investors Services rate the Group’s financial strength as Baa1 positive. This rating represents their fourth highest category of nine. A.M Best Company rate the Group’s financial strength as A- stable. This represents their second highest category out of ten.

Our results may be impacted by the inability or unwillingness of our reinsurers to meet their obligations

We transfer our exposure to certain risks to others through reinsurance arrangements. Under such arrangements, other insurers assume a portion of the losses and expenses associated with reported and unreported losses in exchange for a premium. The availability, amount and cost of reinsurance depend on general market conditions and may vary significantly. Any decrease in the amount of our reinsurance will increase our risk of loss.

When we obtain reinsurance, we still remain primarily liable for the reinsured risks without regard to whether the reinsurer will meet its reinsurance obligations to us. Therefore, the inability or unwillingness of our reinsurers to meet their financial obligations or disputes on, and defects in reinsurance contract wordings or processes could materially affect our operations.

Although we conduct periodic reviews of the financial statements and reputations of our reinsurers, our reinsurers may become financially unsound by the time they are called upon to pay amounts due, which may not occur for many years. In addition, reinsurance may prove inadequate to protect against losses or may become unavailable in the future at commercially reasonable rates.

We also participate in a number of fronting arrangements where the majority of business written under the arrangement is ceded to third parties who assume most of the risks, resulting in additional credit risk that the third parties will not meet their financial obligations on the business written.

Catastrophes and weather-related events may adversely affect us

General insurance companies frequently experience losses from catastrophes. Catastrophes may have a material adverse effect on our consolidated financial condition, results of operations and cash flows. Catastrophes include windstorms, hurricanes, earthquakes, tornadoes, severe hail, severe winter weather, floods, fires, terrorist attacks and epidemics. In addition, prolonged periods of dry weather can give rise to subsidence resulting in substantial volumes of claims, particularly under U.K. household buildings policies. The incidence and severity of these catastrophes are inherently unpredictable. The extent of our losses from catastrophes is a function of the total amount of losses our clients incur, the number of our clients affected, the frequency of the events and the severity of the particular catastrophe. Most catastrophes occur in small geographic areas. However, windstorms, hurricanes, floods and earthquakes may produce significant damage in large, heavily populated areas, and subsidence claims can arise in a number of geographic areas as a result of exceptional weather conditions. Our efforts to protect ourselves against catastrophe losses, such as the use of selective underwriting practices, the purchasing of reinsurance and the monitoring of risk accumulations, may not be adequate.

The cyclical nature of the general insurance industry may cause fluctuations in our results

Historically, the general insurance industry has been cyclical and operating results of insurers have fluctuated significantly because of volatile and sometimes unpredictable developments, many of which are beyond the direct control of any insurer. Although we have a geographically diverse group of businesses, we expect to experience the effects of this cyclical nature, including changes in premium levels, which could have a material adverse effect on our results of operations.

The unpredictability and competitive nature of the general insurance business historically has contributed to significant quarter-to-quarter and year-to-year fluctuations in underwriting results and net earnings in the general insurance industry. In addition, unanticipated underwriting losses and claims reserve adjustments suffered by our insurance subsidiaries could have an adverse impact on our financial condition and operating results.

 

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We face significant competition from other global, national and local insurance companies and from self-insurance

We compete with global, national and local insurance companies, including direct writers of insurance coverage as well as non-insurance financial services companies, such as banks and broker-dealers, many of which are able or willing to offer alternative products or more competitive pricing. Some of these competitors are larger than we are and have greater financial, technical and operating resources. The general insurance industry is highly competitive on the basis of both price and service. There are many companies competing for the same insurance customers in the geographic areas in which we operate. If our competitors price their premiums more aggressively and we choose to beat or match their pricing, this may adversely affect our underwriting results. Should we choose not to do so the volume of premiums we write will be reduced. In addition, because our insurance products are often marketed through independent insurance agencies which represent more than one insurance company, we face competition within each agency. We also face competition from the implementation of self-insurance in the commercial insurance area. Many of our customers and potential customers are examining the risks of self-insuring as an alternative to traditional insurance.

Changes in foreign exchange rates may impact our results

We publish our consolidated financial statements in pounds sterling. Therefore, fluctuations in exchange rates used to translate other currencies, particularly other European currencies and the Canadian and U.S. dollar, into pounds sterling will impact our reported consolidated financial condition, results of operations and cash flows from period to period. These fluctuations in exchange rates will also impact the pound sterling value of our investments and the return on our investments. For a discussion of the impact of changes in foreign exchange rates on our results of operations for each of 2005 and 2004, see “Item 11—Quantitative and Qualitative Disclosures About Market Risk”.

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ITEM 4. INFORMATION ON THE COMPANY

OVERVIEW

Royal & SunAlliance is the product of the merger in 1996 of two of the then largest U.K. insurers Royal Insurance Holdings plc and Sun Alliance Group plc.

Royal & Sun Alliance Insurance Group plc is a public limited company registered in England and Wales No. 2339826. The registered office and principal office of the company is 9th Floor, One Plantation Place, 30 Fenchurch Street, London, EC3M 3BD. The company’s website address is www.royalsunalliance.com and its telephone number is + 44 (0)20 7111 7000.

R&SA is a multinational insurer operating in 27 countries and covering risks in over 130 countries. Our objective is to run property and casualty insurance businesses with strong market positions to deliver:

 
Sustainable profitable performance.
     
 
Targeted growth.
     
 
Continuous operational improvement.

Our portfolio of businesses is diverse and provides exposure to markets at different stages in the insurance cycle and at different stages of development. Consequently our strategies vary from market to market but there are a number of common themes supporting our businesses, such as leveraging Group expertise and focusing on operational improvement to enhance operational efficiency, controls and the customer experience.

In September 2003, we announced the outcome of a review of our operations that we instituted in April 2003. The purpose of the review was to provide a comprehensive picture of our businesses, the markets and their long term viability and attractiveness. The review also examined the operating performance of the business to identify opportunities for further improvement. Following the review we implemented a strategy to:

 
Focus on property and casualty in markets and segments where we have strong positions;
     
 
Strengthen the Group’s capital base;
     
 
Restructure and derisk the U.S. business;
     
 
Achieve operational excellence in underwriting and claims management;
     
 
Achieve £270 million of annualized expense savings by the end of 2006; and
     
 
Instill a performance management culture, with a clear focus on delivery and accountability.

In 2004 we sold our U.K. and Scandinavian Life operations. We also sold our small operations in Peru, Poland, France, Malta, Pakistan and our associate interests in South Africa and Philippines.

In 2005, we sold our nonstandard automobile insurance business in the U.S. our Japanese operation, our holding in Rothschilds and our equity investment in Thailand.

We are a focused general insurer with strong market positions in our chosen markets and segments. In the United Kingdom we are second largest general insurer based on 2004 gross premiums earned and third largest in the Nordic region (referred to as Scandinavia) based on June 30, 2005 net premiums earned. In our International region we are the seventh largest insurance company in Canada based on 2004 direct premiums written, we are the fourth largest in Ireland based on 2004 net premiums written and are well positioned in some of our other markets.

R&SA offers a broad range of property and casualty insurance products to commercial and personal insurance customers. The Group has complementary businesses which support its insurance operations, such as risk management services including claims management and loss control services, in our major markets around the globe. We market our products through multiple channels, including brokers, other intermediaries, corporate

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partnerships and affinity groups, as well as direct to customers. This multi-channel distribution strategy allows us to reach a broad cross-section of people.

2005 was a very good year for the Group and the impact of three years of management actions and continued delivery against our objectives resulted in a greatly improved financial performance with profit after tax increasing to £605 million. In 2005 we have been building a pipeline for the future through organic growth and selective acquisitions. During the year we acquired the number one Chilean general insurer based on 2003 gross premiums written, a brokerage in Alberta, a Danish marine portfolio and a Canadian marine portfolio.

In 2003 we set out an improvement plan to deliver annualized expense savings of £270 million by the end of 2006. At the end of 2005 we have delivered £240 million of annualized expense savings. We have made good progress in restructuring the business, implementing new systems and focusing on underwriting, claims and customer service.

Key to delivering our strategy is embedding a performance management culture and having the right people. We are committed to developing talent and creating an environment where people are challenged, accountability assigned and performance rewarded. In the last three years, we have significantly strengthened the ‘top 100’ management team and clearly aligned reward with personal performance for over 80% of employees, up from just 15% in April 2003.

In 2005 the operating result for the Group of £698 million (2004: £258 million) has been achieved against the background of a mixed pricing environment and after absorbing the impact of weather events including floods in the United Kingdom and India, storms in Scandinavia and Canada and hurricanes in the Americas. In 2005 the Group reported:

 
net premiums written (gross premiums written less premiums reinsured) of £5,400 million, or $9,288 million (2004: £5,082 million);
     
 
combined operating ratio of 97.0% (2004: 104.8%);
     
 
profit before tax on ordinary activities of £865 million, or $1,489 million (2004: £38 million);
     
 
profit attributable to shareholders of £555 million, or $956 million (2004: loss £125 million);
     
 
total investments, including cash and cash equivalents, of £15,614 million, or $26,856 million (2004: £15,447 million); and
     
 
shareholders’ funds of £2,743 million, or $4,718 million (2004: £2,321 million).

For a discussion of our financial results see “Item 5—Operating and Financial Review and Prospects”.

Our operating segments have been defined based on the way we manage and run our business. The Group is divided into four regions: United Kingdom, International, Scandinavia and United States (which is closed to new business). The Core Group comprises, United Kingdom, International and Scandinavian operations. The Core Group delivered a 2 point improvement in its combined operating ratio to 94.1% in 2005.

The net written premiums of our operations in 2005 were:

 
The United Kingdom accounted for £2,639 million, or 48.8%, of the Group’s net premiums written.
     
 
Scandinavia accounted for £1,324 million, or 24.5%, of the Group’s net premiums written.
     
 
International (which comprises of operations in the mature markets of Canada, Ireland, Italy and selected emerging markets including Latin America and the Middle East) accounted for £1,337 million, or 24.8%, of the Group’s net premiums written.
     
 
The United States accounted for £100 million, or 1.9%, of the Group’s net premiums written.

 

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Our key objective of delivering sustainable profitable performance remains unchanged. With the disposal of our nonstandard automobile business we no longer have any ongoing business in the U.S. Given this change, our previous target for our ongoing business of 100% on average across the cycle is no longer relevant.

Going forward we will report the Core Group’s combined operating ratio together with the insurance result of our U.S. business. Based on our knowledge and assumptions today we would expect the Core Group to deliver a combined operating ratio of around 95% in 2006. In the U.S., on a business as usual basis we anticipate broadly breaking even at the insurance result level in 2006. We remain focused on our objective of bringing certainty and finality to the U.S. exposure. However, the execution of this will be complex.

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PRINCIPAL MARKETS

Overview

We offer a broad range of property and casualty insurance products in our United Kingdom, Scandinavia and International regions. In the United States we offered nonstandard automobile insurance but disposed of this business in November 2005. We have business in markets at different stages of development, with fundamentally different characteristics which present a range of strategic options to deliver growth. The markets in which we operate are competitive and in many of our chosen markets and segments we have strong positions. Our strategies vary from market to market but there are a number of common themes which support our businesses.

The table below presents the distribution of our 2005 and 2004 consolidated property and casualty net premiums written by region and line of business. The Group had a quota share arrangement with Munich Re Group from 2002 and until the end of 2004, pursuant to which 8% of the majority of our property and casualty business written in 2004 in the United Kingdom, Denmark, Canada and Ireland was reinsured. The amount of premiums written ceded in 2004 was £328 million. The Group did not renew the quota share arrangement in 2005 and this had a positive impact on the level of net written premiums in 2005.

In the U.K. we are ranked second largest Commercial insurer and third largest Personal Insurer in each case based on 2004 gross premiums earned. In Scandinavia (which comprises; Denmark, Sweden, Latvia, Lithuania and Norway) we are ranked the third largest based on 2004 gross premiums earned.

Our International business has operations in 21 countries. The business comprises a balanced portfolio of operations in the mature markets of Canada, Ireland and selected emerging markets in Latin America, Asia and the Middle East.

The information presented below for our United States region includes $0.3 billion of net premiums written by the nonstandard automobile business which was sold in November 2005 and negative premiums for discontinued businesses of $0.1 billion arising from mid-term cancellations and reinsurance premiums ceded.

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Property and Casualty Net Premiums Written

The table below presents the distribution of consolidated general insurance net written premiums by region and line of business for the years ended December 31, 2005 and 2004.

    Year ended December 31,

 
    2005

  2004

 
      £ in millions     % of total     £ in millions     % of total  
   

 

 

 

 
United Kingdom:
                         
Personal
    835     15.4 %   783     15.4 %
Commercial
    1,804     33.4     1,775     34.9  
   

 

 

 

 
Total United Kingdom
    2,639     48.8     2,558     50.3  
   

 

 

 

 
Scandinavia:
                         
Personal
    703     13.0     656     12.9  
Commercial
    621     11.5     572     11.3  
   

 

 

 

 
Total Scandinavia
    1,324     24.5     1,228     24.2  
   

 

 

 

 
International:
                         
Personal
    812     15.1     717     14.1  
Commercial
    525     9.7     469     9.2  
   

 

 

 

 
Total International
    1,337     24.8     1,186     23.3  
   

 

 

 

 
Core Group
                         
Personal
    2,350     43.5     2,156     42.4  
Commercial
    2,950     54.6     2,816     55.4  
   

 

 

 

 
Total Core Group
    5,300     98.1     4,972     97.8  
   

 

 

 

 
United States:
                         
Personal
    177     3.3     220     4.4  
Commercial
    (77 )   (1.4 )   (110 )   (2.2 )
   

 

 

 

 
Total United States
    100     1.9     110     2.2  
   

 

 

 

 
Total property and casualty:
    5,400     100.0 %   5,082     100 %
   

 

 

 

 
Total personal
    2,527     46.8 %   2,376     46.8 %
Total commercial
    2,873     53.2     2,706     53.2  
   

 

 

 

 
Total property and casualty
    5,400     100.0 %   5,082     100.0 %
   

 

 

 

 

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The table below presents our 2005 and 2004 property and casualty loss, expense and combined ratios by region and line of business. A loss ratio is the ratio of net incurred losses and loss adjustment expenses to net premiums earned. An expense ratio is the ratio of insurance operating expenses (acquisition and administration costs less reinsurance commissions and profit participations) to net premiums written. A combined ratio is the sum of these two ratios. These ratios are measures of the underwriting profitability of an insurance company. To enable comparison between years we exclude reorganization costs from insurance operating expenses in calculating expense ratios. A combined ratio below 100% generally indicates profitable underwriting. A combined ratio over 100% generally indicates unprofitable underwriting. An insurance company with a combined ratio over 100% may be profitable to the extent net investment results exceed underwriting losses.

Property and Casualty Loss, Expense and Combined Ratios

The table below presents general insurance loss, expense and combined ratios, expressed as a percentage of net premiums, by region and line of business for the years ended December 31, 2005 and 2004:

    Year ended December 31,

 
    2005

  2004

 
      Loss
Ratio (%)
    Expense Ratio (%)     Combined Ratio (%)     Loss
Ratio (%)
    Expense Ratio (%)     Combined Ratio (%)  
   

 

 

 

 

 

 
United Kingdom:
                                     
Personal
    62.9     33.3     96.2     62.3     34.3     96.6  
Commercial
    61.6     31.1     92.7     66.7     30.2     96.9  
   
 
       
 
       
Total United Kingdom
    62.1     31.8     93.9     65.1     31.4     96.5  
   
 
       
 
       
Scandinavia:
                                     
Personal
    83.6     18.9     102.5     84.4     17.3     101.7  
Commercial
    64.2     21.3     85.5     67.8     20.9     88.7  
   
 
       
 
       
Total Scandinavia
    74.4     20.0     94.4     76.5     19.1     95.6  
   
 
       
 
       
International:
                                     
Personal
    63.5     29.3     92.8     67.3     28.7     96.0  
Commercial
    58.0     39.6     97.6     58.6     39.0     97.6  
   
 
       
 
       
Total International
    61.4     33.3     94.7     63.9     32.7     96.6  
   
 
       
 
       
Core Group
                                     
Personal
    69.0     27.6     96.6     70.2     27.3     97.5  
Commercial
    61.5     30.6     92.1     65.1     29.7     94.8  
   
 
       
 
       
Total Core Group
    64.9     29.2     94.1     67.4     28.7     96.1  
   
 
       
 
       
United States:
                                     
Personal
    63.2     24.8     88.0     67.8     30.0     97.8  
Commercial
                         
   
 
       
 
       
Total United States
    144.4     68.9     213.3     137.7     93.1     230.8  
   
 
       
 
       
Total property and casualty:
                                     
Total personal
    68.6     27.5     96.1     84.7     32.4     117.1  
Total commercial
    65.6     32.2     97.8     65.4     29.7     95.1  
   
 
       
 
       
Total property and casualty
    67.0     30.0     97.0     73.9     30.9     104.8  
   
 
       
 
       

To enable comparison between years we exclude reorganization costs from insurance operating expenses in calculating expense ratios. Our reorganization costs amounted to £86 million in 2005 and £118 million in 2004. Including the reorganization costs our combined ratio would have been 98.6% in 2005 and 107.0% in 2004.

Our consolidated property and casualty combined ratio for 2005 was 97.0% and for 2004 was 104.8%. See “Item 5—Operating and Financial Review and Prospects” for a discussion of the factors contributing to our underwriting result in 2005.

 

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Products

A key element of our strategy is customer focus. Accordingly, we offer products tailored to meet the needs of our customers.

Products for Personal Customers

Our products for personal customers include the following property and casualty products:

Household. Insurance covers against loss of or damage to the buildings and contents of private dwellings with a range of additional features, such as coverage for valuables away from home and liability arising from ownership or occupancy.

Personal automobile. Insurance covers for liability for both bodily injury and property damage and for physical damage to an insured’s vehicle from collision and various other perils.

Other personal lines. Products that we now offer consist primarily of:

 
Accident insurance—Policies which provide insured benefits in the event of accidental death or disability.
     
 
Travel insurance—Policies which provide benefits in the event of cancellation and/or curtailment, travel delays, loss of personal baggage and/or money, emergency medical and travel expenses and legal expenses.
     
 
Pet insurance—Policies which provide benefits in the event of veterinary treatment fees, death or loss of pet and third party liability.
 
Products for Commercial Customers

Our products for commercial customers include the following property and casualty products:

Property. Insurance covers for loss or damage to buildings, inventory and equipment from natural disasters, including hurricanes, windstorms, earthquakes, floods, hail, explosions, severe winter weather and other events such as theft and vandalism, fires and financial loss due to business interruption resulting from covered losses.

Casualty/Liability. Insurance covers for:

 
Employers’ liability—This protects the insured companies against claims from employees arising from accident, injury or industrial disease;
     
 
Public liability—This protects an organization against claims arising from the conduct of its business or its products resulting in injury to or damage to third parties or property;
     
 
Professional indemnity—This protects professionals such as architects and engineers against claims of negligence in relation to the services they provide; and
     
 
Directors’ and officers’ liability—This protects executives and non-executives against the possibility of legal action.

Commercial automobile. Insurance covers for businesses against losses incurred from personal bodily injury, bodily injury to third parties, property damage to an insured’s vehicle, and property damage to other vehicles and other property resulting from the ownership, maintenance or use of automobiles and trucks in a business.

Other commercial lines. Includes:

 
Engineering—Consists of engineering insurance, inspection and risk management business for machinery, plant and construction.

 

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Specialty lines—Customized liability and specialized risk insurance covers for particular classes or groups of clients.
     
 
Marine—Insurance covers for physical loss or damage to cargo and vessels.
     
 
Aviation—Aircraft property damage and liability insurance cover.
     
 
Transit—Insurance covers for goods in transit and freight liability for the transportation industry.
 
United Kingdom
 
Overview

We have operated in the United Kingdom since our founding in 1710. In September 2004, we disposed of our U.K. Life and asset accumulation business. This decision reflects our strategy of focusing capital and resources in property and casualty insurance markets. We are the second largest property and casualty insurer in the United Kingdom, with leading positions in both personal and commercial lines, based on 2004 gross premiums earned. Our United Kingdom region employs approximately 10,500 people in 25 offices.

Our focus in the United Kingdom is on seeking to develop our property and casualty insurance business profitably by taking advantage of our experience in underwriting as well as claims and customer management.

We have implemented a U.K. Business Transformation Program to review a wide range of business improvements and expense savings. The savings are expected to arise principally from improvements in our systems and processes following the significant reduction in the number of products offered pursuant to our review. As part of the program, we are evaluating options for improving operational efficiencies. As part of our improvement to operational efficiencies, we planned to move 1,200 jobs to India over a two year period beginning September 2004. To date approximately 550 jobs have been transferred and the balance are expected to transfer by year end 2006.

United Kingdom Property and Casualty Business

Our U.K. property and casualty business offers a range of personal and commercial products nationwide. We market our property and casualty products through multiple channels in the United Kingdom. We distribute personal products through affinities, brokers, agents and direct channels. We market to the public by telephone and mail and through the internet. We distribute commercial products through international, national and local brokers, agents and direct to customers.

The U.K. property and casualty market is mature and highly competitive in both personal and commercial lines. Prior to the World Trade Center terrorist attack, competition and over-capacity had led to underwriting losses and difficult pricing conditions for the market in general. Underwriting losses incurred by the U.K. property and casualty insurance market as a whole, having approximately doubled from £1,095 million to £2,477 million between 1997 and 1998, deteriorated further to £2,927 million in 2000. However, in 2001, following the World Trade Center terrorist attack, market conditions changed dramatically with significant price increases partly offset by increased reinsurance premiums as capacity was significantly reduced. The FSA also sought to instill greater underwriting discipline into the commercial market. Consequently, the underwriting result of the U.K. market as a whole in 2004 improved to a profit of £1,360 million.

In the household market, property premiums increased by 2.5% in 2004 and 9.6% in 2003. The premium increases resulted in a continued trend of underwriting profit in the property segment with £778 million in 2004, exceeding 2003 by £411 million.

The U.K. personal and commercial automobile market incurred a £71 million underwriting loss in 2004. This marks a downturn in the market compared to 2003 when the automobile market almost reached profitability with an underwriting loss of just £5 million. This sector has been adversely affected by rising claims costs and rising changes in provisions contributing to an increase in claims and expenses, which have exceeded the 7.4% increase in net premiums written in 2004.

The U.K. market as a whole, other than automobile made an underwriting profit of £1,431 million in 2004. Net premiums written in the overall U.K. market other than automobile increased by 2.5% in 2004.

 

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In response to adverse market conditions, the U.K. insurance industry has experienced significant consolidation in recent years. We estimate that, based on 2004 gross premiums earned, the five largest insurance groups now have a combined market share of approximately 39% of the property and casualty market.

In 2004, the overall U.K. commercial property and casualty market’s premium income was reduced by almost 1.0%. The impact of the pricing pressure is clear when compared to the premium growth rate of 17.7% in 2003 and 16.6% in 2002. General liability premium income remained static in 2004, property premium income displayed the highest level of growth increasing by 2.8% and within a tough rating environment automobile premium income decreased by 2.5%.

In personal lines, competition is primarily based on price, service, convenience and, increasingly, brand recognition. In commercial lines, competition is based on price, and on relationship management, quality of service, brand recognition and availability of value added services. We compete principally with the other insurers writing property and casualty business with major operations in the United Kingdom in all channels as well as with the major international insurers in the broker channel. In personal lines, we have also experienced increasing competition from new entrants, such as retailers using their brands to distribute insurance.

The table below presents the distribution of our 2005 and 2004 property and casualty net premiums written and combined ratios by product group in the United Kingdom.

    2005

  2004

 
      £ in
millions
    % of
Total
    Combined
Ratio %
    £ in
millions
    % of
Total
    Combined
Ratio %
 
   

 

 

 

 

 

 
Personal:
                                     
Household
    383     14.5 %   90.4     384     15.0 %   97.1  
Personal automobile
    404     15.3     102.9     370     14.5     101.6  
Other
    48     1.8     101.8     29     1.1     87.2  
   
 
       
 
       
Total Personal
    835     31.6     96.2     783     30.6     96.6  
   
 
       
 
       
Commercial:
                                     
Property
    711     27.0     91.6     780     30.5     81.3  
Casualty
    348     13.2     96.8     358     14.0     100.9  
Commercial automobile
    599     22.7     88.9     507     19.8     96.4  
Other
    146     5.5     112.7     130     5.1     167.0  
   
 
       
 
       
Total Commercial
    1,804     68.4     92.7     1,775     69.4     96.9  
   
 
       
 
       
Total United Kingdom
    2,639     100.0 %   93.9     2,558     100.0 %   96.5  
   
 
       
 
       

In 2005, we had a 12.0% share of the household market sector and a 4.6% share of the personal automobile market sector, based on 2004 gross premiums earned. We distribute our personal lines business through affinities, brokers, agents and direct marketing to the public by telephone, mail and the internet. In 2005, the affinity channel accounted for 19% of our U.K. personal lines business, brokers and professional agents accounted for 29% and direct sales accounted for 52%.

We write personal lines business, primarily household and accident insurance that is marketed under the names of financial services institutions, including banks and mortgage lenders. We call this distribution channel our affinity distribution channel as it involves working with other companies in the marketing of our products. Our affinity channel gives us access to a broader base of consumers than we might otherwise be able to reach by allowing us to capitalize on the existing broad customer base and brand recognition of our affinity partners. In 2005 we successfully negotiated a number of deals with affinity partners enabling us to grow this side of our business. We also have a number of long-standing relationships with major affinity groups, such as automobile clubs through which we write primarily automobile insurance. Additionally, we intend to focus on opportunities to form relationships with commercial customers to market our products to their employees.

We are a significant direct insurer in the U.K. personal lines market. In the direct markets, we focus our marketing efforts on the more profitable customer groups using our brand name, “MORE TH>N”. We are continuing with significant media advertising in support of the brand. We sell household, automobile and other

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personal policies via the telephone, newspaper advertisements, direct mail campaigns and the internet. To serve our direct and affinity customers, we operate call centers during extended operating hours that provide new business quotes, service existing business and deal with claims over the telephone.

The personal lines broker distribution channel consists of brokers, agents and other intermediaries, including major chains, groups of brokers operating under common marketing frameworks and smaller firms operating under their own names. The principal personal lines distributed by brokers are personal automobile and household insurance. In the broker channel, by carefully monitoring relationship profitability, we focus on our more profitable brokers and business lines. We reviewed the profitability of all of our broker relationships as part of a review announced in November 2002 which led to significant reduction in sales by this channel. In 2005, our improved pricing sophistication, allowing us to deliver competitive prices and acceptable returns from this sector has enabled us to increase our participation in this market.

In the U.K. commercial market, we are the second largest commercial lines insurer based on 2004 gross premiums earned, conducting business with a majority of the companies comprising the U.K. FTSE 100 stock index. We also operate in the London Market. The London Market is a market for international insurance and reinsurance, comprising mainly high exposure and complex risks. Companies operating in the London Market underwrite specialized risks such as marine, aviation and directors’ and officers’ liability. In 2005, commercial lines gross premiums written of £2.2 billion accounted for 66% of our U.K. property and casualty business. Our principal competitors are the large U.K. and European insurers writing property and casualty business although the commercial market is increasingly seeing competition from major U.S. insurers.

We are the second largest U.K. insurer in the three commercial markets of public and general liability, property, and automobile, based on 2004 gross premiums earned. We have a 14.4% share of the commercial automobile market, a 13.0% share of the commercial property market and an 8.6% share of the commercial public and general liability market, all based on 2004 gross earned premiums. We also have significant shares of the marine, engineering and transit markets.

Our commercial customers range from individual traders and small businesses to large multinational companies in such diverse industries as construction, financial services, manufacturing and the arts. We have structured our operations to target the needs of these diverse customer groups by arranging our commercial business into three customer segments:

 
Small Business—which is comprised of small business customers with annual gross revenues of up to £1 million who are largely price and process oriented;
     
 
Corporate—which is comprised of mid-market customers with annual gross revenues of between £1 million and £100 million;
     
 
Risk Solutions—which is comprised of large U.K. multinational companies with annual gross revenues of over £100 million who require customized products and service; and
     
 
Specialist Businesses—provides specialist insurances such as marine and property investors.

We distribute our U.K. commercial lines business nationwide, and, consistent with our strategy of providing global coverage for our commercial customers, we also offer international products to our clients with global operations. We believe our competitive advantage in the commercial market consists of our ability to underwrite a broad range of commercial products, our nationwide network, our quality-accredited claims performance and our relationship management skills. This is supported by our 16 commercial service centers and approximately 3,700 people.

We distribute our commercial lines business through international, national and regional brokers, independent intermediaries, agents and direct to customers. In 2005, brokers and independent agents accounted for approximately 98% of our commercial lines net premiums written in the United Kingdom. We distribute commercial lines business through a network of approximately 4,000 brokers and independent agents located throughout the United Kingdom. Direct business accounted for approximately 2% of our U.K. commercial lines net premiums written in 2005.

 

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In 2006 we are aligning the work we do with brokers, within commercial and personal lines, into a single business area. A new organization structure will be put in place designed to provide clearer alignment to our customers and to give increased focus on our sales processes.

In the commercial market we intend to maintain our strong position in the property and casualty market by enhancing our customer propositions to our key business segments, focusing on our key areas of intellectual capital of underwriting and claims handling and simplifying our business model where possible.

From October 2004, we renewed our contract for another six year term with Motability Finance Limited, a company which provides lease financing on behalf of the Motability charity to enable disabled people to remain mobile. Under the Motability Finance Limited contract, we write automobile insurance that is included in the package offered to persons leasing automobiles through Motability. In 2005, Motability business accounted for 32% of our net automobile premiums written in the United Kingdom.

United Kingdom Life and Asset Accumulation Business

In September 2004, we disposed of our U.K. life and asset accumulation business. This decision reflects our strategy of focusing capital and resources in property and casualty insurance markets.

Scandinavia
 
Overview

We are the third largest general insurer in the Nordic Region. This region comprises Denmark, Sweden, Norway, Latvia and Lithuania. In line with the rest of the Group, our strategy is to focus on markets where we hold positions that enable us to see the positive benefits of the underwriting and pricing actions that we have taken. In both Denmark and Sweden we are the third largest insurer based on 2005 net premiums earned. These businesses are supported by our growing operations in Latvia and Lithuania (Baltics) where we hold market leading positions, in each case, based upon 2005 gross premiums written.

We operate in Scandinavia through our Danish subsidiary, Codan A/S, the holding company of the insurance companies writing property and casualty business. We currently own approximately 72% of Codan. The balance is publicly traded on the Fondsborsen, the Danish stock exchange.

Scandinavian Property and Casualty Business

The majority of our sales are made directly to the company’s customers, through tied agents, or key account managers in connection with customer visits, and through customer consultants based in call centers. In addition to these direct sales channels, in Denmark we continued to expand our distribution network through affinity arrangements with companies that have a strong distribution network, representing 7% of total sales for 2005. Consequently, another three banks, among these Spar Nord, chose to join the insurance solution we developed for the Danish Association of Local Banks in the Danish market. As a result of the experience gained from the sale through Danish banks, we decided to sell insurance in the Swedish market through a banking partnership with Swedbank (FöreningsSparbanken). In addition, in Denmark and Sweden we have entered into partnerships with a number of selected motor manufacturers to sell insurance products and focusing on the motor sector in Denmark we have jointly developed a vehicle inspection and insurance cover product. Sales through brokers represented 22% of total sales for 2005. Internet sales represent 2% and do not yet account for a significant proportion of sales. However, in the Swedish market, we recorded increasing customer interest in this sales channel.

Personal motor accounted for 25% of our 2005 property and casualty net premiums written in Scandinavia, commercial motor accounted for 17%, property products accounted for 20%, household products accounted for 15%, personal accident products accounted for 12%, marine products accounted for 3% and other products accounted for 8%. Commercial clients include a number of the leading Scandinavian companies, as well as medium and small businesses in Scandinavia.

The operational performance improvement program introduced in 2003 has now moved to business as usual, with the commitment of delivering on our targets by continuously improving our claims handling and underwriting capabilities, as well as constantly monitoring and updating our product offering.

 

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Pursuing opportunities for acquisition based growth, led to the acquisition during 2005 of TopDanmark’s marine portfolio which consolidates our number one position in Danish marine, based upon 2005 gross premiums written.

During 2005, we took the next step in driving forward the pan Nordic organizational initiative by realigning our organization along business lines rather than by geographical regions. The new organization consists of a number of divisions; Commercial, Personal, Key Accounts, Marine and the Baltics. These business divisions will be serviced by a number of pan Nordic support functions. We will continue to evaluate opportunities for enhancing scale and efficiency in the forthcoming years.

Our employees are key to our success. We are well on our way to moving towards a true performance culture, implementing a performance orientated bonus system for all employees, which is integral to embedding the new culture. We are establishing a more open and challenging culture, which is fairer and offers better promotion prospects with clear and open structures. We believe that this new culture makes us better placed to get the right people for the right jobs. We now have more effective tools to measure leadership performance, thus making it possible for everyone to see their strengths and areas for development. This culture will help us to develop our business.

We are committed to driving the pan Nordic organization forward but recognize that each country is different and our customer propositions, customer segmentation, pricing models and brands are adapted for each market. As a result, we remain committed to our multibrand strategy in our primary markets where we trade under a variety of brand names: Codan; Trekroner and Privatsikring in Denmark and Trygg-Hansa; Aktsam and Tre Kronor in Sweden.

In Scandinavia, net premiums written of £1,324 million were up 8% on 2004 and the underwriting result improved by 20% to £65m. The Scandinavian combined ratio of 94.4% improved by 1.2 points on 2004.

The claims ratio in 2005 was 74.4% in 2005, which was 2.1 points better than the prior year while the expense ratio reflected an increased sales focus and a general strengthening of support functions, including a number of additional regulatory costs. The improvement in our claims ratio reflects the result of the performance improvement program focusing on more sophisticated pricing models, expansion of rate plans into the part of the commercial book that was previously manually underwritten, as well as continued management action to improve our claims handling and sales efficiencies.

Our Commercial business, with a combined ratio of 85.5%, performed strongly reflecting the benefits of a review of the entire portfolio and increasing premium rates to levels that properly reflect the risk in recent years. In Personal lines, the combined ratio of 102.5% and the Swedish Personal lines combined ratio of 104.7% reflects the decision to strengthen personal accident reserves. In Denmark the combined ratio for Personal lines was 99.5%.

A number of factors influenced our 8% growth in net premiums written, including improvements in the way in which we structure our reinsurance arrangements.

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The table below presents the distribution of our 2005 and 2004 property and casualty net premiums written and combined ratios by line of business for Scandinavia.

    Year Ended December 31,

 
    2005

  2004

 
      £ in millions     % of
Total
    Combined Ratio %     £ in millions     % of
Total
    Combined Ratio %  
   

 

 

 

 

 

 
Personal:
                                     
Denmark
    207     15.7 %   99.5     193     15.7 %   98.5  
Sweden
    440     33.2     104.7     415     33.8     104.1  
Other
    56     4.2     92.4     48     3.9     93.6  
   
 
       
 
       
Total
    703     53.1     102.5     656     53.4     101.7  
   
 
       
 
       
Commercial:
                                     
Denmark
    299     22.6     97.4     258     21.0     96.0  
Sweden
    280     21.1     72.4     280     22.8     81.1  
Other
    42     3.2     91.4     34     2.8     94.5  
   
 
       
 
       
Total
    621     46.9     85.5     572     46.6     88.7  
   
 
       
 
       
Total Scandinavia
    1,324     100.0 %   94.4     1,228     100.0 %   95.6  
   
 
       
 
       

The table below presents our 2005 and 2004 property and casualty loss, expense and combined ratios for Scandinavia by line of business.

    Year Ended December 31,

 
    2005

  2004

 
      Loss
Ratio %
    Expense Ratio %     Combined Ratio %     Loss
Ratio %
    Expense Ratio %     Combined Ratio %  
   

 

 

 

 

 

 
Personal
    83.6     18.9     102.5     84.4     17.3     101.7  
Commercial
    64.2     21.3     85.5     67.8     20.9     88.7  
Total Scandinavia
    74.4     20.0     94.4     76.5     19.1     95.6  

We have continued to enhance our concept of dynamic pricing, where prices are based on market factors, price elasticities and technical price. We have also expanded our rate plan based pricing to the part of our commercial book which was previously manually underwritten.

Our customer value propositions have been refined for the Personal market with enhanced value propositions for targeted customer groups, notably families and the over 50 age group. In Commercial we have introduced customer value propositions aimed at being the best in the market for advisory services. We facilitate Commercial clients’ risk management activities with counseling programs, product offerings, claims adjustment programs, and claims prevention programs.

In 2005, customer surveys in Denmark and Sweden showed high levels of customer satisfaction. In both Denmark and Sweden, we recorded a net positive inflow of Personal customers in 2005. We believe that the work to improve our value propositions is a major contributor to this increased number of customers.

We will continue to develop and improve our distribution channels in Scandinavia, where most insurance is written direct through call centers and tied agents for both Personal and Commercial insurance. Unlike the position in many other countries, only a limited proportion of the commercial book is written through brokers.

The markets of Latvia and Lithuania have exciting growth prospects following entry into the European Union in May 2004. In these markets we have gained market share consolidating our number one position. We continue to drive growth and reduce operating costs. Net premiums written for 2005 are up 26% on 2004 to £87 million and the combined ratio was 90.3%. We will maintain our focus on growth within these markets as well as continue to develop the infrastructure by utilizing best practice from the Group’s other operations.

 

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In line with our strategy of becoming a pure general insurer we disposed of our Danish Life insurance operation in 2004 and our Latvian life insurance operation in 2005.

We remain committed to improving our core capabilities; pricing, underwriting and claims handling. We believe focusing on our core capabilities will help to mitigate the effect of any softening of the rating environment and maintain our profitability. In addition, we will be looking for further profitable growth opportunities.

In summary, we will maintain our focus on the markets and business lines where we have scale and see evidence of sustainable profitable growth. With the changes we have made in our performance culture and organizational structure, our team is well positioned to deliver on these opportunities.

International
 
Overview

Our International businesses are a balanced portfolio of operations in the mature markets of Canada, Ireland and Italy and selected emerging markets in Latin America, Asia and the Middle East. In Canada, we are a leading provider of property and casualty insurance products in both the commercial and personal insurance markets. We believe that our Canadian and Irish businesses have attractive market positions and long term development potential. We will choose market segments where we have a competitive advantage and actively manage the risk profile of each business with a focus on profitability. The majority of our International businesses produced an underwriting profit in 2005.

In March 2005, following the disposal of our Japanese business, we announced the merger of our Asia and Middle East regions to create a new enlarged region.

Our International region employs approximately 6,500 people.

The table below presents the distribution of our 2005 and 2004 net premiums written and combined ratios by product group for International.

    Year Ended December 31,

 
    2005

  2004

 
      £ in millions     % of
Total
    Combined Ratio %     £ in millions     % of
Total
    Combined Ratio %  
   

 

 

 

 

 

 
Personal:
                                     
Canada
    436     32.6 %   94.9     360     30.4 %   96.7  
Europe
    237     17.7     86.5     229     19.3     96.4  
Latin America
    109     8.2     100.4     67     5.7     97.8  
Asia & Middle East
    30     2.2     84.1     61     5.1     87.5  
   
 
       
 
       
Total Personal
    812     60.7     92.8     717     60.5     96.0  
   
 
       
 
       
Commercial:
                                     
Canada
    142     10.6     94.6     127     10.7     94.6  
Europe
    169     12.7     99.4     166     14.0     101.7  
Latin America
    140     10.5     102.1     99     8.3     94.0  
Asia & Middle East
    74     5.5     91.7     77     6.5     97.9  
   
 
       
 
       
Total Commercial
    525     39.3     97.6     469     39.5     97.6  
   
 
       
 
       
Total International
    1,337     100.0 %   94.7     1,186     100.0 %   96.6  
   
 
       
 
       

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The table below presents our 2005 and 2004 property and casualty loss, expense and combined ratios by line of business for International.

    Year Ended December 31,

 
    2005

  2004

 
      Loss
Ratio %
    Expense Ratio %     Combined Ratio %     Loss
Ratio %
    Expense Ratio %     Combined Ratio %  
   

 

 

 

 

 

 
Personal
    63.5     29.3     92.8     67.3     28.7     96.0  
Commercial
    58.0     39.6     97.6     58.6     39.0     97.6  
Total International
    61.4     33.3     94.7     63.9     32.7     96.6  
 
Canada

In Canada we offer insurance products and services to customers across the country. With a market share of 4.1% in 2004 we are the seventh largest insurance company based on gross direct premiums written, which excludes premiums for Canadian multinational business written outside of Canada and then ceded back to Canada. Our Head Office is located in Toronto and is supported by fully serviced Regional offices located in the major territories across Canada. We offer a wide-range of insurance products and services that are designed to meet the needs of both our personal and our commercial customers. Our products are distributed to our customers through independent brokers, managing general agents, third party administrators and direct to policyholders. Our underwriting, policy processing and claim services are provided through Regional Offices that are located in Ontario, Quebec, Newfoundland, Nova Scotia and Alberta. In 2005 we extended our position as the largest writer of marine insurance based on direct premiums written with the acquisition of a significant marine program. We also expanded our direct writing capabilities in Western Canada through the acquisition of Morgex Insurance Group based in Alberta.

The Canadian property and casualty industry produced a third consecutive underwriting profit in 2005 with the provisionally published combined ratio reported at 92.3% compared to the 90.5% reported in 2004. The market is highly competitive with over 100 separate insurance groups writing direct premiums of $35 billion in 2004. A number of provincial government insurers also participate in the market writing an additional $4 billion primarily in personal automobile insurance. The leading insurance company held a 10% market share in 2004 while the top 10 insurance companies collectively held a market share of 54%. The majority of insurance products and services are distributed through independent brokers with brokered companies writing approximately 64% of Industry’s total net premiums written. Automobile is the dominant product in Canada representing 52% of net premiums written. Household and Commercial Property premiums collectively represent 29% of premiums while liability and other commercial premiums represent 19%.

We have a well established multi-channel distribution capability that allows us to market our products and services through intermediaries, managing agents and directly to policyholders. In personal lines, we market our products through four separate brands, each with its own targeted business focus. The Royal & SunAlliance brand utilizes brokers and third party administrators to distribute both traditional household and automobile products as well as specialty products to policyholders across most provinces and territories in Canada. Western Assurance also utilizes the broker channel to distribute traditional products in Ontario focusing on policyholders that possess preferred underwriting characteristics. The Johnson Corporation is our direct writer that writes personal lines business primarily through group sponsorships affiliations. In 2005 The Johnson Corporation acquired the Morgex Insurance Group to significantly increase its presence in Western Canada. We also write household and automobile products for groups through our intermediated Ascentus brand.

In commercial lines we market the majority of our products under the Royal & SunAlliance brand through a network of independent brokers to businesses across all of Canada. We also distribute a variety of marine products through a subsidiary managing general agent, Coast Underwriters. In 2005 we acquired a significant marine portfolio from ING extending our position as the largest provider of marine insurance in Canada based on direct premiums written. Our commercial products are managed under the three broad segments of Small Business, Custom Risk and Specialty Risks. Our Small Business strategy is based on standardized products, disciplined pricing and underwriting, and efficient delivery through our brokers. Our Custom Risk (mid-market) strategy is based on customized products, industry segmentation, superior underwriting capability and

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value-added delivery. Our Specialty Risk strategy is based on risk management expertise within selected specialties and our highly skilled underwriting and pricing capabilities.

Europe

Ireland: The profitability of the Irish market maintained very high levels again in 2005 with an industry COR likely to be less than 85%. However, insurance premiums continue to reduce in response to structural changes that have rebased the industry claims costs to a lower level. Further rate reductions are anticipated in 2006 and 2007.

The market is relatively concentrated, with the five largest market participants accounting for 67% of the gross premiums written in 2004. The two main local insurers, who were fifth and sixth largest in 2004, have been growing strongly in recent years at the expense of the top four companies. Our Irish business is the fourth largest in the market with 2004 net premiums written of €325 million and a 11% market share based on 2004 gross premiums written.

Our strategy is to be successful in our preferred market segments by focusing on strategic business classes, reducing claims costs and providing differentiated services and/or product offerings to our preferred partners.

Italy: Royal & SunAlliance Assicurazioni is based in Genoa with regional offices in Milan, Rome, Padua and Turin. Our business is focused in the geographical areas of the North and the Centre of Italy, with Southern Italy representing only 2.3% of our total premiums written. Our Italian operation is a solid well performing business with a sound track record of profitability, combined with growth. Our growth is above market average with growth of 4.8% in gross premiums written in 2005. It underwrites property and casualty business, with personal lines accounting for 58% of gross premiums written in 2005 and commercial lines accounting for 42%, with motor representing 51%. We have a clear focus on preferred segments with distinctive competencies. Non-tied multi-channel distribution allows for flexible and selective underwriting with over 230 non-tied agents and 300 international and domestic brokers. Net premiums written in 2005 were €253 million.

Latin America

We currently write property and casualty business in nine countries in Latin America, in Argentina, Brazil, Chile, Colombia, Mexico, the Netherlands Antilles, Aruba, Uruguay and Venezuela. We write the major lines of property and casualty business in Latin America primarily through brokers and agents. In 2005, our Latin America property and casualty business accounted for 18.6% of the International business’s net premiums written, with total property and casualty net premiums written of £249 million.

In October 2005, we acquired Compania de Seguros Generales Cruz del Sur SA, the leading property and casualty insurance company in Chile, and Argentinian sister company, La Republica Compania Argentina de Seguros Generales SA.

Prior to this we had intentionally reduced our presence to remain only in those countries where we can build a leading position and deliver sustainable profit performance. We have significantly reduced non-core exposures through a combination of strategic sales and cancellation of certain relationships. Prior to 2005, we disposed of our 20% shareholding in United Barbados, our 51% shareholding in Royal & Sun Alliance Insurance (Jamaica) Limited, our 75% shareholding in Royal & Sun Alliance (Eastern Caribbean) Limited, our 100% shareholding in Royal & Sun Alliance (Bahamas) Limited, our agency relationship with Freisenbruch Meyer Insurance Services in Bermuda, our 94.3% shareholding in Royal & Sun Alliance Insurance (Puerto Rico) Inc., our 64.9% shareholding in Royal & Sun Alliance Seguros Fenix in Peru, our agency relationship with the Falkland Islands Company and our Chilean life subsidiary, La Construccion.

We write both personal and commercial lines in Latin America, primarily property, automobile, marine, engineering and casualty insurance. In 2005, our commercial lines business net premiums written increased to £140 million, or 56.2% of our net premiums written in Latin America and our personal lines accounted for £109 million, or 43.8%. We believe that the personal lines market in the region continues to offer good growth opportunities, particularly through corporate partnership relationships with banks and other financial institutions.

 

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Our target commercial customers are medium to large sized companies, as such companies are defined within their local markets. We have invested to ensure quality service to our customers and distribution partners. We have electronic broker connectivity in all our operations.

We distribute both commercial and personal property and casualty products in Latin America through the major international brokers, local agents and brokers and corporate partnerships, primarily through banks and other financial institutions. The vast majority of our commercial business in Latin America is written through international brokers, as well as larger local intermediaries. Our personal lines business is principally transacted through brokers, agents and corporate partnerships but also on a direct basis in Argentina, which we established in 1998 as one of the first direct operations in Latin America.

In Latin America, we compete with large international insurers and the larger local insurers, some of which are either partially or wholly state-owned. The Latin American markets are competitive, driven in part by the perceived potential for growth in the region by these regional and global players. In 2005, rates continued to reduce due to the highly competitive nature of the markets, however our operations continued to only write business which they deemed to be profitable and declined business where the rates were below our acceptable price.

Asia & Middle East

Our operations in Asia and Middle East consist of Saudi Arabia, the UAE, Oman, Bahrain, Egypt, China, Hong Kong, Singapore, India and Malaysia through owned operations and equity investments. These operations are managed out of our regional head office in Dubai. We disposed of our business in Japan in February 2005. In July 2005, we sold our minority investment in Thailand.

The majority of our business is commercial lines, with net premiums written for 2005 of £74 million; personal lines business for 2005 accounted for £30 million net premiums written. Major classes of business in Asia & Middle East are casualty and motor business which account for 66% of the total net premiums written. Our commercial lines consist primarily of commercial property, casualty, engineering and marine insurance products while our personal lines consist largely of automobile and personal accident insurance. Our Asia and Middle East property and casualty premiums were predominantly derived from brokers, agents and corporate partnerships.

Local regulations in some of the Asian markets create significant barriers to entry for foreign firms, preventing majority foreign ownership and ensuring that local companies maintain substantial market share. In China, however, steps continue to be taken to open up the Chinese market following China’s entry into the World Trade Organization in 2001. We view China and India as longer term opportunities, with both markets expanding and maturing.

Competition remains strong in the Asia and Middle East region among numerous local and international insurers. Most of our Asian and Middle Eastern markets are dominated by local insurers.

United States

The United States region, headquartered in Charlotte North Carolina, has continued to pursue its strategic redirection for its property and casualty business, announced September 2003. Since then, we’ve decreased net premiums written by 98.6%, with our remaining in force business primarily in Personal Lines. The reorganization continues to support the Group’s strategy to protect its investment in the U.S., safeguard assets appropriately and minimize the risk of volatility in the overall Group operating result.

A major milestone was the consolidation of insurance companies to reduce the complexity of the organizational structure, better manage capital, and decrease operating expenses.

Our other stabilization efforts have also been successful. During 2005, we reduced open claims by 37.4%, decreased corresponding claim reserves by a further $1.2 billion to $3.4 billion, and collected almost $1.3 billion of reinsurance. Expenses are down by a further 28%, and we have reduced our collateralized debt obligations (“CDO”) exposure by more than 80% since the beginning of 2003. The performance of the investment portfolio was again very strong in 2005,with the investment result improving by £16 million to £116 million from £90 million in 2004 despite high cash outflow.

 

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In July 2005 we announced the sale of the nonstandard automobile business to Sentry Insurance a mutual company. The sale was completed in November 2005 following receipt of all appropriate regulatory approval. As a result of the sale, assets and liabilities held by the three legal entities that were sold of $268 million and $194 million, respectively, were removed from the balance sheet. The sale also included a reinsurance agreement to cede the nonstandard automobile business written by a fourth legal entity (Guaranty National) that was not part of the sale. This reinsurance agreement resulted in the transfer of unearned premium reserves of $26 million and loss and loss adjustment expense reserves of $64 million. The closing balance sheet is subject to adjustment as a result of the true up process scheduled to be completed in 2006. This could result in an adjustment to the purchase price and reported gain on the sale.

In late 2005, we filed withdrawal plans in relevant states. As of December 31, 2005, approvals had been received from Maryland and Florida. Discussions were ongoing with several other states. As of March 31, 2006 Personal Lines withdrawal plans were complete for all states except California, New York and Rhode Island AIP.

In order to continue the simplification of the legal entity structure and reduce the number of domestic states, Grocers Insurance Company was merged with Security Insurance Company of Hartford and The Sea Insurance Company of America was merged with Royal Indemnity Company as of December 31, 2005. The previous agreement to sell Grocers Insurance Company was terminated due to the inability of the buyer to obtain regulatory approval. Also, the redomestication of Guaranty National Insurance Company from Colorado to Connecticut was completed in December 2005.

Marine Indemnity Insurance Company of America was sold in January 2006 as a “shell” company for the value of its state insurance licenses, following receipt of approval from the New York insurance department on January 12, 2006. The aggregate pre-tax profit on this sale is approximately $2 million and was reflected in the first quarter 2006. Following the Marine sale, our U.S. operation has 4 remaining U.S. insurance companies domiciled in either Connecticut or Delaware. We filed a plan to move to a single regulatory structure on April 21, 2006 and have now received approval.

Following the sale of the nonstandard automobile business, our U.S. operation has very few policies remaining in force. Execution of the business strategy is focused on settlement of existing policyholder obligations as expeditiously as possible, including policyholder obligations that were retained following disposal or sale of businesses. The portfolio of policyholder obligations includes the commercial property and casualty businesses and standard preferred personal home and automobile businesses.

Commercial business covers claims related to guaranteed cost and loss sensitive business with large deductible policies, particularly in workers’ compensation, mainstream commercial market policies for distinct customer segments including grocers, manufacturing, healthcare, higher education, monoline workers compensation, architects and engineers, multinational accounts of Japanese insurers, marine coverage for international cargo, commercial hull, and property and liability, as well as services for overseas-based customers. Guaranteed cost business is where the premium is fixed at policy inception, while loss sensitive products are those where the premium can vary depending on the loss experience under the policy or variability in risk characteristics.

Under some insurance contracts with deductible features, we are obligated to pay the claimant the full amount of the claim. We are subsequently reimbursed by the policyholder for the deductible amount, and we are subject to credit risk until such reimbursement is made. Retrospectively rated policies were also written historically. Although the retrospectively rated feature of the policy substantially reduces insurance risk for us, it also introduces credit risk to us. To address the credit risk associated with loss sensitive business we adhere to company-wide collateral guidelines.

Commercial lines business also included various financial products, although a decision was made in 2001 to exit this sector of the market place due to high capital requirements to support the business. This business provides coverages for specific tranches within CDO’s as well as credit enhancement, debt service and residual value insurance products. At December 31, 2005 the gross and net exposure for CDO’s, aggregated approximately $241 million, which is comprised of $201 million of principal exposure and $40 million of interest guarantees. During 2005, we terminated eight CDO transactions, resulting in a $431 million reduction to the overall exposure. These terminations resulted in a net settlement payment of $49 million. The effect of these

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terminations significantly reduced the volatility and idiosyncratic risks associated with the CDO portfolio. As part of the terminations, $24 million of escrow accounts held for the benefit of certain CDO counterparties were released to the company on an unencumbered basis.

Starting in 2005, total held reserves are comprised of derivative reserves and insurance reserves as a result of the adoption of derivative accounting standard IAS 39 “Financial Instruments – Recognition and Measurement” for U.K. financial reporting. IAS 39 was adopted by the company for the year ended December 31, 2005 and 2004 was restated to give effect for the IAS 39 adoption. On the adoption of IAS 39, seven synthetic CDO transactions were reclassified from insurance to derivative contracts and gross derivative liabilities of $188 million (net $149 million) were recorded at fair value. The company derives the fair value of these contracts from termination quotes received from counterparties for the short-term synthetic contracts and a discounted cash flow approach, using the S&P CDO Evaluator model, for the two long-term contracts. The five short-term synthetic transactions were terminated in the 1st quarter of 2005 and two long-term contracts remain outstanding. Total held net reserves were $196 million as of year-end 2005 and $330 million at year-end 2004 representing a $134 million reduction in 2005. This reduction relates to the termination of the CDO transactions and other adjustments during the year. During February 2006 one of the remaining two contracts was terminated generating a small pre tax gain. The fair value of the remaining contract is $71 million.

The held reserves are management’s best estimate based on known events that have occurred and have a high probability of occurring as of the balance sheet date, and as such management believes the reserve position to be sufficient. The ultimate CDO loss outstanding will depend on the performance of underlying debt obligations. Actual losses may vary significantly from the modeled ultimate possible loss outstanding and could have a material adverse effect on the financial condition of the company.

Other similar commercial products written during 1998-2002, provided residual value insurance on numerous commercial aircraft that guaranteed their value at the end of lease term. At December 31, 2005 such guarantees (17 policies) aggregated $240 million and was supported by collateral. Financial Structures Limited, a subsidiary of the U.S. Group has guaranteed the residual value of three Boeing 747-400 commercial aircraft with policy expiration dates in 2007 and 2010. In March 2006, two of the policies were terminated ($27.5 million exposure).

Credit risk insurance policies cover loans made to students in various post-secondary trade schools, primarily truck-driving schools. These credit risk insurance policies and the loans are the subject of litigation. For further discussion on litigation risks, see “Item 8 – Financial Information – Legal Proceedings”.

Since the September 2003 announcement of our renewal rights transactions, we have worked aggressively to stabilize the U.S. operation. While uncertainties remain regarding specific segments of the U.S. portfolio, implementation of the transition plan and ongoing evaluation of the U.S. business have reaffirmed the decisions made in 2003. The ultimate goal is to achieve operational stabilization through six critical drivers:

 
Claims management – meet our policyholder obligations and provide stewardship over our corporate assets;
     
 
Expense management – ensure that our expense base is commensurate with our operational needs;
     
 
Transition of resources and assets – manage the consolidation of our U.S. operations to a stabilized, cost effective, functionally aligned structure that can support continuing obligations;
     
 
Legal – provide proper management and resolution of claims, corporate litigation and regulatory risk;
     
 
Investment management – optimize our asset type and maturity mix so that expected liability outflows are matched with equivalent investment asset inflows; and
     
 
Reinsurance recoverables – maximize the cash available to our operations through aggressive reinsurance collections and cash management.

Underlying these six critical drivers is a continued emphasis on process controls, robust risk assessment, and performance management initiatives, to ensure the governance structure of the stabilized operation can be supported.

 

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INSURANCE INVESTMENTS

Overview

Investment policy for the Group’s insurance investments is established and controlled by our Group Corporate Centre and by local operational management. Day to day management of the individual investment portfolios is achieved either by the employment of external fund managers or by investment operations within the Group. Our insurance investment portfolios primarily consist of assets supporting our property and casualty liabilities as well as our shareholders’ funds. During 2004 we disposed of our U.K. and Scandinavian life and asset accumulation businesses leaving a minimal exposure to life and asset accumulation investment portfolios. From December 31, 2004 remaining life investments, relating to our life operations in Mexico and Colombia, are included within our general insurance investment portfolios.

The estimated fair value of our investments (excluding cash deposits) as of December 31, 2005, and 2004, was £13,968 million and £13,552 million, respectively.

Within the United Kingdom, the Group’s investments are primarily managed by F&C Asset Management (“F&C”) under a 10 year contract that commenced during 2002. Although day to day fund management operations are undertaken by F&C, investment policy for these assets continues to be set by the Group and regular detailed reporting is covered by the management agreement.

In Scandinavia, the investment portfolios of Codan and Trygg-Hansa, are primarily managed by Skandinavska Enskilda Banken under a separate agreement. In Canada, the management of portfolios has been recently outsourced to TD Asset Management and Phillips Hagger & North Investment Management under separate agreements. Investment policy for these assets is also set by the Group and monitored accordingly.

Within the United States, the Group continues to utilize its own investment operations to undertake the management of its insurance investment portfolio. Guidelines are set for the investment activities of our other investment portfolios and portfolio positions are monitored on a regular basis to ensure compliance.

Investment Results

Our results are in part dependent upon the quality and performance of our investment portfolios. As of December 31, 2005, the estimated fair value of our general insurance investment portfolios was £13,968 million. These amounts differ from the total investments shown in our consolidated balance sheet as they exclude interests in associated undertakings which are shown as investments in our consolidated balance sheet, but are not managed as part of our worldwide investment portfolios.

The table below presents our net investment results recognized in income on our worldwide general insurance investment portfolios for the years ended December 31, 2005 and 2004.

    Investment income   Net realized gains/(losses)   Net unrealized gains/(losses)   Impairments   Total investment return  
   
 
 
 
 
 
    2005   2004   2005   2004   2005   2004   2005   2004   2005   2004  
   
 
 
 
 
 
 
 
 
 
 
    (£ in millions)  
Real estate
  11   18   43   38   27   9       81   65  
Equity securities
  59   58   128   21       (5 ) (16 ) 182   63  
Fixed income securities
  454   389   35   48           489   437  
Other investments:
                                         
Loans secured by mortgages
  2   5               2   5  
Other loans
  4   3               4   3  
Other
  12   19   5   6           17   25  
Deposits, cash and cash equivalents
  61   59               61   59  
Derivatives
      (21 )   (9 ) (1 )     (30 ) (1 )
   
 
 
 
 
 
 
 
 
 
 
Net investment return
  603   551   190   113   18   8   (5 ) (16 ) 806   656  
   
 
 
 
 
 
 
 
 
 
 

Our net investment result recognized as income within the results from discontinued operations, on our worldwide life insurance investment portfolios for the year ended December 31, 2004 was £1,276 million. We

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disposed of our U.K. life and asset accumulation business in September 2004 and we disposed of our Scandinavian life and asset accumulation business in October 2004.

The table below presents our unrealized capital gains and losses recognized directly in equity, for our worldwide general insurance investment portfolios, which are all classified as available for sale assets, for the years ended December 31, 2005 and 2004.

    Net unrealized gains/(losses)   Net realized gains transferred to Income Statement   Impairments transferred to Income Statement   Net movement recognized
in equity
 
   
 
 
 
 
      2005     2004     2005     2004     2005     2004     2005     2004  
   

 

 

 

 

 

 

 

 
    (£ in millions)  
Equity securities
    186     56     (128 )   (21 )   5     16     63     51  
Fixed income securities
    (48 )   11     (35 )   (48 )           (83 )   (37 )
Other
    9     7     (5 )   (6 )           4     1  
   

 

 

 

 

 

 

 

 
Total
    147     74     (168 )   (75 )   5     16     (16 )   15  
   

 

 

 

 

 

 

 

 
Investment Strategy

We invest our shareholders’ funds together with our assets supporting our property and casualty insurance liabilities. In determining our investment policy, we are primarily concerned with:

 
ensuring that our investments can be liquidated into cash to meet our insurance liabilities as they arise; and
     
 
matching the currency of our investments with our liabilities to avoid unnecessary exchange exposure.

Within these parameters our investment policy focuses on maximizing our total expected returns while managing the inherent volatility of the various types of our investments.

Our Group Asset Management Committee (“GAMC”) which is chaired by our Chief Financial Officer and includes our Chief Executive Officer, determines and manages the strategy of our general insurance investment portfolios, with a particular focus on setting the level of our exposure to the major asset classes. The Royal & SunAlliance Group Investments Team is responsible for the monitoring and implementation of global investment strategy on our worldwide general insurance funds. This role is undertaken within the overall risk framework established by the Board Risk Committee.

Our general insurance investment portfolios are concentrated in listed securities. We use derivative financial instruments to reduce our exposure to adverse fluctuations in interest rates, foreign exchange rates and equity markets. We have strict controls over the use of derivative instruments. A discussion of the risks associated with these derivatives and risk management techniques is included in “Item 11—Quantitative and Qualitative Disclosures About Market Risk”. The distribution of fixed income securities by credit quality and asset type is determined on a country-by-country basis in accordance with operational limits approved by the GAMC that reflect Group risk tolerances, local insurance regulations and fixed income markets.

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Investment Composition

The table below presents the estimated fair value of our worldwide general insurance investment portfolios as of December 31, 2005 and 2004.

    As of December 31,  
   
 
    2005   2004  
   
 
 
      £ in millions     % of Total     £ in millions     % of Total  
   

 

 

 

 
Fixed income securities
    11,609     74 %   11,158     72 %
Equity securities
    1,683     11     1,657     11  
Other financial assets and short term investments
    241     2     320     2  
Real estate
    435     3     417     3  
Cash and cash equivalents
    1,617     10     1,866     12  
   

 

 

 

 
Total
    15,585     100.0 %   15,418     100.0 %
   

 

 

 

 
 
Fixed Income Securities

We hold fixed income securities in our general insurance investment portfolios with an emphasis on listed securities that are liquid and the duration of which provide an appropriate match against our projected insurance liabilities.

The majority of our fixed income portfolio is rated by Standard & Poor’s, Moody’s or similar rating agencies. As of December 31, 2005, 99% of our fixed income portfolio was invested in investment-grade (BBB or better) securities and 59% of our fixed income portfolio was invested in AAA rated securities.

The table below presents the scheduled maturities for our investments in fixed income securities for our worldwide general insurance investment portfolios as of December 31, 2005 and 2004.

    As of December 31,  
   
 
    2005   2004  
   
 
 
      £ in millions     % of Total     £ in millions     % of Total  
   

 

 

 

 
Less than one year
    2,615     23 %   3,056     27 %
One to two years
    2,147     18     1,989     18  
Two to three years
    1,734     15     1,903     17  
Three to four years
    1,520     13     1,230     11  
Four to five years
    999     9     959     9  
Greater than five years
    2,594     22     2,021     18  
   

 

 

 

 
Total
    11,609     100.0 %   11,158     100.0 %
   

 

 

 

 

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The table below presents the composition of our fixed income securities portfolio based on estimated fair value as of December 31, 2005 and 2004 by Standard & Poor’s investment rating.

    As of December 31,  
   
 
    2005   2004  
   
 
 
      £ in millions     % of Total     £ in millions     % of Total  
   

 

 

 

 
AAA
    6,786     59 %   7,198     64 %
AA
    2,608     22     2,297     21  
A
    1,665     14     1,242     11  
BBB
    450     4     341     3  
Less than BBB
    100     1     80     1  
   

 

 

 

 
Total
    11,609     100.0 %   11,158     100.0 %
   

 

 

 

 
 
Shares and Other (Variable Yield Securities) and Units in Collective Investment Vehicles

Our exposure to shares and other variable yield securities and units in Collective Investment Vehicles (“CIV”) primarily consists of equity investments although there is also a significant exposure to collective investment vehicles investing in equities, bonds and cash. As of December 31, 2005, our total exposure to collective investment vehicles accounted for approximately 25% of our total variable yield securities portfolio. Our equity security investments are primarily concentrated in our investment portfolios in the United Kingdom. For our general insurance investment portfolios, we invest in equity securities to act as support for part of our shareholders’ funds and with the aim of achieving capital appreciation.

Approximately 93% of our equity investments by estimated fair value as of December 31, 2005 were listed on approved securities markets. Our major portfolios are diversified so as to provide a broad exposure across all sectors of individual stock markets with restrictions on the maximum investment in any one equity security or equity sector set by reference to local benchmarks and insurance regulations.

Real Estate

Real estate accounted for £435 million of the estimated fair value of our investment portfolios as of December 31, 2005. The majority of our real estate portfolio is located in the United Kingdom. As of December 31, 2005, the estimated fair value of our real estate portfolio in the United Kingdom was £355 million. Outside of the United Kingdom, our primary real estate investments are in Scandinavia. As of December 31, 2005, the estimated fair value of our real estate portfolio in Scandinavia was £74 million.

Cash and cash equivalents

We had £1,617 million in cash and cash equivalents in our worldwide general insurance investment portfolios as of December 31, 2005. We hold cash and cash equivalents either to meet known short term commitments or as an asset allocation decision in the relevant investment portfolio.

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PROPERTY AND CASUALTY RESERVES

General

We establish property and casualty loss reserves to account for the anticipated ultimate costs of all losses and related loss adjustment expenses (“LAE”) on losses that have already occurred. We establish reserves for reported losses and LAE, as well as for incurred but not yet reported (“IBNR”) losses and LAE. Loss reserve estimates are based on known facts and on interpretation of circumstances including our experience with similar cases and historical claims payment trends. We also consider the development of loss payment trends, levels of unpaid claims, judicial decisions and economic conditions.

We use a variety of statistical techniques and a number of different bases to set reserves, depending on the business unit and line of business in question, as described in “Item 5—Operating and Financial Review and Prospects—IFRS and U.S. GAAP Critical Accounting Policies and Estimates”.

Loss Reserve Development

The tables below present changes in the historical property and casualty reserves that we established in 1996 and subsequent accounting years. The Group adopted International Financial Reporting Standards (“IFRS”) as adopted by the European Union for the year ended December 31, 2005. Previously the Group’s consolidated financial statements were prepared in accordance with applicable U.K. accounting standards and the Statement of Recommended Practice issued by the Association of British Insurers in November 2003. We have provided the later five years loss development data on an IFRS basis and the earlier five years loss development data on a U.K. GAAP basis.

The top line of each table shows the estimated reserves for unpaid losses and LAE set up as of each balance sheet date. Each amount in the top line represents the estimated amount of future payments to be made for losses and LAE for losses occurring in that year and in prior years. The upper (paid) portion of the tables presents the cumulative amounts paid through each subsequent year on those losses for which reserves were carried as of each balance sheet date. The lower (reserve re-estimated) portion of the tables shows the re-estimate of the initially recorded reserves as of each succeeding year end, ignoring claims paid, in the case of 2001 through 2005 prepared on an IFRS basis, at current period cumulative average rates of exchange, and, in the case of 1996 through 2000 prepared on a U.K. GAAP basis, at the latest period end rate of exchange. The estimate changes as more information becomes known about the actual losses for which the initial reserves were set up and as the rate of exchange changes. The cumulative redundancy/(deficiency) line reflects the cumulative changes in estimate since the initial reserve was established. The cumulative redundancy/(deficiency) is equal to the initial reserve as restated for exchange less the liability re-estimated as of December 31, 2005.

Reserves for losses and LAE are an accumulation of the estimated amounts necessary to settle outstanding claims as of the date for which the reserve is stated. The following data is cumulative and therefore ending balances should not be added since the amount at the end of each calendar year includes activity for both the current and prior years.

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CONSOLIDATED LOSS DEVELOPMENT—GROSS OF REINSURANCE
IFRS Basis (1)
 
    As of December 31,  
   
 
      2001     2002     2003     2004     2005  
   

 

 

 

 

 
    (£ in millions)  
Initial net reserves for unpaid losses and LAE
    10,565     10,653     11,056     10,820     10,843  
Initial retroceded reserves
    4,865     4,902     5,314     4,267     4,228  
   

 

 

 

 

 
Initial gross reserves
    15,430     15,555     16,370     15,087     15,071  
Exchange adjustment (3)
    (1,168 )   (506 )   (133 )   237     (384 )
   

 

 

 

 

 
As restated for exchange (4)
    14,262     15,049     16,237     15,324     14,687  
   

 

 

 

 

 
Paid (cumulative) as of:
                               
One year later
    4,763     4,320     4,276     3,530        
Two years later
    7,462     7,138     6,854              
Three years later
    9,547     9,135                    
Four years later
    11,040                          
Reserve re-estimated as of:
                               
One year later
    15,603     16,305     16,602     15,475        
Two years later
    16,969     16,998     17,172              
Three years later
    17,445     17,601                    
Four years later
    17,994                          
Cumulative redundancy (deficiency)
    (3,732 )   (2,552 )   (935 )   (151 )      

U.K. GAAP Basis (1) (2)

    As of December 31,  
   
 
      1996     1997     1998     1999     2000  
   

 

 

 

 

 
    (£ in millions)  
Initial net reserves for unpaid losses and LAE
    9,305     9,388     9,391     10,834     10,992  
Initial retroceded reserves
    2,241     2,240     2,152     3,183     3,476  
   

 

 

 

 

 
Initial gross reserves
    11,546     11,628     11,543     14,017     14,468  
Exchange adjustment (3)
    (165 )   (4 )   104     164     (57 )
   

 

 

 

 

 
As restated for exchange
    11,381     11,624     11,647     14,181     14,411  
   

 

 

 

 

 
Fair value adjustment to acquired loss reserves
                      130        
Paid (cumulative) as of:
                               
One year later
    3,320     3,469     3,564     4,796     5,032  
Two years later
    5,125     5,303     5,562     7,653     8,328  
Three years later
    6,313     6,655     7,119     9,794     10,659  
Four years later
    7,251     7,702     8,197     11,379     12,062  
Five years later
    7,950     8,403     9,106     12,281     12,997  
Six years later
    8,462     9,085     9,594     13,033        
Seven years later
    8,920     9,456     9,995              
Eight years later
    9,198     9,793                    
Nine years later
    9,506                          
Reserve re-estimated as of:
                               
One year later
    11,147     11,397     11,387     14,430     15,660  
Two years later
    10,871     11,080     11,617     15,354     16,477  
Three years later
    10,639     11,214     12,064     16,109     17,204  
Four years later
    10,739     11,513     12,365     16,562     17,898  
Five years later
    11,094     11,882     12,602     16,963     18,582  
Six years later
    11,423     11,971     12,864     17,539        
Seven years later
    11,494     12,278     13,108              
Eight years later
    11,805     12,595                    
Nine years later
    12,147                          
Cumulative redundancy (deficiency)
    (766 )   (971 )   (1,461 )   (3,358 )   (4,171 )

 

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(1)
As described above, the Group adopted IFRS for the year ended December 31, 2005. Previously the Group’s consolidated financial statements were prepared in accordance with U.K. GAAP. We have provided the later five years loss development data on an IFRS basis and the earlier five years loss development data on a U.K. GAAP basis. The key differences, in regard to loss development, between the IFRS basis and the previously reported U.K. GAAP basis are as follows:
 
i) all data is reported at current period cumulative average exchange rates on an IFRS basis whereas numbers are reported at original period end rates in the U.K. GAAP table;
 
ii) operations disposed of have been excluded in their entirety from the IFRS loss table whereas they are included in the data in the U.K. GAAP table;
 
iii) certain contracts reported as insurance contracts under U.K. GAAP do not meet the definition of insurance contracts under IFRS and hence are excluded from the IFRS table; and
 
iv) all data is reported gross of claims discount.
(2)
In 2001, we changed our accounting policy and we subsequently discounted provisions for outstanding claims and the related reinsurance recoveries for those categories of claims where there was a particularly long period from occurrence to claims settlement and where there existed a suitable claims payment pattern. The impact of this change in accounting policy was that the claims provisions for asbestos and environmental claims were discounted for the first time in 2001. In the loss development tables presented in this document we have omitted the discount of the asbestos and environmental claims provisions, and hence the reserves shown in the tables differ from the reserves in the financial statements.
(3)
The exchange adjustment is the difference between the initial reserve at the original rate of exchange and, in the case of the IFRS basis loss development table the cumulative average rate of exchange for the year ended December 31, 2005 and, in the case of the U.K. GAAP basis loss development table the initial reserve at the rate of exchange ruling on December 31, 2005.
(4)
Reconciliation of initial reserves to the balance sheet is set out below:
        2004     2005  
     

 

 
      (£ in millions)  
 
Gross reserves and LAE for unpaid losses per loss table
    15,324     14,687  
 
Exchange adjustment to original closing rates of exchange
    (237 )   384  
     

 

 
 
Gross reserves and LAE for unpaid losses per loss table at original closing rates of exchange
    15,087     15,071  
 
Discounting
    (842 )   (868 )
 
Disposals
    70      
 
Transfer to held for sale
    (27 )    
     

 

 
 
Gross reserves and LAE for unpaid losses per balance sheet
    14,288     14,203  
     

 

 

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CONSOLIDATED LOSS DEVELOPMENT—NET OF REINSURANCE
IFRS Basis (1)
 
    As of December 31,  
   
 
      2001     2002     2003     2004     2005  
   

 

 

 

 

 
    (£ in millions)  
Initial net reserves for unpaid losses and LAE
    10,565     10,653     11,056     10,820     10,843  
Exchange adjustment (3)
    (509 )   (194 )   (110 )   76     (238 )
   

 

 

 

 

 
As restated for exchange (4)
    10,056     10,459     10,946     10,896     10,605  
   

 

 

 

 

 
Fair value adjustment to acquired loss reserves
                               
Paid (cumulative) as of:
                               
One year later
    3,283     3,001     2,790     2,383        
Two years later
    5,086     4,798     4,464              
Three years later
    6,433     6,107                    
Four years later
    7,306                          
Reserve re-estimated as of:
                               
One year later
    10,666     10,950     11,264     10,794        
Two years later
    11,308     11,519     11,494              
Three years later
    11,830     11,869                    
Four years later
    12,034                          
Cumulative redundancy (deficiency)
    (1,978 )   (1,410 )   (548 )   102        

UK GAAP Basis (1) (2)

    As of December 31,  
   
 
      1996     1997     1998     1999     2000  
   

 

 

 

 

 
    (£ in millions)  
Initial net reserves for unpaid losses and LAE
    9,305     9,388     9,391     10,834     10,992  
Exchange adjustment (3)
    (94 )   31     78     37     (192 )
   

 

 

 

 

 
As restated for exchange
    9,211     9,419     9,469     10,871     10,800  
   

 

 

 

 

 
Fair value adjustment to acquired loss reserves
                      130        
Paid (cumulative) as of:
                               
One year later
    2,499     2,706     2,863     3,772     4,176  
Two years later
    3,905     4,133     4,588     5,934     6,474  
Three years later
    4,942     5,277     5,735     7,370     8,137  
Four years later
    5,652     6,108     6,562     8,417     9,006  
Five years later
    6,153     6,656     7,157     9,060     9,210  
Six years later
    6,536     7,073     7,501     9,303        
Seven years later
    6,842     7,355     7,564              
Eight years later
    7,055     7,449                    
Nine years later
    7,184                          
Reserve re-estimated as of:
                               
One year later
    8,897     9,085     9,112     11,117     11,553  
Two years later
    8,709     8,780     9,193     11,605     11,830  
Three years later
    8,501     8,819     9,533     11,856     12,474  
Four years later
    8,527     9,121     9,642     12,294     12,752  
Five years later
    8,800     9,315     9,801     12,528     13,492  
Six years later
    8,974     9,308     10,077     13,127        
Seven years later
    8,977     9,608     10,324              
Eight years later
    9,279     9,865                    
Nine years later
    9,548                          
Cumulative redundancy (deficiency)
    (337 )   (446 )   (855 )   (2,256 )   (2,692 )

 

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1)
As described above, the Group adopted IFRS for the year ended December 31, 2005. Previously the Group’s consolidated financial statements were prepared in accordance with U.K. GAAP. We have provided the later five years loss development data on an IFRS basis and the earlier five years loss development data on a U.K. GAAP basis. The key differences, in regard to loss development, between the IFRS basis and the previously reported U.K. GAAP basis are as follows:
 
i) all data is reported at current period cumulative average exchange rates on an IFRS basis whereas numbers are reported at original period end rates in the U.K. GAAP table;
 
ii) operations disposed of have been excluded in their entirety from the IFRS loss table where as they are included in the data in the U.K. GAAP table;
 
iii) certain contracts reported as insurance contracts under U.K. GAAP do not meet the definition of insurance contracts under IFRS and hence are excluded from the IFRS table; and
 
iv) all data is reported gross of claims discount.
2)
In 2001, we changed our accounting policy and we subsequently discounted provisions for outstanding claims and the related reinsurance recoveries for those categories of claims where there was a particularly long period from occurrence to claims settlement and where there existed a suitable claims payment pattern. The impact of this change in accounting policy was that the claims provisions for asbestos and environmental claims were discounted for the first time in 2001. In the loss development tables presented in this document we have omitted the discount of the asbestos and environmental claims provisions, and hence the reserves shown in the tables differ from the reserves in the financial statements.
3)
The exchange adjustment is the difference between the initial reserve at the original rate of exchange and, in the case of the IFRS basis loss development table the cumulative average rate of exchange for the year ended December 31, 2005 and, in the case of the U.K. GAAP basis loss development table the initial reserve at the rate of exchange ruling on December 31, 2005.
4)
Reconciliation of initial reserves to the balance sheet is set out below:
        2004     2005  
     

 

 
      (£ in millions)  
 
Net reserves and LAE for unpaid losses per loss table
    10,896     10,605  
 
Exchange adjustment to original closing rates of exchange
    (76 )   238  
     

 

 
 
Net reserves and LAE for unpaid losses per loss table at original closing rates of exchange
    10,820     10,843  
 
Discounting
    (722 )   (748 )
 
Disposals
    54      
 
Transfer to held for sale
    (22 )    
     

 

 
 
Net reserves and LAE for unpaid losses per balance sheet
    10,130     10,095  
     

 

 
 
Analysis of Reserving Movements
 
Year ended December 31, 2005

In 2005 we experienced net favorable reserve development of £102 million. Within this overall amount, favorable development of £452 million was seen from 2003 and 2004 partly offset by adverse development of £350 million from 2002 and prior.

There were five main areas where significant reserve movements occurred in 2005:

 
Commercial Property Worldwide. These are short-tailed classes of business where estimates are made using assumptions based on actual paid claims and case reserves. For the most recent accident year such an assessment at the end of that accident year is based on incomplete information including estimates of the impact of recent events (e.g., the Asian Tsunami in 2004). The ultimate outcome for the most recent accident year at the end of that year is necessarily uncertain. In 2005 there was favorable development of £108 million in this class.
     
   
At the end of 2005 we have used a similar approach in reserving Commercial Property business as in previous years. Should the loss ratio for this business turn out to be 5% more or less than currently estimated then a favorable or adverse movement of £50 million would occur.
     
 
UK Personal Property – Subsidence Reserves. Subsidence is damage to property caused by soil movements following prolonged dry periods. The last Subsidence “event” occurred in 2003. Following an event, reserves are difficult to estimate due to delays in the reporting of claims and uncertainties in the assessment of the cost of repairing the damage suffered.
     
   
By the end of 2005 emerging claim experience indicated that we had overestimated the ultimate number of claims originating from the subsidence event and that the average cost of settling such

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claims was also less than originally assumed. The effect of allowing for the actual experience in estimating the cost of the remaining claims was a reduction of £14 million in the ultimate cost.
     
   
The reserves for the remaining subsidence claims arising from the 2003 are relatively modest and so future movements of the size experienced in 2005 are unlikely.
     
 
Asbestos – U.K. risks written in the U.K. In 2005 there was adverse development of £45 million. As described below, estimating reserves for U.K., asbestos risks written in the U.K. requires assumptions to be made on future claim frequency and severity. In 2005 we observed a continuation of a trend first seen in 2004 of higher mesothelioma claims numbers than expected. It is not yet clear whether this trend reflects an acceleration of expected claims due to improved diagnosis techniques or simply a change to higher levels of claim numbers. We also saw slightly higher average claim settlements than expected, probably due to a disproportionate number of larger claim payments. Allowing for these factors in making assumptions at the end of 2005 caused the reserve estimate to increase.
     
   
Should mesothelioma claim numbers increase by 20% compared with the current assumption then adverse reserve movements of £63 million undiscounted (£27 million discounted) will be experienced. Should claim severity prove to be 5% higher than currently assumed then the adverse reserve movement will be £16 million undiscounted (£7 million discounted). Both these levels of movements are within recent experience.
     
   
Additional information showing the changes in survival ratios for these reserves is shown below.
     
 
Swedish Personal Accident. In 2005 we experienced adverse development of £52 million in this class. Historically reserves for this very long-tailed class of business have been estimated using paid development methods due to concerns about the reliability of incurred data. In 2005 the case development observed was higher due to an increase in the frequency of cases and higher case estimates for cases diagnosed with certain medical conditions such as stress. Greater weight is now put on incurred methods for estimating reserves.
     
   
Should full weight be given to the latest frequency and severity trends then a further adverse movement of £40 million would be observed.
     
 
U.S. Workers Compensation. In 2005, there was prior year adverse development of £37 million. The primary factor for this development was higher than expected emergence in case reserves for business written in the period 1996-2000. Actual case emergence in 2005 was £21 million, an amount significantly higher than expected. The underlying causes of this increase were greater than anticipated medical inflation and higher than expected levels of re-opened claims. This emergence led to a reassessment of the development factor assumptions used for all accident years and hence to the higher reserve estimates. If the paid loss development patterns increase by 7.5%, a change that is within historical variation, the estimated reserves would increase by £64 million.

In addition to the major movements described above we have also seen a number of more minor movements, both favorable and adverse, as actual claims experience emerges. This is a consequence of the inherent uncertainty of the reserving process. In 2005 the majority of these movements were favorable, particularly for the most recent accident years, due to the same reasons explained in the Commercial Property discussion above.

Year ended December 31, 2004

During the fourth quarter 2004 we undertook a detailed review of reserves held by our U.S. business and, in line with others in the industry, identified the need to strengthen our U.S. loss reserves. We consequently strengthened these loss reserves by £160 million. Of the strengthening £95 million related to workers’ compensation business with the balance across a number of lines including specialty and core segments.

The adverse development of £338 million (under U.K. GAAP basis) for 2004 was mainly due to reserve strengthening in the United Kingdom of £174 million and in the United States of £156 million.

 

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The reserve strengthening of £174 million in the U.K. all arose in accident years 1995 and prior and primarily related to U.K. asbestos reserves. In preparing our U.K. asbestos reserve estimates we use U.K. Health and Safety Executive data tables. During 2004 we adopted the latest updated data tables which indicated a higher incidence of asbestos claims but which were spread over a longer period.

The reserve strengthening of £156 million in the U.S. primarily related to accident years 2003, 2000 and 1995 and prior. Of the £156 million, £95 million related to strengthening of reserves for workers compensation. Following the adoption of a more consistent approach to claims handling practices across the group, resulting in more consistent data for analysis, and higher than expected medical inflation, workers compensation claims emergence in 2004 was higher than that previously expected.

Year ended December 31, 2003

In September 2003, we published the results of a review of our net loss reserves carried out by Tillinghast-Towers Perrin (“the Tillinghast Review”). This review found that our loss reserves at June 30, 2003 were within a reasonable range. However, as the loss reserves were below the Tillinghast best estimate and given the continued uncertainty in relation to asbestos and environmental claims and workers’ compensation claims, we increased our net loss reserves by £563 million. In total during 2003, there was adverse development of £731 million.

The adverse development of £731 million in 2003 primarily arose from reserve strengthening in the U.S. of £617 million and the U.K. of £75 million.

Of the £617 million reserve strengthening in the U.S., £491 million related to accident years 1999 to 2001. The reserve strengthening in the U.S. was mainly due to increases in asbestos, workers compensation and general liability following the completion of the Tillinghast Review. The review established that actual claims emergence across the asbestos, workers compensation and general liability lines of business was running higher than that assumed within our previous loss reserve estimates.

The reserve strengthening of £75 million in the U.K. primarily related to accident years 2000, 1998, and 1995 and prior, which was offset by reserve decreases in 2001 and 2002. The reserve increases primarily related to increases in asbestos reserves following the completion of the Tillinghast Review. The Tillinghast Review established that actual claims emergence on asbestos reserves was running higher than that assumed within our previous loss reserve estimates.

Year ended December 31, 2002

The adverse development of £734 million in 2002 primarily arose from reserve strengthening in the U.S. of £406 million, in the U.K. of £147 million and in International of £121 million.

The reserve strengthening of £406 million in the U.S. primarily arose in accident years 2001, 1999, and 1995 and prior. The reserve strengthening in the U.S. was mainly due to increases in asbestos, workers compensation and auto liability. An asbestos reserve review was undertaken by the Group in 2002 where the latest information projected a higher number of claims than had previously been assumed. Asbestos reserves in the U.S. were increased by £106 million (before discounting). The remaining reserve increases of £300 million primarily related to workers compensation and auto liability and were largely caused by higher than expected claims inflation.

The reserve strengthening of £147 million in the U.K. primarily arose in accident years 1998 to 2001 and 1995 and prior. The reserve increases primarily related to increases in asbestos and auto liability reserves. The increase in asbestos reserves of £101 million (before discounting) followed the findings of the internal asbestos review noted above. The increases in auto liability reserves arose after the emergence of higher than expected losses due to an increase in the number of younger drivers being insured.

The reserve strengthening of £121 million in International primarily arose in accident years 2001, 1999, and 1995 and prior. The reserve increases primarily related to auto liability reserves and arose due to higher than expected claims inflation.

 

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Year ended December 31, 2001

The adverse loss reserve development in 2001 was mainly due to the reserve strengthening for asbestos in both the United Kingdom and United States, reserving for the discontinued London Market business and an increase in U.S. workers’ compensation reserves partially offset by a change in estimate of discount on workers’ compensation reserves. These increases in reserves, in particular the reserves for asbestos, have incident dates going back a number of years and so have impacted the cumulative redundancy/(deficiency) for 2001 and all prior years shown in the table above.

Reserve Analysis of earlier years

In 2000, goodwill was increased by an amount that included £130 million as a fair value adjustment to the Orion acquired claims provisions for accident years 1997 to 1999. As this item is not a profit or loss account item for U.K. GAAP, it is shown as an adjustment to the deficiency for the year. For U.S. GAAP purposes, this item is reflected in the income statement. Loss reserve estimates are based on known facts and on interpretation of circumstances including our experience with similar cases and historical claims payment trends. We continually refine reserve estimates in a regular ongoing process as experience develops and further losses are reported and settled. The adjustment was based on an actuarial evaluation undertaken as part of this ongoing process in the fourth quarter of 2000. Claims handling and estimating procedures are inevitably affected by integration activity following an acquisition and this increases uncertainty concerning the adequacy of loss reserves for a period.

A substantial proportion of our property and casualty business, principally personal automobile and household, is short tail and therefore losses are reported and settled relatively quickly. By three years later over 60% of the total claims net of reinsurance initially reserved will generally expected to have been paid and by five years later the expected payment percentage is approximately 75%.

Other than for the reinsurance arrangements with The Chubb Corporation described below, there have been no portfolio transfers significant enough to distort the reserve development tables. The tables presented include the run-off of acquired operations only for those periods subsequent to acquisition. Run-off on the claims reserves of Trygg-Hansa and Orion, both acquired in 1999, were reflected in the loss development tables for 2000 for the first time. A number of non-material acquisitions have been made in the periods covered by the development tables, none of which has significantly affected run-off.

The merger of Royal Insurance and Sun Alliance in 1996 did not bring about any material change in reserving methodology or require additional reserving other than as described below. Some refinement to process took place in the respective actuarial units but on the whole the methodologies used by the two companies produced reserve levels of a consistent strength. It was general practice in both Royal Insurance and Sun Alliance to run a variety of statistical techniques on each reserving population and to select the technique that best approximated the ultimate costs of settling the claim. The selection of method was driven by the nature of the product and the claims experience data available. Methods used included chain ladder, Bornhuetter-Ferguson and average cost per claim.

A reinsurance arrangement between Sun Alliance in the United Kingdom and The Chubb Corporation in the United States was terminated with effect from January 1, 1997. The effect of the change to the reinsurance arrangement was to transfer a portfolio of £175 million of existing net assumed reserves to Chubb. This transfer had no effect on the reserve development redundancies/deficiencies.

The table below reconciles, as of the dates indicated, the gross loss reserve information presented above to the reserves presented in our consolidated financial statements.

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CONSOLIDATED RECONCILIATION OF RESERVES FOR LOSSES AND LAE (IFRS BASIS)

      2004     2005  
   

 

 
    (£ in millions)  
Net reserves for unpaid losses and LAE
    11,101     10,874  
   

 

 
Reinsurance recoveries/receivables for unpaid Losses and LAE
    5,342     4,283  
   

 

 
Gross reserves for losses and LAE at beginning of year
    16,443     15,157  
   

 

 
Disposals excluded from loss tables
        (70 )
   

 

 
      16,443     15,087  
Effect of changes in foreign currency exchange rates
    (410 )   633  
Effect of claims portfolio transfer and other reclassifications
    (124 )   27  
Incurred related to:
             
Current year
    4,882     4,358  
Prior years
    370     151  
   

 

 
Total incurred losses and LAE
    5,252     4,509  
   

 

 
Paid related to:
             
Current year
    1,761     1,695  
Prior years
    4,243     3,530  
   

 

 
Total paid losses and LAE
    6,004     5,225  
   

 

 
Gross reserves for losses and loss expenses at end of year
    15,157     15,071  
Reinsurance recoverable on unpaid losses
    (4,283 )   (4,228 )
   

 

 
Net reserves for losses and loss expenses at year end
    10,874     10,843  
   

 

 
Total incurred as a % of gross reserves
    31.9 %   30.0 %
Current year incurred as % of total incurred
    92.9 %   96.7 %
Prior year incurred as % of total incurred
    7.1 %   3.3 %
Total paid as % of net reserves
    54.3 %   48.1 %
Current year paid as % of total paid
    29.3 %   32.4 %
Prior year paid as % of total paid
    70.7 %   67.6 %

Included in the “effect of claims portfolio transfer and acquisitions” for 2004 are the adjustments arising from the disposal of our disability business in Denmark and our property and casualty operation in Peru.

Included in the “effect of claims portfolio transfer and acquisitions” for 2005 are the adjustments arising from the acquisition of subsidiaries in Chile and Argentina less the adjustments arising from the disposal of our business in Japan.

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Reserves for U.S. Workers Compensation

The level of reserves for U.S. workers compensation, at December 31, 2005, is $1,461 million. The most important assumption for workers compensation reserves is the loss development factors, which implicitly allows for future inflation trends. The Company has reviewed the historical variation in paid loss patterns. If the paid loss development patterns increased by 7.5%, a change that is within historical variation, the estimated reserves would increase by $110 million.

 
The tables below show U.S. Workers Compensation reserve, paid claims and claims numbers data.
 
Total undiscounted reserves
 
 
 
    As of December 31,

 
Accident year
    2002     2003     2004     2005  
   

 

 

 

 
    ($ in millions)  
Prior
    $392     $357     $377     $338  
1996
    39     41     37     39  
1997
    47     49     45     48  
1998
    86     105     90     84  
1999
    164     197     163     127  
2000
    216     270     210     199  
2001
    311     285     226     190  
2002
    472     299     253     194  
2003
        373     269     203  
2004
            59     40  
2005
                1  
   

 

 

 

 
Total
    $1,727     $1,976     $1,729     $1,461  
   

 

 

 

 
 
Amount paid during the year
 
    As of December 31,

 
                     
Accident year
    2003     2004     2005  
   

 

 

 
    ($ in millions)  
Prior
    $37     $43     $43  
1996
    8     5     8  
1997
    15     10     10  
1998
    29     21     18  
1999
    65     46     71  
2000
    114     72     51  
2001
    136     78     41  
2002
    168     89     57  
2003
    109     100     58  
2004
        16     22  
2005
             
   

 

 

 
Total
    $681     $480     $379  
   

 

 

 

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Number of claims open at
 
    As of December 31,

 
Accident year
    2002     2003     2004     2005  
   

 

 

 

 
Prior
    4,789     4,466     4,088     3,526  
1996
    466     384     330     267  
1997
    672     522     393     290  
1998
    1,594     1,151     879     661  
1999
    3,476     2,342     1,685     1,186  
2000
    7,930     5,475     3,976     2,131  
2001
    11,879     8,917     7,176     3,504  
2002
    14,398     8,778     6,127     3,316  
2003
        9,412     5,385     2,956  
2004
            978     506  
2005
                11  
   

 

 

 

 
Total
    45,204     41,447     31,017     18,354  
   

 

 

 

 
 
Number of new claims during the year
 
    As of December 31,

 
Accident year
    2003     2004     2005  
   

 

 

 
Prior
    178     69      
1996
    148     118     73  
1997
    170     152     76  
1998
    437     290     90  
1999
    892     569     371  
2000
    1,838     1,149     894  
2001
    3,571     1,585     193  
2002
    9,666     2,406     490  
2003
    19,892     4,702     1,074  
2004
        2,874     627  
2005
            26  
   

 

 

 
Total
    36,792     13,914     3,914  
   

 

 

 

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Reserves for Asbestos and Environmental Losses

The following tables outline the asbestos provisions on an IFRS basis as at December 31, 2005, 2004 and 2003, using exchange rates applicable on those dates, analyzed by risk and survival ratio for U.K. and U.S. risks. Survival ratio is an industry standard measure of a company’s reserves expressing recent year claims payments or notifications as a factor of liabilities.

As of December 31, 2003
    Total     U.K. Risks written in U.K.     U.S. Risks written in U.K.     U.S. Risks written in U.S.  
   

 

 

 

 
    (£ in millions)  
Provisions
                         
Net of reinsurance
    967     449     178     340  
Net of discount
    642     307     130     205  
   

 

 

 

 
Survival Ratios – On Payment
                         
(Gross of discount)
                         
One Year
    28     32     63     19  
Three Years
    27     46     33     16  
Survival Ratios – On Notification
                         
(Gross of discount)
                         
One Year
    21     23     2     18  
Three Years
    19     25     31     13  

 

As of December 31, 2004
    Total     U.K. Risks written in U.K.     U.S. Risks written in U.K.     U.S. Risks written in U.S.  
   

 

 

 

 
    (£ in millions)  
Provisions
                         
Net of reinsurance
    1,012     579     133     300  
Net of discount
    572     298     88     186  
   

 

 

 

 
Survival Ratios – On Payment
                         
(Gross of discount)
                         
One Year
    24     30     22     19  
Three Years
    27     43     31     15  
Survival Ratios – On Notification
                         
(Gross of discount)
                         
One Year
    18     26     23     11  
Three Years
    19     28     20     12  

 

As of December 31, 2005
    Total     U.K. Risks written in U.K.     U.S. Risks written in U.K.     U.S. Risks written in U.S.  
   

 

 

 

 
    (£ in millions)  
Provisions
                         
Net of reinsurance
    1,051     612     122     317  
Net of discount
    600     327     71     202  
   

 

 

 

 
Survival Ratios – On Payment
                         
(Gross of discount)
                         
One Year
    22     44     8     18  
Three Years
    25     39     15     18  
Survival Ratios – On Notification
                         
(Gross of discount)
                         
One Year
    19     29     16     11  
Three Years
    20     29     17     13  

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The tables below present the changes in the historical asbestos and environmental reserves established by us for 2003 and subsequent accounting years.

ASBESTOS LOSS DEVELOPMENT TABLE—GROSS OF REINSURANCE
(IFRS BASIS(1))
 
    As of December 31,

 
      2003     2004     2005  
   

 

 

 
    (£ in millions)  
Initial net reserves for
                   
Unpaid loss and LAE
    975.7     1,021.1     1,060.7  
Initial retroceded reserves
    253.4     326.6     334.6  
   

 

 

 
Initial gross reserves as originally reported
    1,229.1     1,347.7     1,395.3  
Exchange adjustment to 2005 rate of exchange
    30.9     68.7      
   

 

 

 
Initial gross reserves at 2005 rate of exchange
    1,260.0     1,416.4     1,395.3  
   

 

 

 
Paid (cumulative) as of :
                   
One year later
    73.8     73.6        
Two years later
    147.7              
Reserve re-estimated as of:
                   
One year later
    1,421.4     1,468.7        
Two years later
    1,542.4              
Cumulative redundancy/(deficiency) before unwind of discount
    (282.4 )   (52.3 )      

 

ASBESTOS LOSS DEVELOPMENT TABLE—NET OF REINSURANCE
(IFRS BASIS (1))
 
    As of December 31,

 
      2003     2004     2005  
   

 

 

 
    (£ in millions)  
Initial net reserves for
                   
Unpaid loss and LAE
    975.7     1,021.1     1,060.7  
Exchange adjustment to 2005 rate of exchange
    4.4     41.7      
   

 

 

 
Initial gross reserves at 2005 rate of exchange
    980.1     1,062.8     1,060.7  
   

 

 

 
Paid (cumulative) as of:
                   
One year later
    72.2     47.5        
Two years later
    119.9              
Reserve re-estimated as of:
                   
One year later
    1,093.3     1,108.1        
Two years later
    1,180.6              
Cumulative redundancy/(deficiency) before unwind of discount
    (200.5 )   (45.3 )      

 
(1)
The exchange adjustment is the difference between the initial reserve at the original rate of exchange and the initial reserve at the rate of exchange ruling on December 31, 2005.

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ENVIRONMENTAL LOSS DEVELOPMENT TABLE—GROSS OF REINSURANCE
(IFRS BASIS (1))

    As of December 31,

 
      2003     2004     2005  
   

 

 

 
    (£ in millions)  
Initial net reserves for
                   
Unpaid loss and LAE
    171.6     159.5     171.9  
Initial retroceded reserves
    52.1     54.2     67.3  
   

 

 

 
Initial gross reserves as originally reported
    223.7     213.7     239.2  
Exchange adjustment to 2005 rate of exchange
    10.6     19.3      
   

 

 

 
Initial gross reserves at 2005 rate of exchange
    234.3     233.0     239.2  
   

 

 

 
Paid (cumulative) as of:
                   
One year later
    12.9     10.4        
Two years later
    23.5              
Reserve re-estimated as of:
                   
One year later
    223.4     248.2        
Two years later
    259.8              
Cumulative redundancy/(deficiency) before unwind of discount
    (25.5 )   (15.2 )      

ENVIRONMENTAL LOSS DEVELOPMENT TABLE—NET OF REINSURANCE
(IFRS BASIS (1))

    As of December 31,

 
      2003     2004     2005  
   

 

 

 
    (£ in millions)  
Initial net reserves for
                   
Unpaid loss and LAE
    171.6     159.5     171.9  
Exchange adjustment to 2005 rate of exchange
    5.6     14.8      
   

 

 

 
Initial gross reserves at 2005 rate of exchange
    177.2     174.3     171.9  
   

 

 

 
Paid (cumulative) as of:
                   
One year later
    11.6     7.8        
Two years later
    19.2              
Reserve re-estimated as of:
                   
One year later
    168.3     178.6        
Two years later
    188.8              
Cumulative redundancy/(deficiency) before unwind of discount
    (11.6 )   (4.3 )      

 
(1)
The exchange adjustment is the difference between the initial reserve at the original rate of exchange and the initial reserve at the rate of exchange ruling on December 31, 2005.

We have exposure to liabilities for asbestos related and environmental pollution (“A&E”) losses arising from the sale of commercial liability and multi-peril policies prior to 1987. After 1987, policy wordings contained more prescriptive, and in many cases absolute, exclusions for these types of exposure thereby considerably reducing the potential for loss.

Coverages provided under which these liabilities have emerged were in most cases with smaller commercial customers and involved small policy aggregate limits and limits to coverage. We wrote a limited amount of excess coverage in the United States, most of which were excess policies on top of our own primary covers as opposed to primary policies written by other insurers. As a result, to a large extent, we were able to maintain underwriting and policy wording discipline. Excess policies are insurance policies, which provide coverage in excess of the policy limits of another insurance policy, sometimes referred to as the primary policy.

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In other words, primary policies provide insurance coverage only to a defined limit of liability. Excess policies provide additional coverage beyond this liability limit.

Reserving for A&E claims is subject to a range of uncertainties that are generally greater than those presented by other types of claims. These include long reporting delays, unresolved legal issues on policy coverage and the identity of the insureds. As a consequence, traditional loss reserving techniques cannot wholly be relied on and we have employed specialized techniques to determine reserves in a prudent manner using the extensive knowledge of both internal A&E experts and external legal and professional advisors.

Factors contributing to this higher degree of uncertainty include:

 
plaintiffs’ expanding theories of liability, compounded by inconsistent court decisions and judicial interpretations;
     
 
a few large claims, accompanied by a very large number of small claims or claims made with no subsequent payment, often driven by intensive advertising by lawyers seeking claimants;
     
 
the tendency for speculative, inflated and/or unsupported claims to be made to insurers, with the aim of securing a settlement on advantageous terms;
     
 
the long delay in reporting claims and exposures, since the onset of illness and disability arising from exposure to harmful conditions may only become apparent many years later, for example, cases of mesothelioma can have a latent period of up to 40 years;
     
 
inadequate development patterns;
     
 
difficult issues of allocation of responsibility among potentially responsible parties and insurers;
     
 
complex technical issues that may give rise to delays in notification arising from unresolved legal issues on policy coverage and the identity of the insureds;
     
 
the tendency for social trends and factors to influence jury verdicts; and
     
 
developments pertaining to the Group’s ability to recover reinsurance for claims of this nature.

The position in the United States is particularly problematic, as plaintiffs have expanded their focus to defendants beyond the ‘traditional’ asbestos manufacturers and distributors. This has arisen as a consequence of the increase in the number of insureds seeking bankruptcy protection because of asbestos-related litigation and the exhaustion of their policy limits. Plaintiffs, supported by lawyers remunerated on a contingent fee basis, are now seeking to draw in a wide cross section of defendants who previously only had peripheral or secondary involvement in asbestos litigation. This may include companies, which have distributed or incorporated asbestos containing parts in their products or operated premises where asbestos was present. There are also increasing signs of attempts to reopen and reclassify into other insurance coverages previously settled claims, and the filing of claims under the non-aggregate premises or operation section of general liability policies. There are also indications that plaintiffs may seek damages by asserting that insurers had a duty to protect the public from the dangers of asbestos.

Against this background and in common with the industry generally, the Group in the United States receives notifications and approaches from, and on behalf of, insureds who previously had peripheral or secondary involvement in asbestos litigation indicating that they may be seeking coverage under Group policies. Given the uncertainties outlined above as to the potential of loss suffered, the availability of coverage and the often long delay in reporting these issues it is difficult to predict the outcome of these notifications and approaches. The greatest difficulty is with estimating whether the Group has any liability as many of these are discharged at no cost to the Group or have been settled below the quantum sought, although there can be no certainty that this will always be the case. It is clear that there is unlikely to be any firm direction in case law or legislation which would allow for these issues to be resolved satisfactorily in the near term and no likelihood of the plaintiffs’ bar in the U.S. easing its aggressive stance with litigation. We, therefore, expect that these notifications and approaches will continue to be received for some time to come. One such approach received during 2004 from General Motors Corporation is now the subject of ongoing litigation.

 

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Total net outstanding A&E claims reserves at the end of 2005 amounted to £1,233 million. Net A&E reserves have increased from £1,181 million at the end of 2004. The A&E reserves are mainly in the United Kingdom and the United States (approximately £1,181 million), and to a lesser extent in Canada (approximately £52 million). Amounts recoverable from reinsurers as of December 31, 2005 amounted to £402 million. Unrecoverable amounts, which are not included in the above figure, are not significant and have been fully provided for.

Reserves for environmental liabilities include provision for IBNR claims. The Group has provided for IBNR claims based on modeling performed by both internal experts and external consulting actuaries.

As with other claims reserves, A&E reserves are subject to regular internal review and updating. It is our practice to periodically subject reserves to independent actuarial review and in 1996 following a comprehensive review by an independent actuarial consulting firm, A&E reserves in the United States were strengthened by £117 million and in the United Kingdom by £25 million. Our A&E reserves in the United States were reviewed by independent actuaries in 1999 and our overall level of claims reserves were in the range indicated by the actuaries. Asbestos reserves on inbound reinsurance business in the United Kingdom were reviewed by consulting actuaries in 1999. Resulting from this and other reviews, we released gross reserves of £40 million. The net impact of this release after reinsurance was £6 million. The asbestos reserves were reviewed by independent actuaries in 2001 and, before the impact of discounting the reserves, increased by £200 million in the United Kingdom and by £171 million in the United States. Reviews carried out on asbestos reserves on behalf of the Group during 2002 confirmed that the existing provisions were within the range of reasonable actuarial estimates. They were, however, towards the lower end of that range. In light of this, reserves were strengthened by £101 million before the effect of discounting in the United Kingdom and by £106 million before the effect of discounting in the United States. U.S. asbestos reserves were further strengthened by £80 million before the effect of discounting following publication of the Tillinghast Report in 2003. United Kingdom asbestos reserves were increased by £179 million before the effect of discounting to move the reserves further up the range of possible outcomes. In 2004 asbestos reserves in the United Kingdom were strengthened by £148 million before the effect of discounting, following publication of revised estimates for future mesothelioma deaths. In 2005 United Kingdom asbestos reserves were increased by £45m, reflecting higher than expected claim frequency.

In May 2004 we reached agreement in principle with the Administrators of Turner & Newall (“T&N”), an asbestos products manufacturer in administration. This agreement makes available a sum of money towards compensating workers exposed to asbestos by T&N during the years covered by the policies. This should conclude our involvement in any asbestos liabilities of the T&N companies.

Over the past few years, our U.S. operation has been aggressively pursuing A&E claims settlements. This process has involved, where possible, legally enforceable settlement agreements to limit our liabilities. In 2000 the environmental claim payments include the settlement of one large claim for £20 million and in 2001 include one large claim payment of £14 million.

Following recent debate in the U.S. Senate, the prospects of some form of asbestos reform, including a no fault Trust Fund, have substantially diminished during the first quarter 2006. However, the risk remains of reform progressing in a way that does not ensure finality and allows claims for individuals who have failed to establish genuine medical criteria.

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UNDERWRITING AND PRICING

Underwriting and Pricing

Disciplined underwriting, encompassing risk assessment, risk management, pricing and exposure control is critical to our success.

The Group has an Underwriting and Claims Policy that clearly identifies the approach to be adopted in respect of risk selection and management, pricing adequacy, i