Royal & Sun Alliance Executive Summary

Written premiums are growing at a faster rate than competitors A low risk investment strategy enabled the avoidance of dramatic loses in 2008 seen by competitors Cash balances are decreasing as a result of a progressive dividend payout policy and an aggressive acquisition strategy The International division is the strongest, the UK division is the weakest and is only just profitable Net Profits do not support the progressive dividend payout policy Dividend policy appears sustainable if pre tax profits remain as high as in the 2005 to 2008 period If profits continue at the 2009 level or fall further then the reduction in overall cash balances is not sustainable and the company may need to review its dividend policy

Question This report will seek to analyse the profitability of Royal and Sun Alliance RSA compared to its competitors. The base data used will be the audited Annual Reports and Accounts of the companies concerned. Context RSA is a leading general insurer operating in 34 countries and providing products and services to 130 countries. It is the 2nd largest commercial insurer in the UK and the 4th largest personal insurer. It celebrated its 300th year in 2010. RSA pays one of the highest dividend yields in the FTSE 100 at 6.84% in 2009. RSA has increased its dividend year on year over the last five years. It would be interesting to analyse if the company is producing sufficient profits to justify these dividend levels and the sustained increases year on year. Revenue RSA derives its revenue from two main sources, from premiums and from investment returns. Premium Income RSA has shown growth in each of the last 5 years and has grown from 2008 to 2009 by 4.26%. This is analysed further later in this report, under the Key Performance Indicators section, on page 4.

2005 m Premium Income1 Investment Income 5,300

2006 m 5,484

2007 m 5,837

2008 m 6,462

2009 m 6,737

RSAs investment income has remained strong over the 5 year period despite the economic crisis which has engulfed the banking and investment world. This is largely due the groups policy of a low risk strategy, investing mainly in fixed income and cash investments. 2005 m Investment Portfolio2 Investment Returns3 15,610 668 2006 m 12,760 600 2007 m 13,380 709 2008 m 14,850 681 2009 m 14,320 616

RSAs investment split for 2009 is as follows4; Bonds 80% Cash 7% Equities 7% Other 6%

99% of RSAs bond portfolio is invested in investment grade bonds; these are bonds with a high credit rating/low risk profile5. RSAs Chief Executive Officer asserts, in the 2009 group review, that the reduction in investment returns over the last two years is due to lower interest and bond rates. The investment grade bonds have however allowed the company to maintain the value of its Investment Portfolio. I have chosen to compare RSA against Aviva and Legal and General. I have chosen to look at Aviva because it is the UKs largest insurer. I have chosen to look at Legal and General because they are one of the UKs largest insurers. There are a few key differences between RSA, Aviva and Legal and General which should be noted. RSA is a pure insurer whereas Aviva and Legal and General are involved in insurance but more notably savings and investment and life assurance products as well. Comparing the Investment Returns of RSA with Aviva and Legal & General; 2007 m Investment Returns L&G6 Investment Returns Aviva7 Investment Returns RSA
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2008 m - 37,749 - 16,043 681

2009 m 38,201 24,972 616

13,225 9,689 709

RSA Annual Report and Accounts 2005 to 2009 Consolidated Income Statement RSA Annual Report and Accounts 2005 to 2009 Consolidated Balance Sheet 3 RSA Annual Report and Accounts 2005 to 2009 Consolidated Income Statement 4 RSA Annual Report and Accounts 2009, Financial Review, P29 5 RSA Annual Report and Accounts 2009 Financial Review, Investment Assets. (I have considered a full explanation to be outside the scope of this report.) 6 Legal and General Annual Report and Accounts - Consolidated Income Statements 2007, 2008 & 2009 7 Aviva Annual Report and Accounts Consolidated Income Statements 2007, 2008 & 2009
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The investment returns stated above reflect the relative percentage in relation to their investment portfolio, with Avivas total investment portfolio for 2009 at 292,2118 and Legal and Generals at 279,8559. Legal and General and Aviva show much more volatility and further analysis of their accounts shows that in 2008/2009 an average of 48% of Legal and Generals investments were in Equity based securities and Aviva had 16% of its investments in Equity. Legal and General and Aviva are invested in higher risk investments such as equities, these are stock market based investments. In 2008 the FTSE 100 stock market dropped from approximately 6,500 points to 4,000 points10 this is reflected in the decline in investment returns in 2008 shown above. Investment returns and their value are important to RSA and other insurers primarily as a source of income, but they are also needed to match and balance the companys long term liabilities, and underpin its ability to meet claims. It is also a requirement of the Financial Services Authority that the company holds a minimum regulatory capital surplus in order to continue trading. RSA holds capital in the ratio of x 2.4 to the requirement almost constant from the previous year of x 2.5. Legal & General by comparison dropped to a ratio of 1.69 in 2008. It could be argued that the company could increase profits by investing in more risky equity based investments and higher risk/higher yield bonds, it would however run the risk of its capital base being seriously depleted in times of turbulence in the stock markets. The current policies therefore have protected the companys investment assets in a very difficult market. This contrasts with Aviva who made an investment loss in 2008 of 16,043m and Legal & General who made an investment loss of 37,749m in the same year. In summary RSAs strategy of having the majority of its investment portfolio in investment grade bonds has allowed them to maintain the value of its portfolio. It has also allowed them to avoid the steep decline in investment returns seen by its competitors in 2008. Profitability The RSA group has achieved profits before tax over each of the last 5 years which are in line with expectations set out in the budgets at the start of the year. They have reported increases in profits in 3 of the 5 years. Year Total Revenue m 6,006 6,013 6,429 7,143 7,458 Pre Tax Profit m 894 649 670 759 554 Ratio11 % 14.9% 10.7% 10.4% 10.6% 7.4%

2005 2006 2007 2008 2009

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Aviva Annual Report and accounts 2009, notes to the accounts, analysis of investments Legal and General Annual Report and Accounts 2009, Consolidated Balance Sheet 10 Financial Times Website - www.ft.com/uk/markets 11 RSA Annual Report and Accounts 2005 to 2009 Consolidated Income Statement Ratio calculated using Total Revenue divided by Pre Tax Profits.

This ratio shows that although RSA is increasing its revenue year on year, its pre tax profits are not increasing in relation to the revenue. I have looked at the two years when profits decreased and identified the following causes; Pre Tax Profits of 894m in 2005 decreased to 649m in 2006. The Chief Financial Officer in the 2006 Financial Review states that this was not caused by 2006 being a poor year but by one off benefits in 2005 from a revaluation of the pension scheme liabilities and the disposal of 3 businesses. The revaluation of the pension scheme liabilities resulted in a gain on the 2005 profit of 180m, and a further gain of 197m from the disposal of three businesses in the US and Japan. Without these one off items the profit in 2005 could be restated at 517m, giving a substantial increase in Pre Tax Profits from 2005 to 2006.12 The 2009 Pre Tax Profits dropped to 554m from 759m in 2008. An analysis of the accounts shows this to be caused by13 a) b) c) Restructuring costs in the UK of 75m Reduction of 65m in investment income due to low interest rates as explained above An increase in expenses 21m associated with operations in India and Central and Eastern Europe reflecting increased investment and changes to the structure of the businesses from associate to wholly owned.

The average ratio of Pre Tax profits to revenue (2005 to 2009) is 10.67%, this compares well with Aviva at 3.8%14 and Legal & General at 4.09%15. Aviva and Legal and Generals low returns do however reflect the heavy losses made in 2008 on investments. Overall given that over the 5 year period RSA has pursued an aggressive acquisition strategy the companys profit performance would seem to have been modest and the increased turnover does not fully reflect in the pre tax profits. Key Performance Indicators (KPIS) The group itself measures its performance with reference to three main KPIs and I think it is appropriate to consider each of these in turn. I have re performed these calculations and compared them with the figures quoted by RSA to determine their veracity. Net Written Premiums Net written premiums have increased in each of the last 5 years. The total increase in premiums over the period 2007 to 2009 for RSA is 15.4% and this compares favourably with Legal & General at 10% and Aviva at 11.5%.

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RSA Annual Report and Accounts 2005, Financial Review Pension Fund, Financial Review Analysis of Results (Disposals) 13 RSA Annual Report and Accounts 2009, Business Revie Chief Executive 14 Aviva Annual Report and Accounts (2005 to 2009) Consolidated Income Statements Pre Tax Profits and Revenue 15 Legal and General Annual Report and Accounts (2205 to 2009) Consolidated Income Statements Pre Tax Profits and Revenue

Net Written Premiums16 2005 m RSA L&G Aviva 5,300 2006 m 5,484 2007 m 5,837 4,283 29,312 2008 m 6,462 5,327 34,642 2009 m 6,737 4,712 32,673

Group combined operating ratio (GCOR) GCOR is the Ratio of claims and expenses as a percentage of premiums. In effect the lower the ratio the more profitable the group is, 100% would indicate that RSA are paying out in claims and expenses their full premium income.
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GCOR %

2005 94.1%

2006 93.3%

2007 94.9%

2008 94.5%

2009 94.6%

Although this has remained stable over the 5 years and shows that the group is achieving profit through its underwriting business it does hide the fact that the ratio varies significantly across the groups divisions. These differences in divisional performance are looked at later in the report and the action being taken in the UK to rectify the problems. Underwriting Result Underwriting Result is the earned premiums less the cost of claims and operating expenses, it indicates whether premiums cover claims and expenses, excludes the investment returns. 2005 m UR18 263 2006 m 310 2007 m 278 2008 m 384 2009 m 386

The company has managed to increase its underwriting result each year with the exception of 2007 when it experienced large claims due to adverse weather particularly the floods in that year which were responsible for an additional 120m in claims. Neither Legal and General or Avivas accounts split expenses sufficiently enough to enable a comparison of the GCOR or Underwriting Results to be accurately calculated. When re calculating the KPIs for RSA my calculations agree with those stated in RSAs Annual Reports and Accounts, the figures stated in RSAs accounts have been audited and so can be relied upon. In Summary RSAs Net Written Premiums have increased steadily over the 5 year period and at a faster rate than Aviva and Legal and General.
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RSA, L & G and Aviva Reports and Annual Accounts 2005 to 2009 Consolidated Income Statements, Net written premiums = Premiums written less reinsurance 17 RSA Annual Report and Accounts 2005 to 2009 , Consolidated Income Statement 18 RSA Annual Report and Accounts 2005 to 2009 , Consolidated Income Statement, Flood Figure takes from Financial Review Section.

Shareholder Value In order to see if compared with other companies in the insurance industry RSA is delivering shareholder value I have looked at Earnings per share and Dividend yield, and if the dividend is growing. 2005 Share price19 Dividend20 Earnings per share21 Dividend yield %22 128.0p 4.74p 19.9p 3.7% 2006 152.5p 5.87p 15.0p 3.85% 2007 148.5p 7.01p 19.3p 4.72% 2008 138.1p 7.71p 17.3p 5.59% 2009 120.6p 8.25p 12.2p 6.84%

The company has increased its dividend and dividend yield year on year over the last 5 years, although the share price itself has not increased over that time. The dividend yield is one of the highest in the banking and finance sector and exceeds that of Legal & General at 4.8%23 and Aviva at 6.0%24. The earnings per share have shown a reduction, some of which is attributable to more shares being in issue at the end of the 5 year period approximately 15%, the marked reduction in 2009 being due to the drop in profits in that year. The increase in dividend is not being justified by a rise in pre tax profits. 2005 Dividend Cover25 4.23 2006 2.6 2007 2.75 2008 2.24 2009 1.48

The dividend cover has reduced notably over the last 5 years. This is due to the policy of increasing the dividend year on year against the relatively static profits and although the dividend is still supported by stable profits the policy of increasing the dividend year on year whilst pursuing an aggressive acquisition policy must be questioned unless the profitability of the group can be increased to match. The average PE across the FTSE 100 index is 12.3326. The average PE for Financial Services is 18.1, for Non Life Insurance/Assurance 10.26 and for Life Insurance/Assurance 8.1127. These averages suggest that the PE of RSA a Non Life Insurer at 9.97 is relatively normal compared with the sector average of 10.26. Life Insurers Aviva and Legal and General with lower averages compare well in relation to the sector averages for life insurance at 8.11.

RSA Annual Report and Accounts 2005 to 2009, Shareholder information section, Years closing price. RSA Annual Report and Accounts 2005 to 2009. Notes to accounts - note 5, plus financial review section, Interim & Final dividend. 21 RSA Annual Report and Accounts 2005 to 2009, Notes to accounts note 6, undiluted. 22 RSA Annual Report and Accounts 2005 to 2009, Calculated on year end share closing price, Dividend Yield calculated from figures in table. 23 Legal and General Annual Report and Accounts 2009-Calculated using Dividend per share (From Consolidated Income Statement) divided by Share Price (Financial Notes Shareholder Information Section) 24 Aviva Annual Report and Accounts 2009-Calculated using Dividend per share (From Consolidated Income Statement) divided by Share Price (Financial Notes Shareholder Information Section) 25 Calculated from Diluted EPS from RSA Annual Report and Accounts 2009, note 6 financial accounts and Dividend figures above Diluted Earnings per share /dividend per share 26 Financial times uk, stock exchange index series values 27 www.ft.com/equities - FTSE ACTUARIES SHARE INDICES
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2005 P/E ratio RSA28 P/E ratio Aviva P/E ratio L & G 6.43 ---------

2006 10.3 ---------

2007 7.82 12.70 11.6

2008 8.12 6.20 N/A

2009 9.97 8.80 5.40

In summary RSAs PE compares well within its sector and also against Aviva and Legal and General. Its dividend payouts, whilst supported by stable profits, are not in sequence with the profit levels. Review of the Individual Divisions The Company operates through three divisions - International, UK and Emerging Markets. International The largest sector markets are; Scandinavia 52%, Canada 31%, Other Europe 17% 2009 m Net Written Premiums Underwriting result Comb operating ratio UK Cost saving program of 70m introduces in 2010 2009 m Net Written Premiums Underwriting result Comb operating ratio Emerging Markets 21 Countries across Latin America, Asia, Middle East, Central & Eastern Europe 2009 m Net Written Premiums Underwriting result Comb operating ratio 833, 29, 95.1% 2008 m 738, 23, 96.4% 2007 m 615, 18, 95.3% 2,632 75, 98% 2008 m 2,711 99, 97.6% 2007 m 2,688 65, 97.6% 3,249 282 91.7% 2008 m 2,998 262 91.2% 2007 m 2,513 206 91.3%

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RSA 2009 accounts P/E calculated from closing share price (shareholder information section) and note 6 diluted earnings per share

International This is the largest division and contributes the majority of the companies underwriting result at 282m of the 386m total. It has achieved impressive figures over the last three years. Net written premiums increasing by 8% in the last year and by an impressive 18% 2007 to 2008. This has been matched by its underwriting result increasing by 8% and 27% in the same periods. The Combined operating ratio is also much higher than achieved in the other two divisions and has remained between 91.2 % and 91.7% over the three years. Some of this growth it should be noted has been achieved by acquisition but the company has grown not only its turnover but profits over the period. UK The UK has by contrast faced difficult trading conditions over the three years with strong competition on premiums. This reflects in the almost static net written premium figures which fall slightly between 2007 and 2009 and the underwriting result growing strongly by 48% from 2007 to 2008 but falling back by 25% from 2008 to 2009. This also reflects in the much higher combined operating ratio which stays almost constant at 98%. Indicating that the division is only just profitable. During 2010 the company introduced a cost saving program of 75m and has taken action to withdraw from non profitable areas of insurance and reduce its workforce by 1200, this should result in improved results in this division from mid 2010 onwards. Emerging Markets This is the smallest of the three divisions contributing only 12% of net written premiums; however its results in percentage growth terms are excellent increasing Net Written Premiums by 12% from 2007 to 2008 and 13% 2008 to 2009 with the Underwriting Result increasing by 27% and 26% over the same period. The combined operating ratio, whilst not as good as the achieved by the international division, has averaged 95.6% over three years and has reduced by 1.3% in the last year.29 In summary the international division is the strongest of the 3 divisions. The UK is the weakest of the three divisions and its combined operating ratio shows that the division is only jus profitable. Cash Flow The groups cash flow is split into three sections, Operating activities, Investing activities and Financial activities. The movements in the cashflow over the last 5 years are as follows. 2005 m Operating activities Investing Activities Financial Activities Total 31 -130 -225 -324 2006 m 117 781 -389 509 2007 m 303 -681 -186 -564 2008 m 527 -446 -172 -91 2009 m 301 -595 -166 -46030

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Source for section - RSA Accounts & Reports 2007 to 2009 Divisional Business Reviews RSA Annual Report and Accounts 2005 to 2009, Consolidated Cash Flow Statements

The cash position at the year end after adjustment for exchange gains and losses is shown below; Cash, cash equivalents & bank overdrafts at the year end

2005 m Cash 31 Operating Cash Flow 1,612

2006 m 2,040

2007 m 1,538

2008 m 1,614

2009 m 1,105

RSAs cash flow position is strong. It has increased its operating cash flow in each of the last 5 years (excluding 2009), on the whole reflecting the continued profitability of the group. The lower positive cashflow earned from 2009 is the result of lower Pre Tax profits in that year as explained in the profitability section. The restructuring costs in the UK operation (75m) and difficulties and reorganisation in the Italian operation (55m)32 also contributed to the lower positive cashflow. These actions whilst adversely affecting the cash result this year will lower overheads in the 2010 and increase the companys profitability and cash generation. Investing and Financial Cash Flow The general cash outflows in the Investing and financial sections are the result of specific decisions by the companys board. In the investing section it reflects the decision to continue to invest in acquisitions around the world, in 2009 the company made acquisitions in Ireland, Canada, Poland, Russia and the Czech Republic totalling 104m. Whilst in 2008 where the investment costs were lower at 446m this again reflected the company making investments in subsidiary companies of 57m but this was more than offset by gains on property sales of 109m and sold subsidiaries of 78m33. The groups financial cashflow reflects items such as the companys progressive dividend policy, net movements in borrowings and the funds from the purchase and sale of shares. In summary these policies appear sustainable whilst pre tax profits remain high as in the period 2005 to 2008 but if profits continue at the level of 2009 or fall further then the reduction in overall cash balances 2008 to 2009 of 31.5% is not sustainable and the company may need to review its current policies. In conclusion from my analysis I have identified that RSAs cash balances are decreasing as a result of the continued increases on the high dividend payouts and the continued and increase in spending on acquisitions. This expenditure is not supported by the Net Profits generated by RSA. The company may ultimately reach a point where it may have to decide if it wishes to provide its investors with higher dividends now or keep the dividend stable or reduced with the promise that acquisitions will propel the company to generate value for the future.

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RSA Annual Report and Accounts 2005 to 2009, Consolidated Cash Flow Statements RSA Annual Report and Accounts 2009 Financial Review Section 33 RSA Annual Report and Accounts 2008 and 2009 Business and Financial Review Sections