Direct Line We have maintained the heritage of Direct Line in the UK by only selling its products directly to our customers through the phone and internet. We target customers who have a high brand affinity, with a focus on a quick and straightforward customer experience.
Brand Partners is the business-to-business arm of Direct Line Group, specialising in providing personal lines insurance and roadside rescue and recovery products to some of the UK’s biggest brands.
2 Group highlights 4 Group at a glance 6 Business model 8 Chairman’s statement 10 Chief Executive Officer’s review 13 Our strategy 24 Key performance indicators 26 Risk management 30 Operating review 36 Finance review 47 Corporate social responsibility 52 Chairman’s introduction 56 Board of Directors 58 Executive Committee 60 Corporate governance report 68 Committee reports 78 Directors’ remuneration report 91 Other disclosures 95 Directors’ responsibilities statement 96 Contents 97 Independent auditor’s report 98 Consolidated financial statements 103 Notes to the consolidated financial statements 164 Parent company financial statements 167 Notes to the parent company financial statements 171 Additional information 173 Glossary 175 Cautionary statement about forward-looking statements 176 Contact information
Strategic review Read about our journey to date and ongoing strategy from our Chief Executive Officer’s point of view. Learn more about the details of this strategy, the specifics of how we measure our performance through our key performance indicators (“KPIs”), and how we assess and manage our risk.
Performance review The Group’s performance is measured by the results of our divisions, how we manage our finances and our ability to engage with people through our business and the community.
Financial statements This section of our report includes financial statements and notes, as well as other statutory financial information.
This Annual Report & Accounts 2012 contains statements which are not based on current or historical fact and are forward-looking in nature. Please refer to the ‘Cautionary statement’ on page 175.
• New and extended partnership arrangements with Sainsbury’s Bank, Nationwide Building Society, RBS and NatWest
• Significant investment in pricing and claims capabilities, contributing to improved financial performance
Peace of mind Our solid financial position means that we are in a position to provide protection for our customers.
1. Return on tangible equity is adjusted profit after tax from ongoing operations divided by the Group’s average tangible shareholders’ equity. Profit after tax is adjusted to exclude Run-off operations, and restructuring and other one-off costs and is stated after charging tax (using the UK standard tax rate): – Pro forma return on tangible equity is based on the return on tangible equity but assumes that the capital actions taken by the Group (£1 billion dividend payment and £500 million long-term subordinated debt issue) occurred on 1 January 2012.
Leading the market We use multiple brands, products and distribution channels to reach our customer segments for personal lines and commercial insurance in the UK, as well as multiple distribution channels for motor insurance in Italy and Germany
Our business divisions We tailor our products to target specific market segments effectively.
Multi-brand We sell our products across a range of brands. Over 25 years, these brands have fundamentally changed Britain’s insurance industry, making it easier for millions of customers to get good value cover.
We provide commercial insurance, focused on SMEs and micro businesses, in the UK through our own brands NIG and DL4B, as well as through RBS and NatWest.
We are the largest direct motor insurer in Italy and the third largest in Germany, the two largest motor insurance markets in Europe. Private motor insurance is sold through the Direct Line brand and we have around 1.5 million in-force policies.
Our people Our people are essential to delivering products and services for our customers. Everyone from frontline staff, who directly engage with our customers, to the back office and central functions, who run all of the processes that sit behind our products and services, plays a part in ensuring we are meeting customers’ needs. All of this will ultimately help to drive value for our customers and shareholders.
Product distribution We give our customers what they need and make it easy for them to access our products in a way that suits them, ensuring they are appropriately covered when unexpected events happen.
We use a multi-brand, multi-product and multi-channel business model to sell our products and services to retail customers and businesses. Products can be purchased via the internet, phone, PCWs and indirectly via partners and brokers. Each brand represents products targeted at one or more of the insurance market segments: motor, home, rescue, pet, travel, commercial and international. By tailoring the distribution channel mix for each product, we can offer our customers a combination of brands, products and services that best suit their needs.
Settling claims The point at which a customer needs to make a claim is when the value of their policy becomes apparent. Therefore, through active engagement with our customers, we aim to settle their claim as quickly and as easily as possible. Doing this the right way helps us to demonstrate the value of the products and services we provide.
Managing finances We manage our finances to maximise returns within agreed limits. This includes only spending money on items that add the most value to our customers, ensuring a well governed and controlled business, whilst balancing the need to generate a suitable and sustainable return to our shareholders. We also hold assets in excess of our expected liabilities in the form of capital, which is designed to absorb any unexpected losses that might occur.
It was also an important year for the Board, which I joined as Chairman in April. We recruited three additional independent Non-Executive Directors, and I am pleased to report that the Board was at full strength prior to the IPO.
To supplement this plan, the Group announced a new set of targets in September 2012. These are for the Group to generate an overall return on tangible equity (“RoTE”) of 15%; improve the combined operating ratio (“COR”) to 98% in 2013; reduce the COR in Commercial to less than 100% in 2014; and achieve gross annual cost savings of £100 million in 2014.
The Board is encouraged with the progress made in 2012 as demonstrated by a pro forma RoTE of 13.4% and a COR for ongoing operations of 99.2%. Both outcomes show substantial improvement over 2011. Operating profit from our ongoing operations was up 9.3% at £461.2 million.
As a result of receiving state aid, RBS Group is required by the European Commission to cede control of Direct Line Group by the end of 2013 and to divest itself of any remaining shares in the Group by the end of 2014.
Furthermore, RBS Group currently has two nominated directors on the Company’s Board, Bruce Van Saun and Mark Catton. RBS Group has the right to nominate up to two members of the Board as long as it remains a controlling shareholder of Direct Line Group and up to one member provided it owns between 20% and 50% of the shares.
Dividend The Directors have proposed a final dividend of 8 pence per share. This proposal is in line with the policy set out at the time of the IPO. On the basis that the final dividend represents two-thirds of the total annual distribution, the full-year pro forma dividend of 12 pence per share would represent a payout ratio of 55% of earnings from ongoing operations.
The Relationship Agreement sets out that, notwithstanding the significant shareholding held by RBS Group, Direct Line Group is to carry on its business independently of RBS Group. The agreement ceases once RBS Group holds less than 20% of the shares of Direct Line Insurance Group plc (the “Company”).
Under the TSA, RBS Group continues to provide IT and certain other services for a transitional period of up to 36 months.
Unlocking value It has been a momentous year for Direct Line Group and our people have worked diligently to deliver good progress towards our strategic targets
Overview of financial performance Welcome to our first Annual Report & Accounts as a listed company in our own right. I am pleased to report that we have made good progress against our business transformation plan and delivered an operating profit from ongoing operations of £461.2 million for 2012, an increase of 9.3% compared to 2011 (£421.9 million). All divisions were profitable in 2012. This was driven by a return to underwriting profit, demonstrating the effective use of our pricing and data, improved claims processes, as well as the strength of our distribution platform in serving our customers.
Helping our customers As one of the leading motor and home insurers in the UK, our responsibility to motorists and homeowners is more than just processing a claim when an accident or loss has occurred. We consider road safety to be an important element of our work within the community. As such, we have developed partnerships with key road safety stakeholders, such as the charity, Brake, working with them to raise motorists’ awareness of road safety issues.
Chief Executive Officer’s review 10 Direct Line Group Annual Report & Accounts 2012
Since the beginning of our transformation plan in 2010, we have taken action to improve our capital efficiency and to benefit from our scale by consolidating four underwriting entities into one, U K Insurance Limited. We received an ‘A’ credit rating from Standard & Poor’s and an ‘A2’ credit rating from Moody’s, issued £500 million of long-term subordinated debt and prior to the IPO returned £1 billion in dividends to RBS Group.
Distribution We renewed existing strategic partnerships, including Nationwide Building Society and RBS Group, and secured new ones, notably Sainsbury’s Bank. We also launched our Churchill and Privilege motor and home products on comparethemarket.com, which means we have a presence on the four major UK PCWs.
Pricing Since 2010, we have de-risked the motor portfolio and repriced to reflect the risk and cost of bodily injury claims, particularly with younger drivers and certain postcodes. We built capability through implementing a new pricing model and rating engine across the Motor and Home divisions, contributing to significant improvements in our loss ratio performance.
Claims We have undergone a significant transformation in our claims function, including a strategic investment in a new claims system, ClaimCenter, which is now operational for the majority of Motor and Home claims. The benefits are being realised through improved claims processes, including shorter settlement times for customers and improved legal case management.
We aim to achieve this by, for example, deploying the capability built in our pricing and claims functions over the last couple of years and, in 2013, we aim to supplement this by prioritising our distribution and cost initiatives.
Outlook The UK personal lines market remains competitive, particularly in the Motor division. In this environment, the Group will continue its strategy of disciplined underwriting that prioritises maintaining margin over volume. We expect to see improvements to the loss ratio in 2013 as investments in pricing and claims capabilities, together with the improved risk profile of the underwriting portfolio, especially in Motor and Commercial, are recognised. In 2014 we expect to have delivered the £100 million gross annual cost savings and we will continue to look at our expense base as market conditions evolve. Overall we continue to target a 98% COR for ongoing operations in 2013.
We have made great strides since the beginning of our transformation journey in 2010. I am extremely grateful for the hard work, dedication and expertise demonstrated by our people, and I am excited about developing the business even further for the next phase of our journey.
Transforming Direct Line Group Our ambition is to be Britain’s best retail general insurer. We focus on making it easy, while providing great value, for customers to fulfil more of their insurance needs with us
Distribu tion 14 Direct Line Group Annual Report & Accounts 2012
This is a good foundation for us to build on. Our priorities for 2013 and beyond are to improve quote efficiency by developing our digital capability further and using our data and segmentation insight to target our customers better. We aim to increase customer lifetime value through a focus on improving retention and enhanced cross-product propositions that deepen customer relationships. We intend to continue to differentiate our brands to improve how we meet customer needs. For example, Direct Line “Together” rewards customer loyalty in a way that is unique to the sector, with a 10% discount offered on each and every additional Direct Line policy in the customer’s household.
We have been a leading retail general insurer for a long time. This gives us a significant scale advantage in data, with detailed customer level information from 49 million consumer records and eight million claims data points. Using this data more effectively has enabled us to improve profitability through pricing risks more accurately. By continuing to invest in our pricing capabilities we aim to offer our target customers competitive prices, while also continuing to manage value for our shareholders.
We have already enhanced the use of internal and external data, with twice as many risk factors tested as in 2009. We are building a new rating engine with faster links to external data and the real-time deployment of pricing changes. We aim to deliver industry leading technical pricing capabilities that will enable us to calculate the price implied by claims costs more accurately; and superior market pricing that will enable us to offer the right price to our target customers at any given point in time.
Motor current year loss ratio 16 Direct Line Group Annual Report & Accounts 2012
We have fundamentally redesigned our operating model, systems and processes in Claims, following extensive benchmarking against global best practice. We have launched our new claims system, ClaimCenter, across the majority of Motor and Home, enabling us to increase our claims handling efficiency. We have simpler processes in fewer sites, giving our people more control and giving our customers a better experience.
In Motor, we have put in place new processes to manage bodily injury claims proactively, bringing together legal, medical and insurance experts who are supported with specialist case management software. With the launch of our home estimating tool in April 2012, our Property Insurance Advisers can now use tablet computers to scope jobs accurately, apply our schedule of rates and deploy our revised builder network where required. This both improves customer service and controls claims spend.
Number of claims registered on new system 19Direct Line Group Annual Report & Accounts 2012
Number of sites 20 Direct Line Group Annual Report & Accounts 2012
Commercial and 22 Direct Line Group Annual Report & Accounts 2012
International We have 10 years of experience in Europe’s two biggest motor insurance markets and are now getting to scale and profitability
We are well positioned in these two markets that are gradually moving towards direct channels, and we have experienced local management teams in place to adapt to changes in the trading environment. Across both countries, we plan to improve operational efficiency and to leverage our UK expertise in pricing and claims systems.
Definition A measure of financial year underwriting profitability calculated by the sum of claims, commissions and expenses divided by net earned premium. This excludes instalment and other operating income and investment return.
Aim We aim to make an underwriting profit and are targeting a COR of 98% in 2013.
3. RoTE is adjusted to exclude Run-off operations and restructuring and other one-off costs; based on average tangible equity, using UK standard tax rate.
Aim We target risk-based capital coverage of 125% – 150% which we believe is equivalent to the level of capital required for a rating in the ‘A’ range from our credit rating agencies.
Definition The return generated on the capital shareholders have in the business. This is calculated by dividing adjusted earnings by average tangible equity. Pro forma RoTE assumes that the capital actions taken by the Group (£1 billion dividend payment and £500 million long-term subordinated debt issue) occurred on 1 January 2012.
Direct Line Group is subject to a number of risks and uncertainties which could impact our KPIs and performance. Please refer to the following section.
The Board has responsibility for setting and monitoring adherence to the risk strategy, risk appetite and risk framework. The Board has established a risk management model that separates the business’s risk management responsibilities into three lines of defence as set out in the diagram below.
Our risk management structure 3rd Line defence Internal Audit function • Independent assurance on adequacy and effectiveness of risk framework 2nd Line defence Risk function • Advise Board on risk strategy and risk appetite
• Oversight, challenge and support of 1st line 1st Line defence business and support functions • Adhere to risk strategy and risk appetite
The risk appetite statements are expressions of the level of risk we are prepared to accept to achieve our business objectives. In order for these statements to be defined quantitatively as well as qualitatively, they are aligned to key metrics. These metrics are monitored regularly.
The table below sets out these objectives and shows, at a high level, examples of corresponding appetite statements.
The aim of the risk framework is to provide a robust, proportionate, proactive and forward-looking process for risk management across the Group. A central component of this framework is the Group’s policies and minimum standards, which inform the business as to how it is required to conduct its activities and risk management processes to remain within risk appetite. We employ a number of risk tools to manage and monitor risk. The output of our risk management activities is thoroughly tested and reported upon both internally and externally.
The policies and minimum standards cover all key risks to which the Group is exposed. Each policy is supported by minimum standards which set out the minimum level of risk management and other corporate and personal behaviours. The minimum standards are in turn supported by detailed guidance documents.
We incorporate the identification, assessment, management, control, reporting and mitigation of risk as part of our daily operations.
We believe the strengths of our risk framework are: • Strong culture and risk leadership underpinned by training of our people
• Influencing decision-making and shaping behaviours, via the provision of accurate, timely and relevant risk advice and challenge
Po lic y fra m ew or k an d m in im um s ta nd ar ds
Notes: 1. The Chief Risk Officer is a member of the Executive Committee and reports to the Chief Executive Officer, with a right of access to the Board Risk Committee and the Audit Committee, assuring independence of the function. The Chief Risk Officer chairs the executive Risk Management Committee, which reviews material policies for the effective management of risk across the Group.
2. IRISS – Internal Risk Intelligence Software System is designed to facilitate a robust and consistent approach in the way we identify and capture risk information thereby significantly enhancing our ability to measure, report and manage our risks.
Principal risks and uncertainties The Group writes products that are subject to a number of uncertainties and risks. It is a key role of the Risk function to ensure that these risks have been identified, measured and considered throughout the business.
• Monitoring of cost savings to ensure they remain on track
Underwriting and pricing risk We are subject to the risk that inappropriate business could be written (or not specifically excluded) and inappropriate prices charged.
This includes catastrophe risk arising from losses due to unpredictable natural and man-made events affecting multiple covered risks particularly given the concentration of our home business in the UK.
• Quarterly analysis of all property portfolios to determine expected maximum losses
• Investment in enhanced external data to mitigate exposures (for example, flood and individual underwriting risk through Geospatial)
• Technical reserves are estimated by: – A range of actuarial and statistical techniques, with projections of ultimate claims cost involving assumptions across a range of variables, including estimates of trends in claims frequency and average claim amounts based on facts and circumstances at a given point in time
– Making assumptions on other variable factors including; the legal, social, economic and regulatory environments; Ogden discount rate and the process by which it is set; results of litigation; and the extent and terms on which periodical payment orders (“PPOs”) are made by the Courts. Other factors considered include rehabilitation and mortality trends, business mix, consumer behaviour, market trends, underwriting assumptions, risk pricing models, inflation in medical care costs, future earnings inflation and other relevant forms of inflation, the performance and operation of reinsurance assets and future investment returns
– Management’s best estimate of reserves being equal to or in excess of the actuarial best estimate
• We have developed a bespoke risk capture, management and reporting system
• Migration of IT onto a new enhanced platform 28 Direct Line Group Annual Report & Accounts 2012
Investment risk Market risk – the risk of adverse financial impact due to changes in fair values of future cash flows of instruments held in the investment portfolio as a result of changes in interest rates, credit spread, foreign exchange rates and property values.
Credit risk – the risk of exposure if another party fails to perform its financial obligations, including failing to perform them in a timely manner.
Adverse movements due to asset value reduction, mismatch in assets and liabilities, and default of third parties.
Regulatory risk Changes in law and regulations are not identified, understood, or are inappropriately and incorrectly interpreted, or adopted, or business practices are not efficiently modified. Further, there is a risk that current legal or regulatory requirements are not complied with. For example, in the beginning of 2012, the FSA imposed a £2.17 million fine on the Group in relation to complaint file alterations.
Conduct risk The risk of failing to deliver the appropriate treatment for our customers throughout all stages of the customer journey and that our people fail to behave with integrity.
Loss of brand value negatively impacts our ability to retain and write new business.
• Our brand and reputation risk is regularly reviewed by various governance committees
• We seek to offer a superior service to customers and to treat customers fairly in line with FSA principles
As long as RBS Group remains a significant shareholder, there are certain risks that apply to the RBS Group and, should they arise, may have an adverse impact on our business. For example, RBS Group will continue to exert substantial influence over us while it has a substantial shareholding; RBS Group could face the risk of full nationalisation or other resolution procedures; our contractual arrangements may be impacted by events that occur within RBS Group; and RBS Group is subject to a variety of risks as a result of implementing the state aid restructuring plan which could adversely affect us. RBS Group has a legal obligation to divest its controlling interest in the Group by the end of 2013 and completely divest by the end of 2014. The manner and exact timing of any divestment is uncertain.
Group performance We continue to improve our financial performance, despite the backdrop of a competitive market and subdued investment returns
The following table analyses ongoing operating profit / (loss) by division: Divisional ongoing operating profit
Market Following the significant increases in premium rates experienced in 2010 and 2011, the UK private motor insurance market has been broadly flat during 2012. Small bodily injury claims in particular have received considerable political and regulatory attention, with the prospect of a balanced package of reforms including: • Banning solicitors’ referral fees
• Reducing fixed legal costs for bodily injury claims to below £10,000
Outlook The UK motor market is expected to remain particularly competitive during 2013. The full effects of the move to gender neutral pricing, the package of upcoming legal reforms and the referral of the UK motor insurance market to the Competition Commission are still to be felt. We support the direction of the overall package of the legal reforms and continue to engage proactively with key stakeholders. Overall, we believe that, taken together, the effect of the package of civil justice reforms should be at least ‘net neutral’ for the Group in the medium term. However, there remains considerable uncertainty about the details and timing of the reforms. We will continue to prepare for a range of outcomes.
Highlights • Retained position as the UK’s leading motor insurer by in-force policies, stabilising the policy count after substantial de-risking in 2010 and 2011
• Continued to enhance our pricing and claims capability, contributing to a reduction of 7.1 percentage points in the loss ratio
• Extended our distribution reach through launching on comparethemarket.com with the Churchill, Privilege and Sainsbury’s Bank brands
“ The UK Personal Lines business has maintained its focus on value within an increasingly competitive market. We are continuing to invest in pricing and claims excellence and are focused on delivering value for our customers.” Tom Woolgrove, Managing Director of Personal Lines 31Direct Line Group Annual Report & Accounts 2012
• In-force policies broadly stable, reflecting competitive market conditions for new business
• Partnership extended with Sainsbury’s Bank, signing an arm’s length distribution agreement with RBS Group and renewal and extension of Nationwide Building Society partnership
Market The size of the UK home insurance market has been relatively stable in recent years with limited growth in the housing stock and competitive pressure through the growth of the PCW distribution channel. These constraints have remained in 2012, with little observed new business premium inflation from major market players. This competitive environment is expected to continue.
During 2012, we implemented a new rating capability for Home. This allowed us to make a step change in our ability to set renewal prices more accurately and, at the end of 2012, resulted in a material improvement to our peril level risk pricing.
In-force polices reduced by 1.6% from 2011, due mainly to pressure on new business sales. This was partly offset by our ongoing retention initiatives as we continued to focus on a balanced approach of ensuring existing customers were retained, whilst investing in rating capability and insight to maintain our competitiveness in the market.
• Increased Green Flag branded presence at roadside and new marketing campaign
Market The UK breakdown market is well established with three major providers; AA, RAC and Green Flag. The market has historically displayed strong returns, although the total market premium has been impacted in recent years by lower car ownership, due to the economic climate.
The pet and travel markets continue to be competitive, with the growth in PCWs acting to diversify distribution. Customer numbers are expected to remain broadly stable.
A distribution agreement has been signed with RBS Group for the provision of rescue and travel insurance through packaged bank accounts, strengthening our partnership relationship as we separate from RBS Group. A new strategic service partner agreement with external recovery agents, embedded in 2012, has created an increased Green Flag branded presence at the roadside and we have launched a new marketing campaign for the brand.
Market This year was another challenging year for the UK commercial market as overall premium rates remained under pressure. Motor experienced increasing rates in response to bodily injury claims, whereas liability rates struggled to keep up with underlying claims inflation. This, together with depressed investment returns, has been countered by a number of cost reduction initiatives across the market.
The COR improved from 107.6% to 103.3% as the business focused on operating efficiencies following strong growth in 2011.
The German environment has remained positive for direct market growth and has seen premium rates increase in 2012 and a benign economic backdrop. Direct Line Germany experienced strong growth in year end business which we expect will help it build further scale in 2013.
• 3.9% increase in gross written premium in local currency terms
International “The International business has continued to strengthen its position in the two markets in which we operate. We have delivered a substantial increase in profits, contributing to the improvement in the Group result. ” Jamie Brown, Managing Director of International 35Direct Line Group Annual Report & Accounts 2012
Improving efficiencies We continue to experience improvements in our financial performance, despite a backdrop of a competitive market and subdued investment returns. Our balance sheet remains strong and we have taken actions to improve its efficiency
“ In 2012 we demonstrated good earnings momentum coupled with active capital management. We aim to continue to focus on producing strong, sustainable returns for shareholders.” John Reizenstein, Chief Financial Officer
Gross written premium for Commercial was broadly flat, reflecting the growth of lower average premium business through DL4B, partially offset by the exit of a number of unprofitable schemes.
Underwriting profit The Group’s COR improved by 2.6 percentage points to 99.2% (2011: 101.8%), resulting in an increase in underwriting profit to £28.2 million (2011: loss of £72.3 million). This was primarily the result of a 3.1 percentage points improvement in the loss ratio, reflecting actions taken to improve risk selection and the implementation of the claims transformation programme. In addition, a lower commission ratio reflected the non-repeat of a payment made to RBS Group in 2011 under a historic profit share arrangement. Offsetting these improvements was a modest increase in the expense ratio as a result of lower net earned premium and a number of one-off items. These included an increase in the final recharge from RBS Group in the first half of the year and parallel running costs reflecting the build out of corporate functions prior to separation from RBS Group on 1 July 2012.
Overall operating profit from ongoing operations of £461.2 million was a 9.3% increase on 2011 (2011: £421.9 million). A significant improvement in the underwriting result, primarily relating to pricing actions, improvements to risk mix and the Group’s claims transformation plan more than offset lower instalment and other operating income. Investment return was broadly in line with 2011 and was supported by higher realised investment gains.
The Group views the current-year attritional loss ratio as a good indicator of underlying performance as it excludes prior-year reserve movements and claims from weather events in the Home division.
The Home COR of 96.6% was 1.5 percentage points higher than full year 2011 as a result of a number of offsetting items. Overall, the Home loss ratio was stable with higher weather related claims being offset by reserve releases from prior years. The attritional current-year loss ratio was broadly in line with 2011. The expense ratio was higher reflecting the trends seen at the Group level.
The Rescue and other personal lines COR improved by 3.6 percentage points compared to 2011, driven by a reduction in the commission ratio following the non-repeat of a profit commission payment in 2011. The 2012 result continued to benefit from prior-year reserve releases related to the run-off of the legacy creditor book. Future results of the division are not expected to benefit from similar reserve releases.
Instalment income of £125.4 million reduced by £13.1 million compared to the prior year (2011: £138.5 million) as a result of lower average in-force policies during 2012 and changes to risk mix from previous years. Penetration rates for instalment income remain good.
The expense ratio increased by 1.5 percentage points to 23.0% due to lower net earned premium and a modest increase in operating expenses.
Ongoing operating expenses rose by £17.2 million from the prior year (2011: £837.6 million), with the increase principally driven by a number of one-off items including an increase in the final recharge from RBS Group in the first half of 2012 and parallel running costs reflecting the establishment of corporate functions prior to separation from RBS Group on 1 July 2012.
From 1 July 2012 the Group no longer paid a recharge to RBS Group and this was replaced by directly paying third-party suppliers for the majority of services previously provided by RBS Group. Consequently, expenses previously reported under management fees are now reflected within their relevant line items. The Group continues to pay RBS Group for transitional IT infrastructure, the costs of which are included within other operating expenses.
Total Group Ongoing operations 2012 £m 2011 £m 2012 £m 2011 £m
Run-off The Run-off segment, which includes the exited personal lines broker and TPF businesses, made a profit of £6.1 million in 2012 compared with a loss of £23.9 million in 2011. Reserve releases for 2012 were £67.5 million, the majority of which were due to TPF.
The Group agreed with TPF the level of final reserves to be retained by the Group in respect of the run-off of remaining claims under TPF policies and finalised certain other matters arising out of the expiry of the distribution arrangements. Following determination of the reserves, the risks and rewards of the run-off for this line of business were transferred to the Group and subsequently, the £258.5 million loan was repaid to TPF on 8 January 2013.
Restructuring and other one-off costs for 2013 are estimated to be approximately £140 million. Approximately £70 million relates to one-off costs associated with the cost savings programme and a further £70 million relates to IT migration. The total one-off cost of IT migration continues to be estimated at around £100 million, with the remaining £30 million expected to be incurred in 2014.
Finance costs Finance costs increased to £28.7 million (2011: £2.7 million), primarily reflecting interest on the £500 million of long-term subordinated debt issued in April 2012.
The Group’s direct and indirect contribution to the Exchequer is significantly higher than the UK corporation tax that the Group pays on its profits. During 2012, the sum of taxes either paid or collected was in excess of £650 million. This included insurance premium tax, income tax and national insurance but excluded irrecoverable VAT.
Profit for the year and return on tangible equity Profit for the year amounted to £184.3 million (2011: £249.0 million).
RoTE increased to 11.5% (2011: 10.0%) as a result of both the improved operating result from ongoing operations and the capital actions taken to improve the efficiency of the Group’s capital position. Had the £1 billion dividend to RBS Group and issue of £500 million long-term subordinated debt taken place prior to the start of the year, the RoTE, on a pro forma basis, would increase to 13.4%.
Earnings per share Basic and diluted earnings per share of 12.3 pence fell 25.9% compared with 2011, reflecting the increase in restructuring and other one-off costs which more than offset the increase in operating profit from ongoing operations.
Cash flow Net cash from operating activities before investment of insurance assets was an outflow of £966.0 million in 2012 principally due to cash used by operations of £731.4 million, reflecting higher payments of current and prior-year claims relative to declining premium income, and significant payments relating to restructuring and separation in the first half of the year. Tax of £232.4 million was also paid. Net cash from operating activities before investment of insurance assets was an outflow of £359.8 million in 2011, principally due to cash used by operations of £378.0 million, reflecting higher payments of current and prior-year claims relative to declining premium income. Net cash released from investment of insurance assets was £2,004.8 million in 2012 and £38.8 million in 2011. The increase in 2012 reflects a net liquidation of investments in available-for-sale financial assets and a net decrease in investment balances held with credit institutions in 2012 relative to a net increase in 2011.
During 2012, the Group paid dividends totalling £1 billion to RBS Group, repaid loans to RBS Group of £246.4 million and received net proceeds of £493.0 million from the issue of long-term subordinated debt. Finance costs in relation to this debt resulted in cash outflows of £16.1 million. Altogether, the net outflows from financing activities during the period amounted to £774.5 million.
The reduction in net asset value and tangible net asset value primarily relates to the £1 billion of dividends paid to RBS Group during 2012. Adding back these dividends, net asset value per share rose by 6.3% in 2012 and tangible net asset value per share rose by 5.2% in 2012.
Reserving Estimation of claims reserves is a central aspect of financial management. Insurance is inherently uncertain requiring the use of judgement in estimating the ultimate claims liability. The factors that must be considered when assessing the level of outstanding liabilities include class of business, timeliness of notification of claims, validity of claims made against a policy and validity of the amount of the claim. At any time there is a range of possible outcomes at which the claims reserves could ultimately settle and as time passes the uncertainty surrounding likely claims settlement reduces. The uncertainty is greater for bodily injury claims due to time it takes for these claims to settle. This is particularly true for PPOs awarded to settle some bodily injury claims, in which annually indexed payments could be awarded over the lifetime of the injured party.
Actuarial reviews are carried out quarterly with over 95% of all claims reserves being reviewed at least annually. Actuarial best estimates are produced internally, and are subject to independent external review at least annually. Reserves are based on management’s best estimate set by the Group, which will be at least equal to the actuarial best estimate at a legal entity level. The Group will set reserves informed by a range of actuarial outputs including percentiles and scenarios. It will consider the level of historic variability inherent in the claims data and other short- and long-term risks not reflected in the actuarial data.
The Group’s reserves are particularly susceptible to potential retrospective changes in legislation and new court decisions, for example, a change in the Ogden discount rate. This is the discount rate set by the relevant government bodies and used by courts to calculate lump sum awards in bodily injury cases. The rate is currently 2.5% per annum but is currently under review by the Ministry of Justice. From 2010, the Group has calculated its estimated reserve based on an assumed Ogden discount rate of 1.5% in recognition of the uncertainty regarding the future rate. Applying an Ogden discount rate of 2.5% would reduce the estimated reserves by £184.7 million as at 31 December 2012. Applying an Ogden discount rate of 0.5% would increase the estimated reserves by £259.3 million.
Most of the Group’s technical reserves are held on an undiscounted basis and, therefore, do not allow for the investment income which will be earned on the technical reserves after the balance sheet date until the claims are fully settled. The one exception is the technical reserves held in respect of PPOs which are held on a discounted basis, in line with the ABI Statement of Recommended Practice (“SORP”), and where the Group assumes an investment return of 4.0% (2011: 4.5%). Claims for PPOs are also assumed to inflate at 4.0% (2011: 4.5%) per annum resulting in a real discount rate of 0.0% (2011: 0.0%).
As the Group has moved to operating on a stand-alone basis there have been substantial changes to the reserving practices and processes including: • Increased focus on reporting to the Group and Audit Committee reflecting additional reserving governance
• Building a UK commercial property portfolio to diversify returns and provide asset returns with a correlation to inflation
• Transferring the management of the International operations credit investment portfolios to an external asset manager
During 2012, the portion of investment portfolio backing the Run-off operations was converted to cash prior to settlement with TPF. Post final settlement, residual cash retained is being reinvested in line with asset benchmarks for the UK portfolio.
Corporate, sovereign, local government and supranational debt securities account for 76.6% of the portfolio, of which 41% are rated as ‘AAA’ and a further 49% are rated as ‘A’ or ‘AA’.
Investment property holdings shown as at 31 December 2011 comprised three properties which were sold to RBS in the first half of 2012. Investment property held at the end of 2012 has been purchased since August 2012 and relates to commercial premises.
2. Pfandbrief holdings in the German portfolio are overweight as a result of legacy holdings, which are in the process of being run down.
Notes: 3. Asset allocation at 31 December 2012 includes investment portfolio derivatives, which have been netted and have a mark-to-market value of £7.8 million.
Risk-based capital The Group uses its own risk-based capital model, as part of its individual capital assessment (“ICA”) for the UK general insurance underwriter, to determine how much capital is required to operate within its risk appetite and strategy. The Group has an overall target of holding capital resources in the range of 125% to 150% of the risk-based capital requirement.
The International entities hold capital in excess of that required by their local regulators.
Capital position The Group presents its solvency information on a regulatory reporting basis. The Group is well capitalised with an estimated Insurance Group Directive (“IGD”) coverage ratio of 279.4% (31 December 2011: 319.0%). The Group also has an estimated risk-based capital coverage ratio of 151.4% as at 31 December 2012 (31 December 2011: 169.5%).
2. Includes that element of the subordinated dated notes applicable for regulatory capital purposes.
The table below sets out the Group’s financial leverage ratio: As at 31 December 2012 2011
Credit ratings Standard & Poor’s and Moody’s Investors Service provide insurance financial strength ratings for U K Insurance Limited, the Group’s UK general insurance underwriter. U K Insurance Limited is currently rated ‘A’ (strong) with a stable outlook by Standard & Poor’s and ‘A2’ (good) with a stable outlook by Moody’s.
Solvency II The FSA has extended its planning horizon to 31 December 2015 in response to delays in Solvency II legislation. The Group’s Solvency II programme is being reshaped in the light of these delays and the application date for internal model approval revised. The Group’s internal model produces Solvency II, enhanced ICA and economic capital numbers for the UK general insurance business. The Group’s new risk management system has significantly improved and automated risk management activity and the Solvency II data warehouse implementation is progressing. As an interim measure, the FSA is expected to regulate the Group via an enhanced ICA regime until Solvency II is implemented in the UK.
Employee experience Strategy People matter. They do much more than their jobs; they help us achieve our vision to be the best.
Challenges and opportunities As we continue with our transformation programme, it is vital that we continuously monitor our employee engagement levels and behaviours through various channels. We will focus on measures of their experiences before, during and after their time with us.
This is reflected in the Global Transitional Companies Norm Group1, which we outperform in 13 of 15 categories including: • 14% higher for treating each other with respect
Importantly, we know that our people leaders have faith in the future: 82% are optimistic about developments, and we are rated 7% higher than other financial services organisations for managing change.
Business practices Strategy Embedding CSR in our day-to-day business operations is critical if we are to build a sustainable business – one which our customers, shareholders and employees value and respect. Our strategy is to encourage and reward behaviour which makes the communities we impact safer places to be through product innovation, customer education and working with government and other bodies.
Achievements in 2012 1) Involve and consult our people To make the Group a great place to work, we know it is important to involve and consult our people on the design and delivery of all our major transformational initiatives. We do this through: our business-wide employee representative body (“ERB”), which ensures all employees have a voice; an in-house social media platform called ‘Best-Quest’, used by more than 30% of our employees to discuss improvement ideas and initiatives; and an intranet-based comment and feedback facility. This has proved to be a popular channel through which they are embracing our values. A key achievement of the programme was the distillation of the ideas received from employees to arrive at a set of values to govern the way the Group operates.
We are already involved in a number of important areas, for example: road safety through our sponsorship programmes with Brake; industry initiatives on uninsured drivers; and combating the increase in fraudulent claims. There is a clear opportunity for us to expand these programmes and deepen our support through product innovation and customer education.
Achievements in 2012 • We chaired an industry seminar called ‘Steering Young
• We launched a range of severe weather guides to help our customers prepare their homes for bad weather and to minimise any damage caused.
• Our severe weather response vehicle (mobile office), helps us to reach more customers in areas that have been extremely badly affected. It is a local base where our customers and suppliers can come and speak to us.
• We established Health & Safety (“H&S”) governance procedures including an H&S Executive Committee and elected representatives from across the business.
Community Strategy We are committed to helping make communities safer – safer for our customers, safer for our people and safer for the areas in which we operate. To help do this, our aim is to create a culture of volunteering across our business, giving all our employees one paid day off a year to get actively involved with one of our new national charity partners or local community charities.
Our three main areas of focus are: • Road safety education
Road safety We see it as a duty and an important issue to campaign to make our roads safer for all users. The Direct Line brand has fostered a nine-year working relationship with road safety charity Brake. An ongoing sponsorship of Brake’s Parliamentarian of the Year Awards takes place every January to recognise MPs who campaign on road safety issues.
Education is key to making our roads safer. The Group has signed up to the European Road Safety Charter, an initiative that shares good practice to resolve road safety issues across the European Union. In Westminster, we sponsor policy debates by way of panel discussions on subjects such as the impact of uninsured drivers, how to reduce the risk to young drivers and combating fraud. Our new public policy focus is on helping young drivers through improved education and technology. Beep-Beep Days are sponsored in schools across the UK, teaching children the rules of the road in a fun way.
We have further strengthened our relationship with Brake by making it a national charity partner. Under this arrangement, all our employees now have the opportunity to become involved in educating young children.
Catch22 – this organisation is a forward-looking social business with many years’ experience of providing services that give young people an alternative to getting into trouble, crime and anti-social behaviour. Through the Catch22 Community Space Challenge project, our employees volunteer to work alongside local young people to transform neglected public spaces.
Supporting our employees in charitable giving We also support our employees in their charitable giving through our payroll giving scheme, matching their monthly contributions by up to £50 per person per month. Our Community Cashback scheme gives employees the opportunity to apply for an annual award of £250 for their charitable endeavours. We also recognise the great things that our employees do to support local communities, both within and outside work, through our Chief Executive Awards scheme.
Challenges and opportunities There are many ways in which we get involved in programmes, sponsorships and volunteering with a number of organisations that work in and for the community. If we spread this activity too wide, we will dilute our impact. To counter this challenge we chose to partner with four charities whose activities are aligned with our commitment to make communities safer.
In collaboration with The Prince’s Trust, we’re helping disadvantaged young people get back into the workplace.
Our specialist mobile office helps us base ourselves right in the heart of communities that are in crisis.
We have defined our ambitions as follows: • Buildings – the high profile of our portfolio provides a very visible opportunity to demonstrate our practical commitment to CSR. We aim to encourage recycling and biodiversity to consume less energy, water and to produce less waste.
• People – we aim to connect people in ways that benefit the environment, from car pools to volunteer groups.
We aim to achieve all this by: • Creating and maintaining healthy workplaces by physical upgrade; maintaining suitable environmental conditions; targeting and reducing high energy usage by improving plant efficiency; introducing new technologies; and encouraging change from our employees.
• Undertaking water and waste audits; seeking to minimise waste at source and disposal to landfill and to maximise re-use, recycling and energy from waste. We will look to minimise water use and recycle where appropriate.
• Encouraging reduction in car travel through improved travel planning, facilities and agile working practices, and by promoting car sharing and cycling to work.
In 2007, we were one of the founding members of ClimateWise, an industry-wide membership group, which works with the University of Cambridge to analyse the effects of climate change and how the industry can combat them.
• We were one of the first insurers to provide insurance for electric vehicles and have committed to supporting the move towards more sustainable vehicles.
Committed to high standards in governance Our pursuit of strong governance is based on the conviction that it is good for our business
Dear shareholders and other stakeholders I am pleased to be writing this report at an exciting time for Direct Line Group. We became a listed company on 16 October 2012, a point which represents a significant milestone in the development of our business.
More than 27 years after the Group was originally launched in partnership with RBS Group in 1985, subsequently becoming a wholly-owned subsidiary in 1988, we achieved substantial operational separation last summer.
27 April: The Company announced that Mike Biggs had been appointed as Chairman and that Bruce Van Saun, Group Finance Director of RBS Group, had been appointed as a Non-Executive Director.
Leadership As a Board we are focused on strong governance. This first Annual Report & Accounts as a listed company allows us to set out the steps we have taken to deliver against our stated objective of achieving good practice governance.
15 January 2013: The Company announced the award to Capgemini UK plc of a five-year contract to design, deliver and run a new IT infrastructure for the Group whereby our corporate and business applications will be migrated from RBS Group IT infrastructure to an independent platform.
2 November: The Company announced that operating profit from ongoing operations of £347.9m for the nine months to 30 September 2012 had increased by 3% over the prior period.
3 September: The Company declared and paid a further interim dividend of £200m to the RBS Group. The Company also announced that Clare Thompson had been appointed as a Non-Executive Director.
14 September: The Company announced its intention to proceed with an IPO. The Company also announced that Priscilla Vacassin had been appointed as a Non-Executive Director.
16 October: 1,500m shares were admitted to trading on the London Stock Exchange under the ticker ‘DLG’.
17 October: Following the exercise of an over-allotment option in respect of a further 67.5m Ordinary Shares to be sold on the market, RBS Group sold 520.8m Ordinary Shares in the Company. The sale represented 35% of the total share capital and generated gross proceeds of £911m received by RBS Group.
Effectiveness Following my appointment as Chairman in April last year, my first priority was to establish an effective Board able to guide Direct Line Group as a newly-listed company. Unusually for a subsidiary group, Direct Line Group had already had independent Non-Executive Directors on its Board for over nine years. In the approach to the IPO, we embarked on a programme of reviewing the Board composition and produced detailed candidate profiles specifying the skills and qualities required of our Directors. The profiles included requirements for a diversity of experience to match the range of the Group’s businesses, as well as deep experience of the financial services sector and significant Board experience in major listed businesses. By September 2012, we had appointed five independent Non-Executive Directors, in addition to two RBS Group-nominated representatives.
A fuller description of how the Board was set up to respond to the business’s needs and the challenges it faces is provided on page 64.
Following appointment, the Directors commenced induction programmes designed to familiarise them with the operation of the Group and its management and to provide updates regarding significant developments affecting listed companies and our business sector.
• Launched initiatives targeting £100 million of gross annual cost savings in 2014.
• Carried out a successful inaugural capital markets transaction with £500 million of Tier 2 subordinated debt issued in April 2012.
• Continued to deliver the Group’s transformation plan and is making progress towards its target of a 15% RoTE.
• Awarded a five-year contract to Capgemini UK plc to design, deliver and run a new IT infrastructure for the Group whereby our corporate and business applications will be migrated from RBS Group IT infrastructure to an independent platform at a cost of approximately £100 million.
In addition, the Company refreshed its committees during 2012 to ensure the Board has adequate support to provide assured oversight of the business. The composition, attendance, role and focus of each committee are described later in this report.
Remuneration The subject of Directors’ remuneration continues to receive attention from shareholders, regulators and the public. It is clear to me that transparency in reporting on remuneration is key to obtaining the confidence of investors. Although the result of the Department of Business, Innovation and Skills’ consultation on revisions to the remuneration reporting regulations is not expected until later in 2013, Direct Line Group intends to adopt the recommendations, where practicable, within the confines of current regulatory and legislative requirements.
• Overseeing the Group’s progress in pursuit of its stated targets, including those relating to COR and RoTE.
• Reviewing the main elements of governance architecture to ensure that they are fit for purpose for the newly-listed entity.
• Conducting a full Board evaluation, since the Board will have been in place for sufficient time to make such a review appropriate.
• Reviewing the Group’s policy on gender diversity to consider how more women can be promoted to senior and executive management roles.
Experience and qualifications Mike has almost 40 years’ experience of the UK and international financial services sector. He was Chief Executive Officer and Group Finance Director of Resolution plc, the FTSE 100 UK life assurance business and is currently Chairman of Resolution Limited. He was previously Group Finance Director of Aviva plc. He has a Masters degree in History from the University of Oxford and is an Associate of the Institute of Chartered Accountants of England and Wales. Mike is 60.
Chief Executive Officer Appointment Paul was appointed as Chief Executive Officer in August 2009.
Experience and qualifications Paul was the Chief Executive Officer of RBS Group’s mainland UK retail banking business, having joined in 2004 as Managing Director with responsibility for products and marketing.
Before joining RBS Group, Paul held a number of senior roles in multi-channel retailing in businesses that were then parts of the GUS and Kingfisher groups. Paul started his career in marketing, with UK and European roles at Procter & Gamble. Paul read Philosophy, Politics and Economics at the University of Oxford. He is a fellow of the Chartered Institute of Bankers in Scotland. Paul is 43.
Key strengths and contribution Glyn has undertaken a number of senior roles within the financial services industry. He brings knowledge of insurance from his time as Chairman of Aspen. As a former Chief Executive Officer in the asset management industry he also understands the City and shareholders well.
External appointments Mark sits on The Royal Bank of Scotland Group plc’s management committee and is Chief Executive Officer of UK Corporate and Institutional Banking at RBS Group, a position he has held since 2008.
Key strengths and contribution Mark is one of two Non-Executive Directors nominated by The Royal Bank of Scotland Group plc as the majority shareholder. He has 20 years’ experience in corporate banking and financial markets to add to the perspectives around the boardroom table.
Experience and qualifications Jane spent 12 years with KPMG, where she worked in the financial sector, becoming the director responsible for delivery of corporate governance, internal audit and risk management services in the North of England. Jane has also 56 Direct Line Group Annual Report & Accounts 2012
has insight into corporate governance developments and best practice in financial reporting through his membership of the Financial Reporting Review Panel of the Financial Reporting Council. Accordingly, he is able to advise the Group on its governance framework and financial reporting policies and can draw on his experience in our industry sector.
Experience and qualifications Clare was a partner at PricewaterhouseCoopers (PwC) from 1988 to 2011. During her 23 years as a partner of PwC, she held several senior and high profile roles, particularly within the insurance sector. She is a graduate of the University of York with a degree in Mathematics and is a Fellow of the Institute of Chartered Accountants in England and Wales. Clare is 58.
held executive roles as Director of Audit, and Risk and Governance Director at Aviva’s UK Life business. Jane is a graduate of the University of York with a degree in music and is a Fellow of the Institute of Chartered Accountants in England and Wales. Jane is 45.
External appointments Jane is Chair of the Audit and Risk Committee and Non-Executive Director at Reclaim Fund Ltd. She is an Independent Member of the Fairness Committee at ReAssure Ltd; and Chair of the Audit and Risk Committee and Senior Independent Director at Calderdale and Huddersfield Foundation Trust. Jane has her own financial sector consulting business, delivering audit, enterprise risk management and corporate governance advisory and consulting services to the financial sector. She is also a magistrate.
Non-Executive Director Appointment Andrew joined the Board in March 2011 and is Chair of the Audit Committee and Chair of the Investment Committee.
Experience and qualifications Andrew retired from Legal & General Group plc, where he was the Group Finance Director, in 2009. He is a Fellow of the Institute of Chartered Accounts in England and Wales. Andrew is 59.
External appointments Bruce is currently the Group Finance Director for The Royal Bank of Scotland Group plc.
1 Robert Bailhache Director of Communications Appointment Rob joined as Director of Communications in February 2012.
2 Jamie Brown Managing Director of International Appointment Jamie joined the Group in 1997.
Experience and qualifications Jamie joined as part of the Motor team, initially setting up Direct Line Rescue. In 1999 he was responsible for the acquisition and integration of Green Flag. In 2001 he moved to Italy to lead the development of the Direct Line business in that market, and in 2007 took broader responsibility across the Group’s other European businesses. Previously Jamie followed a career both inside and outside the insurance industry in the UK and overseas. He is a Chartered Accountant and has spent six years in the accountancy profession, 23 years in the insurance industry with AIG, Churchill and Direct Line and six years in other industries.
4 Jonathan Greenwood Managing Director of Commercial Appointment Jonathan joined the Group in 2001.
8 Humphrey Tomlinson General Counsel and Company Secretary Appointment Humphrey joined the Group in November 2011.
9 José Vazquez Chief Risk Officer Appointment José joined as Chief Risk Officer in March 2012.
Experience and qualifications Previously he was Human Resources Director and a member of the Board at T-Mobile Limited. Before this, he held a number of human resources, general management and marketing roles in the food manufacturing, fast moving consumer goods, telecoms and public sectors. He holds a BSC (Honours) degree in Management and Personnel Practice from Aston University, and is a Fellow and Graduate of the Chartered Institute of Personnel and Development.
The UK Corporate Governance Code The following report details how the Board has applied the principles and provisions in the Financial Reporting Council’s UK Corporate Governance Code 2010 (the “Code”), as required by the UK Listing Rules. The report fulfils the requirements of the Corporate Governance statement for the purposes of the Disclosure and Transparency Rules.
The Company was not listed and therefore not subject to the Code until 16 October 2012. However, the Board considers that the Company had achieved the required level of compliance with the Code by the time it listed. The Company is compliant with the Code with the exception that the Company’s Directors, some of whom joined the Board in the run-up to the IPO, are yet to be subject to an annual assessment. It is intended that such an assessment will take place for all Directors during 2013.
Leadership What is our integrated approach to corporate governance? The Group undertook a significant programme of work to establish a governance system appropriate for a stand-alone listed company. This included the adoption of a new set of high-level controls, risk management policies and minimum standards. The Group also observed examples of good governance practice and emerging legal and regulatory developments to anticipate and meet the expectations of its investors and other stakeholders.
“As a Board we are collectively responsible for leading the business and targeting long-term success. We are all fully committed to acting in the Company’s best interests to take the Company along this journey.” Mike Biggs, Chairman 60 Direct Line Group Annual Report & Accounts 2012
Policies and minimum standards The Group operates under a system of policies and supporting minimum standards. In addition to covering areas across the business such as risk, internal controls, finance and operational policies and minimum standards, these include Stock Exchange announcements; registrar processes; the control of inside information; share dealing; disclosure requirements and the requirements under the ongoing obligations of the Listing Rules and the Disclosure and Transparency Rules.
Three Lines of Defence The Board has adopted a ‘Three Lines of Defence’ operating model as part of our approach to risk management. The model addresses: • the roll-out of our risk strategy and wider risk framework throughout the business; • a risk function to implement and develop the policy framework; and
We provide further information on this model in the Risk Management report on page 26.
The role of the Board is to organise and direct the affairs of the Group in a manner that is most likely to promote its long-term success for the benefit of its members as a whole.
Senior Independent Director • To provide a sounding board for the Chairman and to serve as an intermediary for the other Directors when necessary.
Prior to listing on 16 October 2012 After listing on 16 October 2012
Mike Biggs3 4 of 4 5 of 5 3 of 3 1 of 1
Glyn Jones4 1 of 1 – 3 of 3 0 of 1
Jane Hanson 8 of 8 9 of 10 3 of 3 1 of 1
Clare Thompson4 1 of 1 2 of 2 3 of 3 1 of 1
Priscilla Vacassin4 1 of 1 1 of 1 3 of 3 0 of 1
Paul Geddes 8 of 8 10 of 10 3 of 3 1 of 1
4. Clare Thompson and Priscilla Vacassin joined the Board on 3 and 13 September respectively. Mark Catton and Glyn Jones joined the Board on 24 September 2012.
Who are the Directors? The Board currently comprises the Chairman, who was independent on his appointment to the Board, two Executive Directors, five independent Non-Executive Directors and two non-independent Non-Executive Directors nominated by The Royal Bank of Scotland Group plc.
How are the roles of the Chairman and Chief Executive Officer distinct? The roles and responsibilities of the Chairman and the Chief Executive Officer are clearly differentiated. The division of responsibilities at the top of a Company is required by the Code to ensure that no one person may exert absolute control. The role statements of both the Chairman and the Chief Executive Officer were reviewed during the year and approved by the Board on 21 September 2012. These statements for the Chairman and the Chief Executive Officer, which explain their responsibilities, are available on the Group’s website.
What is the governance framework below Board and Board Committee level? Although the Board is ultimately responsible for the success of the Company, Paul Geddes, the Chief Executive Officer, has received delegated authority from the Board to manage the Group’s day-to-day operations.
Paul Geddes and these senior executives are supported by the functional departments of the Group.
In assessing the independence of each Director we considered whether each was independent in character and judgement and particularly whether there were relationships or circumstances which were likely to affect his or her judgement.
Mark Catton and Bruce Van Saun are non-independent Non-Executive Directors by virtue of being nominated for appointment to the Board by RBS Group, the Company’s majority shareholder. RBS Group has committed to the European Commission to sell Direct Line Group as a condition of its receipt of state aid in 2009. To comply with this requirement, RBS Group must cede control of Direct Line Group (that is, reduce its shareholding to below 50%) by the end of 2013 and must have divested its entire interest by the end of 2014. Mark Catton and Bruce Van Saun will step down in stages as RBS Group’s holding in the Company diminishes. Please refer to page 82 for further information.
Insurance Banking Finance Management consultancy Corporate governance Audit Asset management Human resources Marketing Risk management
In addition, all 10 have experience of working in the financial services sector.
What is the process for appointing new people to the Board? The Company spent considerable time on recruiting its new Directors during 2012. Assisted by selection consultants JCA Group, and deploying skills matrices to identify desired attributes, the Directors pursued a formal, rigorous and transparent selection procedure. Separate requirements were developed for Non-Executive Directors, the Senior Independent Director and the Chairman. Our target search criteria for Board members included: Experience • Significant Board experience in major listed businesses.
• Extensive knowledge and operational experience in insurance at a senior level.
• An independent thinker who is able to engage constructively and add real value to Board discussions.
• Well organised and committed, an individual who takes their Non-Executive role seriously.
• Robust, straight talking, open and approachable with a non-emotional and calm demeanour.
• Supportive of the executive team while being able to challenge constructively.
• A sound understanding of the requirements of good public reporting and the ability to identify whether what is being presented in meetings stands up against reporting standards.
The selection procedure included a number of interviews with JCA Group and meetings with existing Board members. The Company also obtained a range of references for each candidate.
How long are the Directors appointed for? The Directors may appoint additional members to the Board during the year. Subsequently, in accordance with a provision of the Code and the Company’s Articles of Association, Direct Line Group submits Directors for re-election on an annual basis, subject to the Group’s independence criteria (where appropriate), ongoing commitment to Group activities and satisfactory performance.
What level of commitment is expected from our Board members? All our Directors, including the Chairman, have indicated that they are able to allocate sufficient time to the work of Direct Line Group to enable them to discharge their respective duties and responsibilities effectively. Directors’ appointment letters contain a condition to this effect, and Directors were made fully aware, and accepted, that the time commitment would be greater than normal in 2012 given the need to deliver the IPO transaction and associated restructuring activities.
How do we ensure that Board members have adequate resources and training to undertake the role effectively? The Company believes it is crucial to provide Directors with adequate resources and training and devoted considerable time during the year to ensure that all Directors, many of whom were new to the business, received induction to help them understand their duties and responsibilities and develop knowledge of the business as quickly as possible. These sessions were based on a comprehensive technical acclimatisation programme, developed specifically to meet the needs of Direct Line Group Directors, with individual Directors provided with specific training in such areas as reserving, including reinsurance.
The Group also intends to engage the services of an external consultant to facilitate the evaluation of the Board and its committees within three years of listing on the London Stock Exchange.
With three women out of 10 Directors, the Government’s guidelines, the recommendations of Lord Davies’s report (Women on Boards) and related initiatives such as the work of the 30 Percent Club have been met in respect of gender diversity.
To further governance of our gender-diversity programme we have included an appropriate remit in the terms of reference of the Nomination Committee. In this, diversity, including gender diversity, features as one of the criteria for
As an organisation we are committed to ensuring that diversity is promoted across our business and that everyone is treated fairly irrespective of their racial or ethnic origin, gender, age, disability, religion, belief or sexual orientation. This will apply during our day-to-day activities at work through to our recruitment process for external candidates and the selection for promotion of internal employees, ensuring that we employ only the best people for the role based on merit and evidence of their qualifications, skills and experience. We also consider ‘diversity’ as including diversity of thought and approach.
We need a wide range of talented people to deliver great service to our diverse customers. Our commitment to valuing diversity is reflected in our Diversity Policy. It is the responsibility of everyone to demonstrate our commitment through how we treat others. Some of the benefits of a diverse workforce include: • Greater access to different perspectives and sources of information.
What is the Board’s responsibility in relation to the financial and business reporting in this Annual Report & Accounts? The Board is responsible for providing shareholders with a fair, balanced and understandable assessment of the Company’s position and prospects.
An explanation from the Directors of their responsibility for preparing the financial statements is set out in the statement of Directors’ responsibilities on page 95. This is complemented by the statement by our auditors explaining their reporting responsibilities on page 97.
• How the Board has concluded that the business remains a going concern is discussed on page 94.
• The Board has delegated to the Audit Committee oversight of the management of the relationship with the Company’s auditors. A separate Audit Committee report is set out on pages 68 to 71 and provides details of the role and activities of the Committee and its relationship with the internal and external auditors.
What action has the Board taken to determine the nature and extent of the significant risks it is willing to take in achieving its strategic objectives? The Board acknowledges it has overall responsibility for the Group’s risk management and internal control system, and has complied with the Code by establishing a continuous process for identifying, evaluating and managing the significant risks the Group faces. This process includes risks arising from social, environmental and ethical matters.
The Board Risk Committee regularly reviews significant risks, their potential impact on the Group’s financial position, variations from agreed risk appetites and the actions taken to manage those risks.
The internal audit function supports the Board by providing an independent and objective assurance of the adequacy and effectiveness of the Group’s operations. It brings a systematic and disciplined approach to evaluating and improving the effectiveness of its risk management, control and governance frameworks and processes.
Remuneration The Board has delegated responsibility to the Remuneration Committee for the remuneration arrangements of the Executive Directors and any applicable senior executives of the Group. Please refer to the Directors’ remuneration report on pages 78 to 90.
4. A member from 16 February 2012 and Chair between 23 February and 16 October 2012. Continues as a member.
6. A member between 28 May 2012 and 16 October 2012.
Committee reports 68 Direct Line Group Annual Report & Accounts 2012
The Group’s Audit Committee was established by the Board on 21 September 2012 to be effective from admission to listing. Prior to the establishment of this Committee, the Group had a combined Risk and Audit Committee, the last meeting of which took place on 31 August 2012. References to the activities of the Audit Committee in this report include those carried out by the Risk and Audit Committee during 2012.
• Received quarterly risk reports until the formation of the Board Risk Committee in September and, in the light of the IPO, ensured that the auditors’ focus was aligned with the areas of greatest risk facing the Group.
• Considered plans and key assumptions relating to the Group’s actuarial reserves, received regular updates regarding movements and emerging trends, and recommended the level of reserves to the Board each quarter.
• Provided oversight of the Fit for Listing work stream and monitored progress towards the target operating model.
What have we achieved? • Facilitated the Group’s separation from RBS Group by supervising the various work streams focusing on the creation of the Group’s target operating model.
• Obtained independent reviews from Towers Watson of the Group’s actuarial reserves at the first and second quarters of 2012 to support the proposed IPO.
• Rolled out and monitored the Group’s system of internal controls appropriate to an independent listed insurance company.
• Reviewed and challenged key assumptions, judgements, analysis of emerging trends and movements on internal and external actuarial best estimates and management best estimate reserves, and recommended the associated levels of reserves to the Board each quarter.
• Providing oversight of the Internal Audit strategic review, that is, the programme of activity being delivered to ensure that the Internal Audit function can continue to meet the expectations of the Board and satisfy emerging regulatory and industry standards for internal audit.
• Ensuring the provision of training and development, particularly in relation to new legislation and regulation.
• Meetings with the external auditors to discuss issues relating to the Committee and for the purpose of training.
• Private meetings with the Head of Internal Audit and the external audit partner to discuss the general control environment and culture of the Group.
Reports to the Board The Chair of the Committee submits a report to the subsequent meeting of the Board on the Committee’s work.
Internal control The Group’s Internal Audit function carries out independent internal audit work.
The Head of the Internal Audit function reports to the Chair of the Audit Committee and the Chief Financial Officer. The Chief Risk Officer reports to the Chair of the Board Risk Committee and to the Chief Executive Officer.
The key control issues that Internal Audit reports to management and to the Committee are monitored on a quarterly basis until the related risk exposures have been properly mitigated.
More details of the management of risk are contained in the Board Risk Committee report on page 71 and the Risk Management report on page 26.
Reserves The Committee approves annual plans for reviews of reserves, informed by internal and external emerging issues. It also considers an appropriate balance between internal actuarial review and external peer review. Consultants appointed to provide validation of actuarial reviews are subject to approval by the Committee.
Simultaneously with this review, the Committee also considers and challenges the appropriateness of proposals made by the Chief Financial Officer for management best estimate reserves for booking, informed both by actuarial analysis, wider commercial insights and principles of consistency from period to period.
Financial reporting The review process undertaken by the Committee prior to the publication of the Group’s financial statements focuses on our critical accounting policies and practices, and on any changes and decisions that require a major element of judgement, unusual transactions, clarity of disclosures and significant audit adjustments. In addition, the Committee reviews the going concern assumption, compliance with accounting standards and obligations under applicable laws, regulations and governance codes and makes appropriate recommendations to the Board.
Both audit and non-audit services provided by Direct Line Group’s external auditor are closely monitored: • The Audit Committee formally approves a list of audit and non-audit services and an associated budget in advance of each financial year in line with the Auditing Practices Board’s Ethical Standard 5.
• All permitted services must be approved before any work commences and applications for approval must be submitted on a prescribed form, signed by the relevant member of the Executive Committee.
• The Audit Committee Chair approves services costing less than £100,000 whilst the Audit Committee approves services costing in excess of £100,000.
In accordance with the Group’s Audit/Non-Audit Services Minimum Standard, all services were approved prior to work commencing and each of the non-audit services was confirmed to be permissible for the external auditor to undertake. The Audit Committee approved fees of £4.5 million payable to Deloitte LLP for services not related to audit work, which accounted for 74% of total fees paid to the external auditor in the year. The majority of non-audit fees relate to the Group’s IPO, for which Deloitte LLP provided additional services as Reporting Accountants.
A summary of fees payable to the auditor for the year ended 31 December 2012 is provided in note 10 to the Group financial statements.
The Audit Committee and Board remained satisfied that the provision of non-audit services by Deloitte LLP has not compromised Deloitte’s independence as the Company’s external auditor.
Auditor performance and independence The performance of the external auditors is assessed every year, including their independence and objectivity and the effectiveness of the external audit process. The effectiveness review includes regular questioning of the external auditor during Audit Committee meetings. The Committee reviews the external audit strategy and receives reports from Deloitte LLP on its own policies and procedures regarding independence and quality control, including an annual confirmation of independence in line with industry standards. The Committee concluded that the performance of the external auditor and the effectiveness of the audit process were satisfactory.
Re-appointment of auditor The Committee intends to undertake a formal review on a regular basis to assess whether the external audit should be re-tendered. Deloitte LLP has been the Group’s auditor since 2000, during which time the Group was audited as a division of RBS Group. Following the Company’s listing on the London Stock Exchange on 16 October 2012, Deloitte remained the Group’s external auditor.
The Board Risk Committee’s terms of reference are available on our website at: www.directlinegroup.com.
4. A member between 28 May 2012 and 16 October 2012.
What will we be focusing on? • Fostering a culture which is aligned to appropriate outcomes for the customer.
• Considering and recommending for approval by the Board: – the design and implementation of risk management and measurement strategies across the Group; and
– the Group’s risk appetite, framework and tolerance levels for current and future strategy.
Frequency of meetings During 2012, the Committee (and its predecessor the Risk and Audit Committee) met on seven occasions; five were scheduled meetings and two of which were additional ad hoc meetings. The members’ attendance record is set out on page 71.
• The arrangements by which our staff may, in confidence, raise concerns regarding possible improprieties regarding financial reporting or other matters.
• Monitored the Group’s compliance with SOX 404 and other statutory and regulatory requirements and recommendations within the scope of the Committee’s terms of reference.
What did the Committee do in 2012? The Corporate Social Responsibility Committee was constituted as part of the Fit for Listing programme and held its first meeting in December 2012. At that meeting, the Committee considered: • The constitution of the Committee, its membership and terms of reference.
What have we achieved? • Approved the constitution and membership of the
• Produced the Corporate and Social Responsibility Plan for 2013 including priorities, policies and community engagement activities.
What will we be focusing on? • Reviewing the Group’s overall Corporate Social
• Reviewing performance and priorities against both internal targets and relevant external benchmarking indices.
This report was reviewed and approved by the Board on 27 February 2013.
What did the Committee do in 2012? • Reviewed its membership, constitution and terms of reference.
• Monitored the delivery of in-train changes to the existing portfolio strategy.
• Reviewed the return on funds invested, having regard to existing investment policies and guidelines.
What will we be focusing on? • Considering changes to the existing asset benchmark composition for the Group’s investment portfolio to improve the expected risk-adjusted returns, respecting the Group’s investment risk appetite set by the Board.
• Reviewing the liquidity requirements of the business and considering the adequacy of liquidity available to meet such needs from the investment portfolio.
• Reviewing the merits of any derivative and asset strategies proposed to mitigate risks associated with long-term liabilities.
• Monitoring the selection and implementation process for any new asset classes approved for the investment portfolio.
Minimum number of meetings per annum The Committee is to meet at least three times a year.
Other attendees include • Chief Executive Officer • General Counsel and
Please refer to pages 66 to 67 for the Group’s approach to diversity, including gender diversity.
• Proposed salaries for executives for the RBS Group Remuneration Committee to consider.
• Considered the terms of the Executive Directors’, executives’ and senior management’s contracts.
• Finalised the rules for the executive and all-employee share plans and Share Ownership Guidelines and approved their adoption and establishment.
• Approved the issue of free shares to employees on IPO.
What have we achieved? • Revised the constitution and membership of the Committee to meet the requirements of a listed company.
• Agreed the high level principles and key terms of the 2013 incentive plan arrangements.
• Prepared the Group’s first Directors’ remuneration report and recommended its inclusion in the 2012 Annual Report & Accounts.
Role and focus The Committee is responsible for setting and oversight of the Group’s remuneration policy. It also makes recommendations to the Board regarding the remuneration arrangements of the Company’s Executive Directors and any applicable senior executives.
Other attendees include • Chief Executive Officer • Chief Financial Officer • Chief Risk Officer • Human Resources Director • Director of Performance and Reward
Notes: 1. Attendance is expressed as the number of meetings attended out of the number of meetings possible or applicable for the Director to attend.
Priscilla Vacassin, Chair of the Remuneration Committee 76 Direct Line Group Annual Report & Accounts 2012
How do we communicate with shareholders? The Executive Directors frequently meet with investors and the Chairman, Senior Independent Director and Non-Executive Directors are available to attend meetings with major shareholders at the shareholders’ request. In such meetings, the Chairman has the opportunity to discuss governance and strategy with shareholders and ensure that any particular shareholder views are communicated to the Board.
The Board is also given the opportunity to understand the views of major shareholders through analysts’ reports, broker briefings and meetings with major shareholders.
At the Company’s first AGM the Chief Executive Officer will make a presentation on the Group’s progress and shareholders will be encouraged to ask questions.
The Company also engages with holders of the Group’s subordinated debt.
What are we focusing on in 2013? We are planning to hold a number of events to foster engagement, in recognition of the importance of maintaining an active dialogue with our shareholders, target investors and other important insurance sector investors. These include: • Presentations of our financial results.
• Investor road shows in the UK, Europe, the US and Canada.
We anticipate that all Directors will attend the AGM and that the Chairs of the Audit, Board Risk, Corporate Social Responsibility, Investment and Remuneration Committees will be available to answer questions.
Linking remuneration to overall business objectives The Group’s strategy, building on its transformation plan, is to unlock the value in the UK’s leading retail general insurance business, together with the Commercial and International businesses and to deliver superior shareholder returns, targeting a 15% RoTE and COR of 98%.
Similarly, we remain committed to the position disclosed at IPO of providing Executive Directors’ remuneration at a market-competitive level compared with relevant peer companies.
• The 2013 salary pool available for pay increases is 2% of base pay. The pool will be distributed based on the individuals’ positions in the market and their personal performance. There will be no general increase for all employees. For the Strategic Leadership Team (the “SLT”) the average increase will be slightly less than 2%. It is not the intention of the Remuneration Committee (the “Committee”) to award a pay increase to either of the Executive Directors in 2013 due to their packages having been reviewed just prior to the IPO.
• The 2012 bonus overall outcome is that the Group bonus payout is marginally below ‘On-target’ in aggregate. We have made good progress on our transformation plan, and the Board is encouraged by the progress towards the targets disclosed in September 2012. However, the level of bonus set in aggregate by the Committee takes into account a wider set of criteria than just these, including general affordability and market practice. We believe that the planned payout is appropriate taking into account these wider criteria. We intend to continue to set stretching but achievable targets for future bonus awards across a range of criteria.
• The 2013 bonus opportunity remains unchanged from the levels disclosed at IPO and for 2013 the metrics will be applied on a rigorous ‘balanced scorecard’ approach that accords with insurance industry practice. This will include financial, risk-based and customer-centric targets.
Structure of report Over the following pages we set out: • The governance surrounding pay decisions in 2012, members of the Committee and advisers to the Committee in 2012.
• The Group’s forward-looking pay policy which is effective for the financial year beginning 1 January 2013.
Priscilla Vacassin, Chair of the Remuneration Committee 78 Direct Line Group Annual Report & Accounts 2012
This report has been prepared by the Committee and approved by the Board, for submission to shareholders at the 2013 AGM.
The Committee is made aware of input from employee groups (such as the ERB) within the Company. The Committee consults with the Chief Executive Officer and the Human Resources Director on matters relating to the appropriateness of all elements of remuneration for Executive Directors and other leadership team members. The Chief Executive Officer and the Human Resources Director are not present when their own remuneration is discussed. The Director of Performance and Reward provides advice on compensation and benefits to the Committee, and the Company Secretary advises the Committee on corporate governance guidelines and provides secretarial assistance to the Committee.
In addition, the Committee has appointed FIT Remuneration Consultants LLP (“FIT”), signatories to the Remuneration Consultants Group’s Code of Conduct, as their independent adviser. FIT provided advice during the year on market practice, governance and incentive plan design. FIT does not provide any other services to the Group. Their total fees for the provision of remuneration services in 2012 were £274,883. Allen & Overy LLP has also provided legal advice in relation to the Group’s executive remuneration arrangements, and has provided the Group with other legal services.
• Ensuring we are competitive in the market allows us to attract, retain and motivate high-calibre employees with the skill sets to deliver our key aims whilst managing costs.
Base salaries are reviewed annually and set in April of each year. No changes will be made to the Executive Directors’ salaries in 2013.
• To motivate employees and incentivise delivery of performance over the one-year operating cycle, focusing on the short to medium-term elements of our strategic aims.
• Target bonus – which is paid for on-target performance against the performance measures being operated for the AIP in the relevant financial year – is currently set at 60% of the maximum opportunity.
• Performance over the financial year is measured against stretching financial and non-financial and individual performance targets set at the start of the financial year.
• For Executive Directors and senior employees, 40% of the award is deferred into shares vesting three years after grant. The percentage deferred will be kept under review by the Committee to ensure that levels are in line with regulatory requirements and best practice. The vesting of Deferred Share Awards is subject to potential clawback at the discretion of the Committee. An additional share payment in lieu of dividends is also paid at vesting of Deferred Share Awards.
• Measures are those key to the business and driving long-term value to shareholders, to ensure that all major decisions are considered with long-term value in mind.
• The plan generally allows for awards with an absolute maximum value of 200% of base salary per financial year (although 300% is permitted in exceptional circumstances).
Pension • To aid retention and remain competitive within the market place.
• Employer products are offered to all employees at a discount. This discount is the same that is offered to all employees.
• Similar principles for base salary are applied to all employees in the Group.
• Maximum and target bonus levels for Executive Directors are set by reference to practice at insurance and general market comparators.
• All variable pay awards are subject to clawback up to three years post vesting at the discretion of the Committee.
Full details of the performance conditions and targets for 2012 and 2013 awards are set out on page 85.
• Executive Directors are eligible to participate in the Group’s defined contribution pension arrangement or alternatively they may choose to receive a cash allowance in lieu of pension.
• To encourage share ownership by the Executive Directors and ensure interests are aligned.
• The CEO and CFO are required to acquire and retain Ordinary Shares in the Company equivalent in value to no less than 200% and 150% of their salaries respectively.
• For an internal appointment, any variable pay element awarded in respect of the prior role may either continue on its original terms or be adjusted to reflect the new appointment as appropriate.
John Reizenstein 1 September 2012 12 months Base salary only for unexpired portion of notice period and to be paid in a lump sum or monthly instalments, in which case instalments are subject to mitigation if an alternative role is found.
Termination policy summary It is appropriate for the Committee to retain discretion to consider the termination terms of any Executive Director, having regard to all the relevant facts and circumstances available to them at the time. The table below sets out the general position although it should be noted that the Committee, consistent with most other companies, has reserved a broad discretion to determine whether an Executive Director should be categorised as a ‘good leaver’ and that discretion forms part of the approved policy. Similarly, while the policy is generally to reduce awards on a pro-rata basis, the Committee has reserved discretion to disapply such reduction if, in the circumstances, it considers that to be appropriate.
If a leaver is deemed to be a ‘bad leaver’, for example leaving through resignation or dismissal
All awards will lapse Will receive all deferred shares at the end of the vesting period
Long-Term Incentive Plan All awards will lapse Will receive a pro-rata award subject to the application of the performance conditions at the end of the vesting period
Will receive a pro-rata award subject to the application of the performance conditions
For as long as RBS Group owns more than 50% of the Ordinary Shares in the Company, Paul Geddes’s and John Reizenstein’s service agreements will continue to have the RBS Group policy provision regarding termination without notice or payment in lieu when personal underperformance is not remedied following a warning from the Board and after reasonable opportunity to remedy it has been given. The Direct Line Group Directors’ service agreement provides that Paul Geddes and John Reizenstein are not eligible to receive any enhanced redundancy terms which may be offered by Direct Line Group from time to time. Their rights to a statutory redundancy payment are not affected.
Non-Executive Directors Non-Executive Directors are appointed for a three-year term which may be renewed by mutual agreement. In common with the Executive Directors, all Non-Executives are subject to annual re-election by shareholders. The term of either Bruce Van Saun or Mark Catton as Directors will cease when RBS Group divests its controlling interest in Direct Line Group. Both will step down as Directors when RBS Group owns less than 20% of Direct Line Group; one will step down once the shareholding drops below 50% and the other when the shareholding drops below 20%.
Directors’ remuneration report continued 82 Direct Line Group Annual Report & Accounts 2012
The Chairman and Non-Executive Directors are not entitled to any compensation on exit.
External directorships The Group encourages Executive Directors to accept, subject to the approval of the Chairman, an invitation to join the board of another company outside the Group in a non-executive capacity, recognising the value of such wider experience. In these circumstances, they are permitted to retain any remuneration from the non-executive appointment. Executive Directors are limited to accepting one external appointment.
Indicative total remuneration levels The charts below aim to show how the remuneration policy set out above for Executive Directors is applied by way of hypothetical performance scenarios.
• On-target – on-target bonus of 60% of maximum and LTIP vesting of 55% of maximum (10% of maximum bonus and 20% of maximum LTIP vest at threshold levels of performance).
• Below target – no bonus and no vesting under the LTIP.
Base pay Benefits Pension Bonus LTIP £0m £1m £4m£3m£2m 590Below target
Base pay Benefits Pension Bonus LTIP £0m £1m £4m£3m£2m 83Direct Line Group Annual Report & Accounts 2012
2012 implementation Base pay The current base salaries paid to the Executive Directors, effective 1 October 2012, are: Director Position Date of appointment to Direct Line Group role
For all other employees, their performance was assessed against the targets set at the beginning of 2012, and senior employees were specifically considered by the Committee.
Deferred Annual Incentive Plan The table below shows details of the deferred awards granted to Paul Geddes and John Reizenstein for the 2012 financial year.
Annual Incentive Plan measures in 2013 For the Executive Directors, 75% of bonus opportunity is linked to clearly measureable corporate targets. These comprise a balanced scorecard of measures, which reflects both financial and strategically important non-financial measures (including a customer-based assessment), with the majority being financial measures. The final 25% is linked to clear personal objectives. Personal objectives are set in line with the Group’s values and will be measured based on achievement of objectives and demonstration of these values.
Details of RBS Group long-term incentive awards previously made to the Executive Directors under RBS Group plans (prior to the IPO) are disclosed on page 89.
• 40% is based on relative TSR performance against the constituents of the FTSE 350 (excluding investment trusts) over a three-year performance period starting on 16 October 2012. The starting TSR is measured over the period of one month following 16 October 2012 and closing TSR will be measured over the last three months of the three-year period.
For these purposes, the Company’s standard definition for RoTE is used, subject to such other adjustments as the Committee considers appropriate.
Vesting on the RoTE scale is weighted, with 40% vesting for RoTE of 15%. Otherwise, there is straight line interpolation by ranking between these points.
The fees for the Chairman and Non-Executive Directors set in 2012 are as follows: Position Fees £’000
Note: 1. As there were no Nomination Committee meetings in 2012, the fees for membership of this Committee were waived.
Notes: 1. Base salary earned during the financial year ending 31 December 2012. This includes eight months as an employee of RBS Group and four months as an employee of Direct Line Group.
2. Benefits in kind and allowances made during the financial year ending 31 December 2012. This includes eight months as an employee of RBS Group and four months as an employee of Direct Line Group.
7. The 2011 statutory figure for John Reizenstein includes a buyout award granted on his appointment in 2011 that had a total value of £219,567 and which vests over a three-year period.
8. Sheree Howard was an Executive Director for the period to 23 March 2012. Pro-rata remuneration during 2012 amounted to base pay of £58,750, benefits of £5,946, pension of £10,572 and bonus of £31,500. The amounts for the year to 31 December 2011 amounted to base pay of £215,000, benefits of £22,409, pension of £17,620 and bonus of £130,000.
Remuneration for the Non-Executive Directors for the year ended 31 December 2012 was as follows: Total 20121 £’000 Total 20111 £’000
Bruce Van Saun and Mark Catton are RBS Group employees and fees are paid to RBS Group. Under the RBS Group policy on internal Non-Executive Directors, Chris Sullivan was not eligible to receive fees for the period he was a Director.
Historical total shareholder return performance This graph is a requirement of Schedule 8 to The Large and Medium-sized Companies and Group (Accounts and Reports) Regulations 2008. However, as the Group has only existed as an independent entity since October 2012 we have provided the entire three-month historical performance versus the TSR of the FTSE 350 index over the same period.
2. Includes holdings of connected persons, as defined in sections 252 – 255 of the Companies Act.
Direct Line Group share awards The table below details the unvested awards held by Paul Geddes and John Reizenstein made under the Group’s LTIP.
Paul Geddes LTIP2 – 388,250 – – 388,2503 7 November 2012 1.96 7 November 2015
John Reizenstein LTIP2 – 234,993 – – 234,9933 7 November 2012 1.96 7 November 2015
Notes: 1. The Group’s share price on 31 December 2012 was £2.164 and the range of prices in the portion of the year where the Group was listed (16 October 2012 to 31 December 2012) was £1.865 to £2.164.
3. This figure does not include those RBS Group LTIP awards transferred into the Direct Line Group’s share options during 2012 as per the table on page 89.
John Reizenstein Free Share Award – 143 – – 143 27 November 2012 2.02 27 November 2015
Note: 1. The Group’s share price on 31 December 2012 was £2.164 and the range of prices in year (11 October 2012 to 31 December 2012) was £1.865 to £2.164.
Legacy RBS Group awards vesting in the year The Executive Directors continue to hold unvested awards previously granted to them under the RBS Group Employee Share Plans as employees of the RBS Group. We include details of these awards within our report as they were awarded to the Executive Directors in respect of their work as Executive Directors of Direct Line Group (previously RBS Insurance).
Directors’ remuneration report continued 88 Direct Line Group Annual Report & Accounts 2012
Note: 1. The market price of RBS Group shares at vesting was £2.16.
RBS Group Long-Term Incentive Plan (“RBS Group LTIP”) awards Awards originally granted under the RBS Group LTIP in 2011 and 2012 will now be delivered in the Direct Line Insurance Group plc shares transferred by RBS Group to the extent that the originally set performance conditions for these awards are considered achieved by the RBS Group Remuneration Committee.
Market price at grant date (RBS Group shares) £ Vesting date
RBS Group LTIP 2012 – 535,906 – 797,000 797,000 9 March 2012 2.80 9 March 20152
2. It was agreed with RBS Group that participants now employed by Direct Line Group holding awards granted in 2011 and 2012 under the RBS Group LTIP would be given the opportunity to have those awards satisfied by the transfer of Direct Line Insurance Group plc shares from RBS Group on vesting. The conversion rate applied to these awards was the average price of RBS Group shares over the five business day period prior to 11 October 2012 divided by the Direct Line Insurance Group plc share offer price (£1.75). This conversion equated to 1.487 Direct Line Insurance Group plc shares for every RBS Group share under grant. Both Executive Directors took up this offer.
3. These are subject to performance conditions to be assessed by the RBS Group Remuneration Committee. The conditions relate to financial and operational performance against the strategic plan for Direct Line Group and effective risk management with, in the case of Paul Geddes only, 25% of vesting also dependent upon RBS Group performance. The 2012 awards also applied measures based on employee and customer satisfaction.
Awards that were originally awarded under the RBS Group LTIP in 2010 will continue to be delivered in RBS Group shares. The table below details the awards held by Paul Geddes made under RBS Group plans.
2. These are subject to performance conditions to be assessed by the RBS Group Remuneration Committee, as described above.
Notes: 1. Vested on 9 March 2012 when the RBS Group share price was £2.80.
2. Vested on 7 March 2012 when the RBS Group share price was £2.62.
The information that fulfils the requirements of the Directors’ report for the purposes of section 415 of the Companies Act 2006 is included within this corporate governance report (pages 52 to 95).
Section 417 of the Companies Act 2006 requires the Directors to present a business review in the Directors’ report. The information that fulfils this requirement can be found on pages 10 to 51, and is incorporated by reference into this corporate governance report.
Disclosure and Transparency Rule 4.1.5(2) also requires this Annual Report & Accounts to include a management report. The information that fulfils this requirement can be found in the business review on pages 10 to 51 and this report on pages 52 to 94.
The subsidiary and associated undertakings which principally affect the profits or net assets of the Group in the year are listed in note 19 to the financial statements.
Significant changes and events Significant changes and events affecting the Group during 2012 and until the date of this report are set out on page 52 to 53 under ‘A year of transformation’.
• make market purchases of up to 150,000,000 shares of the Company (representing approximately 10% of the Company’s issued share capital at the time).
These authorities have not been used to date and shareholders will be asked to renew them at the 2013 AGM. Details are contained in the Notice of AGM.
The Company held no treasury shares during the year or at the date of this report.
Relationship Agreement with RBS Group Under the terms of a Relationship Agreement between the Company and RBS Group, which is described on page 61, RBS Group has nominated Bruce Van Saun and Mark Catton as Directors of the Company.
Under the terms of the agreement, RBS Group may nominate up to two Directors to serve on the Company’s Board of Directors. With the exception of the Relationship Agreement, there is no arrangement or understanding with any shareholder, customer, supplier, or any other external party, providing the right to appoint a Director or a member of the Executive Committee.
Restrictions on the transfer of shares The Relationship Agreement in place between the Company and RBS Group contains certain restrictions on the transfer of the Ordinary Shares registered in the name of RBS Group.
Other disclosures continued 92 Direct Line Group Annual Report & Accounts 2012
Substantial shareholdings In accordance with the provisions of chapter 5 of the Disclosure and Transparency Rules of the Financial Services Authority, the following shareholder has provided the Company with notice of interests in the Company’s voting rights.
Group management uses an intranet-based social media site, run as part of the BEST programme, to share ideas and achieve a common awareness throughout the Group, including those financial and economic factors that affect our performance. The site also contains employee-feedback questionnaires. In addition, the Group encourages the involvement of employees in its performance by allowing eligible employees to participate in our all-employee share ownership plans.
The Group values the diversity of its employees and is committed to creating a working environment that is inclusive of all. The Group embraces people’s differences in order to attract and retain talent and seeks to enable employees to reach their potential; these differences include but are not limited to age, belief, disability, ethnic or national origin, gender, gender identity, marital or civil partnership status, political opinion, race, religion or sexual orientation. These commitments extend to recruitment and selection, training, career development, flexible working arrangements, promotion and performance appraisal.
Disabled employees Applications for employment by disabled persons are always fully considered, bearing in mind the aptitudes of the applicant concerned. In the event of members of staff becoming disabled every effort is made to ensure that they continue their employment with the Group and that they receive appropriate training. It is Group policy that the training, career development and promotion of disabled persons should, as far as possible, be identical to that of other employees.
The average trade creditors of the Group during 2012, which exclude insurance creditors, were equivalent to 26 days’ purchases (2011: 18 days’ purchases), based on the ratio of Group trade creditors at the end of the year to the amounts invoiced during the year.
The Corporate Social Responsibility Committee is responsible for the approval of the Group’s community-based activities; more detail on the role of the Group’s CSR and community development activities can be found in the Corporate Social Responsibility report on pages 47 to 51.
The Group made no political donations during the year (2011: nil).
Governmental regulation To comply with European Union state aid requirements, RBS Group agreed to cede control of Direct Line Group by the end of 2013 and divest its entire interest by the end of 2014. The initial minority tranche of the divestment of Direct Line Group, by way of a public flotation, was effected on 16 October 2012.
Going concern The Group has sufficient financial resources to meet its financial needs and it manages a mature portfolio of insurance risk. The Directors believe that the Group is well positioned to manage its business risks successfully in the current economic environment.
The Financial Review on pages 36 to 46 describes the Group’s capital management strategy, which covers how we measure our regulatory and economic capital needs and how capital is deployed. The financial position of the Group is also covered in that section, including a commentary on cash and investment levels, reserves, currency management, insurance liability management, liquidity and borrowings.
Statement of disclosure of information to auditors Each Director at the date of the approval of this Annual Report & Accounts confirms that: • So far as the Director is aware, there is no relevant audit information of which Deloitte LLP, the Company’s external auditor, is unaware.
This Directors’ report was reviewed and approved by the Board on 27 February 2013.
Humphrey Tomlinson, General Counsel and Company Secretary 94 Direct Line Group Annual Report & Accounts 2012
The Directors are responsible for preparing the Annual Report and the financial statements in accordance with applicable law and regulations.
Company law requires the Directors to prepare such financial statements for each financial year. Under that law the Directors are required to prepare the Group financial statements in accordance with International Financial Reporting Standards (“IFRSs”) as adopted by the European Union and Article 4 of the IAS Regulation and have also chosen to prepare the parent company financial statements under IFRSs as adopted by the European Union. Under company law the Directors must not approve the accounts unless they are satisfied that they give a true and fair view of the state of affairs of the Company and of the profit or loss of the Company for that period. In preparing these financial statements, International Accounting Standard 1 requires that Directors: • properly select and apply accounting policies; • present information, including accounting policies, in a manner that provides relevant, reliable, comparable and understandable information; • provide additional disclosures when compliance with the specific requirements in IFRSs are insufficient to enable users to understand the impact of particular transactions, other events and conditions on the entity’s financial position and financial performance; and
• make an assessment of the Company’s ability to continue as a going concern.
Directors’ responsibility statement We confirm that to the best of our knowledge: 1. the financial statements, prepared in accordance with International Financial Reporting Standards as adopted by the EU, give a true and fair view of the assets, liabilities, financial position and profit or loss of the Company and the undertakings included in the consolidation taken as a whole; and 2. the management report, which is incorporated into the Directors’ report, includes a fair review of the development and performance of the business and the position of the Company and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that they face.
Directors’ responsibilities statement 95Direct Line Group Annual Report & Accounts 2012
Notes to the consolidated financial statements 1. Accounting policies 103 2. Critical accounting estimates and judgements 111 3. Risk management 114 4. Segmental analysis 126 5. Net earned premium 130 6. Investment return 130 7. Instalment and other operating income 131 8. Insurance claims 131 9. Commission expenses 131 10. Operating expenses 132 11. Finance costs 133 12. Tax charge 134 13. Deferred tax 135 15. Earnings and net assets per share, return on equity 136 16. Goodwill and other intangible assets 137 17. Property, plant and equipment 139 18. Investment property 140 20. Reinsurance assets 141 21. Deferred acquisition costs 141 22. Insurance and other receivables 141 23. Derivative financial instruments 142 24. Financial investments 142 25. Cash and cash equivalents 143 26. Assets held for sale 143 27. Share capital 144 28. Other reserves 144 29. Subordinated liabilities 145 30. Insurance liabilities, unearned premium reserve and reinsurance assets 146 31. Life insurance liabilities and reinsurance assets 150 33. Retirement benefits obligations 151 34. Share-based payments 154 35. Trade and other payables including insurance payables 156 36. Notes to the consolidated cash flow statement 157 37. Contingencies and guarantees 158 39. Classification of financial instruments 159 40. Related parties 161 41. Post balance sheet events 163
Notes to the parent company financial statements 1. Accounting policies 167 2. Investment in subsidiary undertakings 167 3. Other receivables 167 4. Current tax assets 168 5. Cash and cash equivalents 168 6. Share capital 168 7. Subordinated liabilities 168 8. Derivative financial instruments 168 10. Trade and other payables 169 12. Cash generated from operations 169 13. Related parties 170 14. Share-based payments 170 15. Risk management 170 16. Directors and key management remuneration 170
Opinion on financial statements In our opinion: • the financial statements give a true and fair view of the state of the Group’s and of the Company’s affairs as at 31 December 2012 and of the Group’s and the Company’s profit for the year then ended; • the financial statements have been properly prepared in accordance with IFRSs as adopted by the European Union; and
Opinion on other matters prescribed by the Companies Act 2006 In our opinion: • the part of the Directors’ remuneration report to be audited has been properly prepared in accordance with the Companies Act 2006; and
• the Company financial statements and the part of the Directors’ remuneration report to be audited are not in agreement with the accounting records and returns; or
Under the Listing Rules we are required to review: • the Directors’ statement, contained within the Directors’ report, in relation to going concern; • the part of the Corporate Governance Statement relating to the Company’s compliance with the nine provisions of the UK Corporate Governance Code specified for our review; and
David Rush (Senior Statutory Auditor) for and on behalf of Deloitte LLP Chartered Accountants and Statutory Auditor London, United Kingdom 97Direct Line Group Annual Report & Accounts 2012
Direct Line Group Annual Report & Accounts 2012 98 £m 2011 £m
Direct Line Group Annual Report & Accounts 2012 99 £m 2011 £m
Cash and cash equivalents 25 1,508.4 1,379.8 Assets held for sale 26 1.0 1.0 Total assets 12,697.9 13,770.1
Equity Shareholders’ equity 2,831.6 3,612.8 Non-controlling interest – 258.5 Total equity 2,831.6 3,871.3
The financial statements were approved by the Board of Directors and authorised for issue on 27 February 2013. They were signed on its behalf by: John Reizenstein Chief Financial Officer 100 Direct Line Group Annual Report & Accounts 2012
Profit for the year – – – – – – 184.3 184.3
Transfer to non-distributable reserve – – – – 32.9 – (32.9) – Capital contribution1 – – – – – – 30.9 30.9 Movement in net assets of Direct Line Versicherung AG2 – – – – – 1.0 (9.2) (8.2) Share-based payments – (5.0) – – – – 0.3 (4.7) Issue of own shares 150.0 – – – – – – 150.0 Own shares redeemed (1,500.0) – 1,350.0 – – – – (150.0)
The attached notes on pages 103 to 163 form an integral part of these consolidated financial statements.
Basis of preparation As required by the Companies Act 2006 and Article 4 of the EU IAS Regulation, the consolidated financial statements are prepared in accordance with IFRSs issued by the IASB as adopted by the EU. The financial statements have been prepared in accordance with and full compliance with IFRSs as issued by the IASB.
The Group in its current structure was formed on 2 April 2012 when the Company acquired Direct Line Versicherung AG from a fellow subsidiary of The Royal Bank of Scotland Group plc. Therefore the basis of preparation represents a reorganisation of entities under common control, which is outside the scope of IFRS 3 ‘Business Combinations’. Accordingly, as permitted by IAS 8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’, it has been accounted for as a group reconstruction as described in Financial Reporting Standard 6, ‘Acquisitions and Mergers’. The consolidated financial statements have been prepared as if the transaction that gave rise to the formation of the Group had taken place at the beginning of the comparative period. Under these principles, the consolidated financial statements have been prepared as if the Company were the holding company of Direct Line Versicherung AG from 1 January 2011, the date of the beginning of the comparative period.
As part of the divestment from RBS Group, the way in which expenses incurred by RBS Group on behalf of the Group changed. Up until 30 June 2012, only some of these expenses were recharged to the Group by RBS Group. From 1 July 2012, some of the services previously provided by RBS Group have been brought in-house and so the expense is now incurred directly by the Group and reflected in expenses in the income statement; other services are still provided by RBS Group under a transitional services agreement (“TSA”) and the expense of these is charged to the Group. In order to aid comparability, the Group’s accounting policy has been changed so that all expenses are included within the income statement. For the avoidance of doubt, this includes external costs incurred by the Group and costs incurred by RBS Group, irrespective of whether RBS Group recharged them to the Group. In the case of expenses incurred by RBS Group and not recharged to the Group, a capital contribution has been credited to retained earnings in the statement of changes in equity to reflect this contribution from a shareholder. In addition there was a further contribution of £6.3 million in respect of overseas taxation. The comparatives for the year ended 31 December 2011 have been prepared on the same basis.
The effect of the above on the Group profit for the year ended 31 December 2012 was to decrease profit after tax by £30.9 million, (31 December 2011: £55.9 million) with an equal and opposite credit in the statement of changes in equity. There was no impact on net assets at 1 January 2011 or 31 December 2011, and accordingly no balance sheet at 1 January 2011 has been provided.
1.1 Basis of consolidation The consolidated financial statements incorporate the financial statements of the Company and the entities that are controlled by the Group at 31 December 2012 and 2011. Control exists when the Group has the power to govern the financial and operating policies of an entity. In assessing if the Group controls another entity, the existence and effect of the potential voting rights that are currently exercisable or convertible are considered.
Direct Line Group Annual Report & Accounts 2012 104 1. Accounting policies continued 1.2 Foreign currencies The Group’s consolidated financial statements are presented in Pounds Sterling which is the presentational currency of the Group. Group entities record transactions in the currency of the primary economic environment in which they operate (their functional currency), translated at the foreign exchange rate ruling at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are translated into the relevant functional currency at the foreign exchange rates ruling at the balance sheet date. Foreign exchange differences arising on the settlement of foreign currency transactions and from the translation of monetary assets and liabilities are reported in the income statement except for differences arising on hedges of net investments in foreign operations. Nonmonetary items denominated in foreign currencies that are stated at fair value are translated into the relevant functional currency at the foreign exchange rates ruling at the dates the values are determined. Translation differences arising on nonmonetary items measured at fair value are recognised in the income statement except for differences arising on availablefor -sale non-monetary financial assets, for example equity shares, which are recognised in other comprehensive income.
Assets and liabilities of foreign operations, including goodwill and fair value adjustments arising on acquisition, are translated into Pounds Sterling at the foreign exchange rates ruling at the balance sheet date. Income and expenses of foreign operations are translated into Pounds Sterling at average exchange rates unless these do not approximate the foreign exchange rates ruling at the dates of the transactions. Foreign exchange differences arising on the translation of a foreign operation are recognised in the consolidated statement of other comprehensive income. The amount accumulated in equity is reclassified from equity to the consolidated income statement on disposal or partial disposal of a foreign operation.
The Group’s long-term assurance contracts include whole-life and term assurance contracts that are expected to remain in force for an extended period of time. These contracts insure events associated with human life (for example, death or the occurrence of a critical illness). These are recognised as revenue when they become payable by the contract holder. Premiums are shown before the deduction of commission.
Investment return Interest income on financial assets is determined using the effective interest rate method. The effective interest rate method is a way of calculating the amortised cost of a financial asset (or group of financial assets) and of allocating the interest income over the expected life of the asset. In the case of financial assets classified as available for sale, estimates are based on the straight-line method, which the directors have determined is a close approximation to the effective interest rate.
Provisions for more recent claims make use of techniques that incorporate expected loss ratios and average claims cost (adjusted for inflation) and frequency methods. As claims mature, the provisions are increasingly driven by methods based on actual claim experience. The approach adopted takes into account the nature, type and significance of the business and the type of data available, with large claims generally being assessed separately. The data used for statistical modelling purposes is generated internally and reconciled to the accounting data.
The calculation is particularly sensitive to the estimation of the ultimate cost of claims for the particular classes of business at gross and net levels and the estimation of future claims handling costs.
Actual claims experience may differ from the historical pattern on which the actuarial best estimate is based and the cost of settling individual claims may exceed that assumed. As a result, the Group sets provisions at a margin above the actuarial best estimate. This amount is recorded as claims provisions.
Direct Line Group Annual Report & Accounts 2012 106 1. Accounting policies continued 1.7 Deferred acquisition costs Acquisition costs relating to new and renewing insurance policies are matched with the earning of the premiums to which they relate. A proportion of acquisition costs incurred during the year is therefore deferred to the subsequent accounting period to match the extent to which premiums written during the year are unearned at the balance sheet date.
Intangible assets that are acquired by the Group are stated at cost less accumulated amortisation and impairment losses. Amortisation is charged to the income statement over the assets’ economic lives using methods that best reflect the pattern of economic benefits and is included in other operating expenses. The estimated useful economic lives are as follows: Software development costs 5 years
Expenditure on internally generated goodwill and brands is written off as incurred. Direct costs relating to the development of internal-use computer software and associated business processes are capitalised once technical feasibility and economic viability have been established. These costs include payroll costs, the costs of materials and services, and directly attributable overheads. Capitalisation of costs ceases when the software is capable of operating as intended. During and after development, accumulated costs are reviewed for impairment against the projected benefits that the software is expected to generate. Costs incurred prior to the establishment of technical feasibility and economic viability are expensed as incurred as are all training costs and general overheads. The costs of licences to use computer software that is expected to generate economic benefits beyond one year are also capitalised.
1.12 Financial assets Financial assets are classified as held-to-maturity, available-forsale and designated at fair value through profit or loss, or loans and receivables. The Group only has available-for-sale financial assets and loans and receivables.
Loans and receivables – Non-derivative financial assets with fixed or determinable repayments that are not quoted in an active market are classified as loans and receivables, except those that are classified as available-for-sale. Loans and receivables are initially recognised at fair value plus directly related transaction costs and are subsequently measured at amortised cost using the effective interest rate method less any impairment losses.
Loans and receivables – If there is objective evidence that an impairment loss on a financial asset or group of financial assets classified as loans and receivables has been incurred, the Group measures the amount of the loss as the difference between the carrying amount of the asset or group of assets and the present value of estimated future cash flows from the asset or group of assets, discounted at the effective interest rate of the instrument at initial recognition.
In the hedge of a net investment in a foreign operation, the portion of foreign exchange differences arising on the hedging instrument determined to be an effective hedge is recognised directly in equity. Any ineffective portion is recognised in the income statement. Non-derivative financial liabilities as well as derivatives may be the hedging instrument in a net investment hedge.
Restructuring provisions are made, including redundancy costs, when the Group has a constructive obligation to restructure. An obligation exists when the Group has a detailed formal plan and has communicated the plan to those affected by the plan.
When the Group has an onerous contract, it recognises the present obligation under the contract as a provision. A contract is onerous when the unavoidable costs of meeting the 108 Direct Line Group Annual Report & Accounts 2012
Scheme assets are measured at their fair value. Any surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). The current service cost and any past service costs together with the expected return on scheme assets, less the unwinding of the discount on the scheme liabilities, is charged to operating expenses. Actuarial gains and losses are recognised in full in the period in which they occur outside the income statement and presented in other comprehensive income.
1.19 Taxation The tax expense represents the sum of the tax currently payable and deferred tax.
The current tax expense is based on the taxable profits for the year as determined in accordance with the relevant tax legislation, after any adjustments in respect of prior years. Taxable profit differs from net profit as reported in the income statement because it excludes items of income or expense that are taxable or deductible in other years and it further excludes items that are never taxable or deductible.
Deferred tax liabilities are calculated at the tax rates expected to apply when the liability is settled and deferred tax assets based on laws and rates that have been enacted or substantively enacted at the balance sheet date. Deferred tax is charged or credited in the income statement, except when it relates to items charged or credited in other comprehensive income, in which case the deferred tax is also dealt with in other comprehensive income.
The consideration for any ordinary share of the Company purchased by the Group (employee trust shares) is deducted from equity. On the cancellation of employee trust shares their nominal value is removed from equity and any excess of consideration over nominal value is treated in accordance with the capital maintenance provision of the Companies Act 2006. On the sale or reissue of employee trust shares the consideration received is credited to equity, net of any directly attributable incremental costs and related tax.
1.22 Dividends Interim dividends on ordinary shares are recognised in equity in the period in which they are paid. Final dividends on ordinary shares are recognised when they have been approved at the AGM.
1.23 Accounting developments The IASB issued an amendment to IAS 12 ‘Income Taxes’ in December 2010 to clarify that recognition of deferred tax should have regard to the expected manner of recovery or settlement of the asset or liability. The amendment and consequential withdrawal of SIC 21 ‘Deferred Tax: Recovery of Underlying Assets’, effective for annual periods beginning on or after 1 January 2012, will not have a material effect on the Group.
In May 2011 the IASB issued IFRS 13 ‘Fair Value Measurement’ which sets out a single IFRS framework for defining and measuring fair value and requiring disclosures about fair value measurements, effective for annual periods beginning on or after 1 January 2013. The new standard will have an impact on the quantitative and qualitative disclosure requirements of financial assets and liabilities of the Group that are not covered by IFRS 7 ‘Financial Instruments: Disclosures’.
In June 2011 the IASB issued amendments to IAS 1 ‘Presentation of Items of Other Comprehensive Income’ which require items that will never be recognised in the income statement to be presented in other comprehensive income separately from those that are subject to subsequent reclassification. The amendments are effective for annual periods beginning on or after 1 July 2012, and will have an impact on the disclosure requirements of the Group’s financial statements commencing on 1 January 2013.
In December 2011 the IASB amended IAS 32 ‘Financial Instruments: Presentation’ for the section dealing with offsetting a financial asset and a financial liability. Effective for annual periods beginning on or after 1 January 2014, to be applied retrospectively, this amendment is not expected to have any effect on the Group.
The IASB has published IFRS 9 ‘Financial Instruments: Recognition and Measurement’ that will apply to financial years beginning on 1 January 2015. The new standard has not been adopted by the EU. The standard is a complete revision and will replace the current standard IAS 39 ‘Financial Instruments: Recognition and Measurement’. The standard reduces the number of valuation categories for financial assets and means that they are recognised at amortised cost or fair value through profit or loss. The rules for financial liabilities correspond to the existing rules in IAS 39 plus a supplement on how credit risk is presented when financial liabilities are measured at fair value. The change in the credit risk for financial liabilities designated at fair value according to the so-called “fair value option” is normally presented in other comprehensive income and not in the income statement, provided that further inconsistencies do not arise in presentation of any eliminated changes in value.
The standard will be complemented by new rules for impairment of financial assets that are categorised as financial assets at amortised cost and new rules for hedge accounting. The adoption of IFRS 9 will impact both the measurement and disclosures of financial instruments (the Group does not plan to adopt this before the year beginning on 1 January 2015).
The reported results of the Group are sensitive to the accounting policies, assumptions and estimates that underlie the preparation of its financial information. The Group’s principal accounting policies are set out on pages 103 to 111. UK company law and IFRSs require the Directors, in preparing the Group’s financial statements, to select suitable accounting policies, apply them consistently and make judgements and estimates that are reasonable and prudent. In the absence of an applicable standard or interpretation, IAS 8 requires management to develop and apply an accounting policy that results in relevant and reliable information in the light of the requirements and guidance in IFRS dealing with similar and related issues and the IASB’s Framework for the Preparation and Presentation of Financial Statements. The judgements and assumptions involved in the Group’s accounting policies that are considered by the Board to be the most important to the portrayal of its financial condition are discussed below. The use of estimates, assumptions or models that differ from those adopted by the Group would affect its reported results.
The most common method of settling bodily injury claims is by a lump sum paid to the claimant and in the cases where this includes an element of indemnity for recurring costs such as loss of earnings or ongoing medical care, settlement normally occurs using a standardised Ogden annuity factor at a discount rate of 2.5%. This is normally referred to as the Ogden discount rate which is a prescribed rate set by the Ministry of Justice. Other estimates are also required for case management expenses, loss of pension, court protection fees, alterations to accommodation and transportation fees.
Impairment provision charges on available-for-sale financial assets at 31 December 2012 amounted to £nil (2011: £2.0 million).
2.3 Fair value Financial assets classified as available for sale are recognised in the financial statements at fair value. In the balance sheet, financial assets carried at fair value are included within available-for-sale debt securities and other investment funds. Unrealised gains and losses on available-for-sale financial assets are recognised directly in other comprehensive income unless an impairment loss is recognised.
2.5 Goodwill The Group capitalises goodwill arising on the acquisition of businesses as discussed in note 1.8. The carrying value of goodwill at 31 December 2012 was £211.0 million (2011: £211.0 million).
Goodwill is the excess of the cost of an acquired business over the fair value of its net assets. The determination of the fair value of assets and liabilities of businesses acquired requires the exercise of management judgement; for example those financial assets and liabilities for which there are no quoted prices and those non-financial assets where valuations reflect estimates of market conditions, such as property. Different fair values would result in changes to the goodwill arising and to the post-acquisition performance of the acquisition. Goodwill is not amortised but is tested for impairment annually or more frequently if events or changes in circumstances indicate that it might be impaired.
Direct Line Group Annual Report & Accounts 2012 114 3. Risk management 3.1 Enterprise-Wide Risk Management framework The ERM framework within the Group is designed to ensure that risk management is a forward-looking discipline, focused on facilitating appropriate and fair outcomes on a consistent and reliable basis for all stakeholders. The ERM process provides the Group with a consistent and holistic view of risk management. Further information can be found in the Risk management section on page 26.
3.2 Risk and capital management modelling The Board has ultimate responsibility for ensuring that the Group has sufficient capital to meet its liabilities as they fall due. The Group carries out detailed capital modelling of its assets, liabilities and the key risks to which these are exposed. This modelling includes the Group’s own assessment of its capital requirements for solvency purposes, in its submission of its ICA to the FSA in respect of its UK regulated entities. The ICA quantifies the insurance, market, credit, liquidity, operational and group risk that the UK regulated entities are undertaking.
The Board is closely involved in the ICA process and signs off on its assumptions and results.
3.3.1 Reserving risk Reserving risk relates to both premiums and claims. It is the risk that reserves are assessed incorrectly such that either insufficient funds have been retained to pay or handle claims as the amounts fall due both in relation to those claims which have already been incurred (in relation to claims reserves) or will be incurred in future periods of insurance (in relation to premium reserves), or a surplus of funds has been retained resulting in opportunity costs.
• assessing the volatility in the reserves to help the Board set management best estimate reserves which it feels comfortable with.
The table below provides a sensitivity analysis of the potential impact of a change in a single factor with all other assumptions left unchanged. Other potential risks beyond the ones described in the table could have an additional financial impact on the Group.
Increase / (decrease) in total equity at 31 December £m £m
Notes: 1. The sensitivities relating to an increase or decrease in the discount rate used for PPOs illustrate a movement in the time value of money from the assumed level of 4%. An increase in the discount rate reflects a decrease in the time value of money and therefore the present value of future liabilities which increases the total equity which would be reflected in the income statement.
4. The sensitivities set out above exclude the impact of taxation.
Each member of staff has a specified handling authority, with controls preventing them handling or paying claims outside their authority, as well as controls to mitigate the risk of paying invalid claims. In addition, there are various outsourced claims handling arrangements, all of which are monitored closely by management, with similar principles applying in terms of the controls and procedures.
A process is in place in the UK business to deal with severe weather and other catastrophic events, known as the ‘Surge Demand Plan’. A surge is the collective name given to an incident which significantly impacts the volume of claims reported to the Group’s claims functions. The plan covers surge demand triggers, stages of incident, operational impact, communication and management information monitoring of the impact.
Certain reinsurance contracts have long durations as a result of PPOs, and insurance reserves therefore include provisions beyond the levels created for shorter term reinsurance bad debt.
Reinsurance risk arises from: • a failure of reinsurance to control exposure to losses, to reduce volatility or to protect capital; • an inability to place reinsurance cost effectively or on acceptable terms; and/or
3.3.4 Insurance concentration risk The Group is subject to concentration risk in a variety of forms, including: • geographic concentration risk – the Group purchases a UK catastrophe reinsurance programme to protect against a modelled 1 in 200 year combined windstorm and coastal inundation loss. The retained deductible is £125.0 million at 31 December 2012. There are also relevant covers to protect the Group’s international businesses; • product concentration risk – the Group’s business is heavily concentrated in the UK general insurance market. However, the Group offers a diversified portfolio of products and a variety of brands sold through a range of distribution channels to its customers; • sector concentration risk – the concentration of the Group to any given industry sector is monitored and analysed in respect of commercial customers; and
3.4 Financial risk The Group is exposed to financial risk through its financial assets and financial liabilities. The Group’s financial risk is concentrated within its investment portfolio and reinsurance.
The strategic asset allocation within the investment portfolio is agreed for each legal entity by the Investment Committee. The Investment Committee determines high level policy and controls, covering such areas as safety, liquidity and performance. They meet at least three times a year to evaluate risk exposure, the current strategy, associated policies and investment guidelines and to consider investment recommendations submitted to it. Oversight of the implementation of decisions taken by the Investment Committee is via various risk fora.
The objectives set out in the investment management minimum standard are: • to maintain the safety of the portfolio’s principal both in economic terms and from an accounting and reporting perspective; • to maintain sufficient liquidity to provide cash requirements for operations; and
• to maximise the portfolio’s total return within the constraints of the other objectives and the limits defined by the investment guidelines.
3.4.1 Market risk Market risk is the risk associated with the adverse impact of the market risk factors movement on the Group’s balance sheet due to changes in the fair value or cash flows of its assets or liabilities.
In 2012, the Group issued £500 million of subordinated debt with a thirty-year maturity and fixed rate coupon for the first 10 years. The cost of the fixed rate coupon has been hedged down to the three-month LIBOR floating rate, using the treasury investment benchmark as a reference.
Credit spread risk The credit spread risk represents the risk of the adverse fluctuation of the values of assets and liabilities due to changes in the level of credit spreads. This represents the main market risk exposure of the Group’s investments in investment grade bonds.
Foreign currency risk The exposure to currency risk is generated by the Group’s investments in US Dollar corporate bonds and its investment in subsidiaries.
Credit spread Impact of an increase in AFS debt securities of 100bps movement in credit spreads1 – – (155.3) (137.3) Interest rate Impact on AFS debt securities of an increase in interest rate of 100bps1,2 12.9 9.2 (168.6) (233.2) Other investment funds and investment property Impact of a decrease in property markets of 15% (19.3) (10.4) (19.3) (10.4) Impact of a decrease in investment funds markets of 15%3 – – – (57.4)
Derivative liabilities At fair value through the income statement: Foreign exchange contracts (forwards) 666.5 0.2 – – 0.2
At 31 December 2012, £4.6 million in cash has been pledged by the Group and £0.8 million in cash and £1.1 million in a US Treasury bond pledged to the Group as collateral with regards to facilitating derivative trading (both interest rate and foreign exchange). The terms and conditions of collateral pledged for both assets and liabilities are market standard. The US Treasury bond is readily convertible to cash and as such there has been no policy established for the disposal of assets not readily convertible into cash.
• reinsurance recoveries – credit exposure to reinsurance counterparties arises in respect of reinsurance claims against which a reinsurance bad debt provision is assessed. The Courts Act 2003, implemented in April 2005, gave the courts the power to award PPOs in place of lump sum awards to cover the future costs element of claims (that is, loss of future earnings and/or cost of future care). PPOs have the potential to increase the ultimate value of a claim and, by their very nature, to significantly increase the length of time to reach final payment. This has increased reinsurance credit risk in terms of both quantum and longevity.
Deposits with credit institutions 1,951.7 – – – 1,951.7 Reinsurance assets 1,102.0 – – – 1,102.0 Derivative assets 37.5 – – – 37.5 Cash at bank and in hand 201.7 – – – 201.7 Insurance and other loans and receivables 1,109.8 50.3 3.9 – 1,164.0 119Direct Line Group Annual Report & Accounts 2012
Direct Line Group Annual Report & Accounts 2012 120 3. Risk management continued
Deposits with credit institutions 3,050.3 – – – 3,050.3 Reinsurance assets 741.6 – – – 741.6 Derivative assets 0.1 – – – 0.1 Cash at bank and in hand 201.9 – – – 201.9 Insurance and other loans and receivables 1,223.1 28.0 1.8 – 1,252.9
The tables below analyse, by type of asset, the credit quality of available-for-sale debt securities (note 24) that are neither past due nor impaired.
Cash at bank and in hand – – 193.2 4.2 4.3 – 201.7 Insurance and other loans and receivables – 10.7 88.7 1.0 1.8 1,061.8 1,164.0
Derivative assets – – 0.1 – – – 0.1 Cash at bank and in hand – – 201.9 – – – 201.9 Insurance and other loans and receivables 1.2 23.7 143.9 – – 1,084.1 1,252.9
Other investment funds at 31 December 2012 were £nil (2011: £382.8 million). These were not included in deposits with credit institutions above, as the disclosure of the funds held by credit quality is considered to be impractical.
In the event that one or more liquidity stresses or scenarios crystallises, or should any other event that may impact liquidity occur, the Group ensures a rapid and controlled response to the event. In such an event, a liquidity crisis management team will be formed to assess the nature and extent of the threat and to develop an appropriate response.
The table below provides information regarding the maturity of available-for-sale debt securities.
In addition to the above, the Group held cash and cash equivalents at 31 December 2012 of £1,508.4 million (2011: £1,379.8 million) to cover short-term liabilities arising from insurance contracts.
backed securities £m 123Direct Line Group Annual Report & Accounts 2012
Direct Line Group Annual Report & Accounts 2012 124 3. Risk management continued
backed securities £m 124 Direct Line Group Annual Report & Accounts 2012
The table below analyses the distribution of debt securities held across industry sectors using Bloomberg classifications as follows: At 31 December
Other investment funds at 31 December 2012 were £nil (2011: £382.8 million). These were not analysed in the above for prior periods, as the disclosure of the funds held by industry sector is considered to be impractical.
There are a number of key factors that cause operational risk: • the Group’s operations support complex transactions and are highly dependent on the proper functioning of its IT and communication systems; • a dependency on the use of third-party information technology, software, data and service providers; • a need to adequately maintain and protect customer and employee information; and
• the ability of the Group to attract and retain key qualified personnel.
Direct Line Group Annual Report & Accounts 2012 126 3. Risk management continued 3.7 Capital adequacy The Group defines its capital requirement in accordance with regulations prescribed by the FSA, other regulatory bodies and the credit rating agencies. Capital is managed in accordance with the Group’s capital management minimum standard, the objective of which is to manage capital efficiently and maintain an appropriate level of capitalisation and solvency.
The Group uses a risk-based capital model to determine how much capital it needs to maintain in order to operate in accordance with its risk strategy for the UK general insurance underwriters established within its ERM framework. The risk-based capital model also supports decision making in the business. In addition, the Group monitors financial resources with reference to the requirements of the IGD.
The Group has an IGD surplus at 31 December 2012 of approximately £1.8 billion (2011: £2.4 billion).
Management information to monitor the Group’s capital requirements and solvency position is produced and presented to the asset and liability committee on a regular basis.
The Group is a general insurer with leading direct market positions in the UK, Italy and Germany. The Group utilises a multibrand, multi-product, multi-channel business model that covers most major customer segments in the UK for personal lines general insurance and a more limited presence in the commercial market.
Home This segment consists of the underwriting of home insurance cover. The Group sells home insurance through its own brands – Direct Line, Churchill and Privilege – and through partnerships or PCWs. The Group’s brand and product offering covers most of the major retail customer segments for home insurance in the UK.
Rescue and other personal lines This segment consists of the underwriting of rescue and recovery insurance products and other personal lines business including travel, pet, life (closed for new business) and creditor.
International This segment consists primarily of motor insurance, sold to private customers in Germany and Italy using a multi-channel strategy through the Direct Line brand and through partnerships and PCWs.
Certain charges are not allocated to the specific operating segments above as they are considered by management to be outside underlying business activities by virtue of their one-off incidence, size or nature. Such charges are categorised as either run-off or restructuring and other one-off items, as described below: Run-off The businesses included in the run-off segment consist of two principal lines, being policies written through partnership arrangements with TPF and NIG personal lines business sold via brokers. The partnership arrangements have been exited and the residual businesses are now in run-off. TPF was entered into as a 50:50 joint venture with Tesco in 1999, whereby the Group underwrote a range of general and life insurance products under the Tesco brand to Tesco customers.
Finance costs (28.7) Profit before tax 249.1 128 Direct Line Group Annual Report & Accounts 2012
The table below is an analysis of the Group’s revenue and results by reportable segment for the year ended 31 December 2011: Motor £m Home £m
Finance costs (2.7) Gain on disposal of subsidiary 1.6 Profit before tax 342.9
Total Group £m 129Direct Line Group Annual Report & Accounts 2012
Premium income from insurance contracts issued: Premium receivable 4,001.4 4,168.3 Change in unearned premium reserve 47.1 354.6
Investment income: Interest income on debt securities 172.5 208.1 Other investment funds income 3.1 8.5 Cash and cash equivalent interest income 19.3 20.4 Rental income from investment property 4.4 6.6
Net realised gains: Debt securities 66.3 54.3 Other investment funds 23.2 – Derivatives1 17.8 –
Impairments of available-for-sale debt securities – (2.0) Net unrealised losses: Derivatives2 (20.0) – Investment property (note 18) (4.8) (14.0)
2. Derivative net unrealised losses includes a £2.1 million loss on interest rate derivatives with a £3.0 million gain on the associated hedged risk and a £11.7 million gain on foreign exchange derivatives with a £32.6 million loss on the associated hedged risk.
Loss adjustment expenses for the year ended 31 December 2012 of £290.3 million (2011: £296.4 million) have been included in the claims figures above.
Commission expenses 316.5 324.5 Expenses incurred under profit participations 136.4 194.4 131Direct Line Group Annual Report & Accounts 2012
Management fees are in respect of expenses recharged from RBS Group up until 30 June 2012; management fees are charged on an arm’s length basis. These costs since 30 June 2012 have been incurred directly and included in staff costs and other operating expenses.
Staff costs 103.9 33.0 Management fees 16.3 42.0 Impairment of goodwill – 10.2 Other operating expenses 72.5 21.8
Fees payable for the audit of: The Company’s annual accounts – Deloitte LLP 0.2 0.1 The Company’s subsidiaries – Deloitte LLP 1.3 1.4 The Company’s subsidiaries – Mazars 0.1 0.1
Total audit fees 1.6 1.6 Fees payable to Deloitte LLP for non-audit services: Audit-related assurance services 0.3 0.3 Taxation advisory services 0.1 – Corporate finance services 4.1 0.7 Other services – 1.0
Fees in relation to corporate finance services relate to the divestment of Direct Line Group from RBS Group. Fees in relation to other services in 2011 relate to the provision of advice and design support on the new claims operating model.
During the year ended 31 December 2012 one Director exercised share options (2011: none).
Note: 1. As described in note 29, the Group entered into a 10-year hedge to exchange the fixed rate of interest on the subordinated loan notes for a floating rate of three-month LIBOR plus a spread of 706 basis points.
Deferred taxation (note 13): Charge / (credit) for the year 13.9 (56.1) Over-provision in respect of prior year (9.8) (18.0)
Current taxation 60.7 168.0 Deferred taxation (note 13) 4.1 (74.1) Tax charge for the year 64.8 93.9
Expected tax charge 61.0 90.9 Effects of: Higher tax rates on overseas earnings 3.0 – Net movement in impairment of goodwill – 2.9 Realised gains on disposal of subsidiary – 0.4 Disallowable expenses 9.6 7.1 Non-taxable items (0.7) – Effect of change in UK taxation rate 2.7 (0.2) Over-provision in respect of prior year (10.8) (7.2)
The following are the deferred tax assets and liabilities recognised by the Group, and the movements thereon, during the current and prior reporting years.
Credit / (charge) to income statement 28.3 (0.6) (0.5) 46.9 74.1
Credit / (charge) to income statement 4.4 (0.6) (0.5) (7.4) (4.1) (Charge) / credit to other comprehensive income (6.1) 0.6 – – (5.5) Other movements (3.6) – – – (3.6)
Per balance sheet: Deferred tax assets 22.5 26.9 Deferred tax liabilities (20.9) (12.1)
The Directors have recommended that, subject to approval at the AGM on 6 June 2013, a final dividend of 8 pence per Ordinary Share totalling £120.0 million is to be paid on 9 June 2013 to members on the register at the close of business on 6 March 2013.
Direct Line Group Annual Report & Accounts 2012 136 15. Earnings and net assets per share, return on equity
Earnings per share is calculated by dividing earnings attributable to the owners of the Company by the weighted average of Ordinary Shares in issue during the period.
Diluted Diluted earnings per share is calculated by dividing the earnings attributable to the owners of the Company and the weighted average of Ordinary Shares in issue during the period adjusted for the dilutive potential Ordinary Shares. The Company has share options and contingently issuable shares as categories of dilutive potential Ordinary Shares.
Weighted average number of Ordinary Shares in issue (millions) 1,499.4 1,500.0 Adjustments for share options and contingently issuable shares (millions) 0.6 – Weighted average number of Ordinary Shares for diluted earnings per share (millions) 1,500.0 1,500.0
Tangible net asset value per share is calculated as total shareholders’ equity (excluding non-controlling interest) less goodwill and other intangible assets divided by the number of Ordinary Shares in issue at the end of the period.
Net assets 2,831.6 3,612.8 Goodwill and other intangible assets (421.5) (365.8) Tangible net assets 2,410.1 3,247.0
Net asset value per share (pence) 189.1 240.9 Tangible net asset value per share (pence) 161.0 216.5 136 Direct Line Group Annual Report & Accounts 2012
Return on equity Return on equity is calculated as follows: £m 2011 £m
Opening shareholders’ equity 3,612.8 3,223.6 Closing shareholders’ equity 2,831.6 3,612.8 Average shareholders’ equity 3,222.2 3,418.2
Fully utilised – (282.1) (282.1) Impairment and write-off of intangible assets – (21.2) (21.2)
Amortisation / accumulated impairment losses At 1 January 2011 125.0 361.9 486.9 Charge for the year – 21.1 21.1 Effect of foreign currency exchange adjustment (1.0) (0.7) (1.7) Impairment and write-off of intangible assets 10.2 (0.1) 10.1
Charge for the year – 30.0 30.0 Effect of foreign currency exchange adjustment (0.6) (0.7) (1.3) Fully utilised – (282.1) (282.1) Impairment and write-off of intangible assets – (10.5) (10.5)
The Group’s goodwill is reviewed annually at 30 September for impairment by comparing the recoverable amount of each cashgenerating unit (“CGU”) to which goodwill has been allocated with its carrying value and updated at each reporting date in the event of indicators of impairment.
The recoverable amount is the higher of the CGU’s fair value less the costs to sell and its value in use. Value in use is the present value of expected future cash flows from the CGU. Fair value is the amount obtainable for the sale of the CGU in an arm’s length transaction between knowledgeable and willing parties.
The recoverable amounts of all CGUs at 30 September were based on the value in use test, using the Group’s latest five-year forecasts. The long-term growth rates have been based on GDP rates adjusted for inflation. The risk discount rates are based on observable market long-term government bond yields and average industry betas adjusted for an appropriate risk premium based on independent analysis.
The recoverable amounts in excess of carrying value for the CGUs where goodwill is held are analysed as follows: CGU Assumptions1
Sensitivity: Impact on recoverable amount of a: Terminal growth rate Pre-tax discount rate
Rescue and other personal lines 3.0% 11.9% 645.8 81.3 74.6 7.3
Notes: 1. Key assumptions used in impairment testing in 2011 were terminal growth rate of 3% and pre-tax discount rate of 12.1%.
Net book amount At 31 December 2012 92.4 139Direct Line Group Annual Report & Accounts 2012
Disposals in the year comprised freehold property occupied by RBS Group under operating leases.
Direct Line Versicherung AG, DL Insurance Services Limited (“DLISL” – the company changed its name from RBS Insurance Services Limited on 10 September 2012) and U K Insurance Limited are owned directly by Direct Line Insurance Group plc. Direct Line Insurance S.p.A is owned indirectly through intermediary holding companies. All subsidiaries are included in the Group’s consolidated financial information and have an accounting reference date of 31 December.
Direct Line Insurance S.p.A Italy Ordinary 100% General insurance Direct Line Versicherung AG Germany Ordinary 100% General insurance DL Insurance Services Limited Great Britain Ordinary 100% Management services U K Insurance Limited Great Britain Ordinary 100% General insurance
The above information is provided in relation to principal related undertakings as permitted by Section 410(2) of the Companies Act 2006. Full information on all related undertakings is included in the Annual Return available from Companies House by visiting www.companieshouse.gov.uk.
Analysis of movement in impairment provision: At 1 January (53.9) (9.2) Impairment loss recognised on reinsurance contracts (7.6) (44.8) Impairment losses reversed 0.8 0.1 21. Deferred acquisition costs £m
Net credit to the income statement 17.1 11.0 22. Insurance and other receivables £m
Receivables arising from insurance and reinsurance contracts: Due from policyholders 965.3 988.9 Impairment of policyholder receivables (9.7) (8.8) Due from agents, brokers and intermediaries 106.6 176.9 Impairment of agent, broker and intermediary receivables (0.3) (0.4) Due from reinsurers 34.8 46.0
Direct Line Group Annual Report & Accounts 2012 142 23. Derivative financial instruments £m 2011 £m
Derivative assets At fair value through the income statement 37.5 – Designated as hedging instruments – 0.1
Derivative liabilities At fair value through the income statement 4.1 – Designated as hedging instruments 2.4 – Total 6.5 –
Available-for-sale debt securities Listed – fixed interest rate 6,854.2 6,747.8 Listed – floating interest rate 302.3 860.1
Loans and receivables Deposits with credit institutions with maturities in excess of three months: Third parties 595.0 1,342.6 Related parties 50.0 147.0
Short-term deposits with credit institutions: Third parties1 1,277.9 1,029.5 Related parties 28.8 148.4
For the purposes of the cash flow statement, cash and bank overdrafts are as follows: £m 2011 £m
On 31 August 2012, board and shareholder resolutions were approved to subdivide the share capital of Direct Line Insurance Group plc from 1.5 billion Ordinary Shares of £1 each to 1.5 billion Ordinary Shares of 10 pence each and 1.5 billion deferred shares of 90 pence each.
The deferred shares were then transferred back to the Company by its parent, The Royal Bank of Scotland Group plc, for no value and immediately cancelled by the Company. This cancellation has created a non-distributable capital redemption reserve in the Company of £1,350.0 million.
The Group satisfies share-based payments under the Group’s share plans primarily through shares purchased in the market and held by employee share trusts. This note gives details of the shares held in these trusts.
Revaluation during the year – gross 11.8 172.0 183.8 Revaluation during the year – tax (3.1) (47.3) (50.4) Realised gains – gross – (52.3) (52.3) Tax on realised gains – 14.1 14.1
Movements in the non-distributable reserve were as follows: £m 2011 £m
The subordinated dated notes were issued on 27 April 2012 at a fixed rate of 9.25%. On issuance the Group entered into a 10-year hedge to exchange the fixed rate of interest for a floating rate of three-month LIBOR plus a spread of 706 basis points. The nominal £500 million bonds have a redemption date of 27 April 2042. The Group has the option to repay the notes on specific dates from 27 April 2022. If the notes are not repaid on that date, the rate of interest would be reset at a rate of the six-month LIBOR plus 7.91%.
The notes are unsecured, subordinated obligations of the Group, and rank pari passu without any preference among themselves. In the event of a winding-up or of bankruptcy, they are to be repaid only after the claims of all other creditors have been met.
There have been no defaults on any of the notes during the year. The Group has the option to defer interest payments on the notes but to date has not exercised this right. The aggregate fair value of subordinated dated notes is £597.6 million (2011: £nil).
Direct Line Group Annual Report & Accounts 2012 146 30. Insurance liabilities, unearned premium reserve and reinsurance assets £m 2011 £m
Reinsurers’ share of general insurance Claims reported (397.8) (318.1) Claims incurred but not reported (511.6) (281.8)
Net general insurance Claims reported 3,571.5 3,718.8 Claims incurred but not reported 1,642.3 1,935.7 Loss adjustment expenses 163.8 153.2 Liability adequacy provision 4.3 3.6
Eight years later 7.7 22.0 – – – – – – – – 29.7 Nine years later (12.1) – – – – – – – – – (12.1)
Liability recognised in balance sheet 116.3 213.7 168.9 255.8 395.3 460.1 804.9 909.4 990.5 1,602.4 5,917.3 2002 and prior 205.9 Loss adjustment expenses 163.8 Total gross liability1 6,287.0
Estimate of ultimate claims costs: At end of accident year 3,207.4 3,486.1 3,869.6 4,030.8 4,341.3 3,816.0 4,113.0 4,219.3 2,946.1 2,570.1 36,599.7
Eight years later 6.2 (5.4) – – – – – – – – 0.8 Nine years later (3.4) – – – – – – – – – (3.4)
Incurred but not reported 2,514.2 (220.8) 2,293.4 Liability adequacy provision 25.4 – 25.4
Cash paid for claims settled in the year (3,547.7) 81.7 (3,466.0) Increase / (decrease) in liabilities: Arising from current-year claims 3,345.3 (134.4) 3,210.9 Arising from prior-year claims (209.9) (17.2) (227.1)
Net exchange differences (21.9) 0.8 (21.1) Decrease in liability adequacy provision (21.8) – (21.8)
Incurred but not reported 2,153.9 (511.6) 1,642.3 Liability adequacy provision 4.3 – 4.3
Movement in prior-year net claims liabilities by operating segment £m 2011 £m
Direct Line Group Annual Report & Accounts 2012 150 30. Insurance liabilities, unearned premium reserve and reinsurance assets continued
Net (decrease) / increase in the year (354.6) 12.8 (341.8) Exchange movement (2.4) – (2.4)
Provisions in respect of new and existing business 45.9 (25.4) 20.5 Expected change in existing business provisions (21.7) 16.2 (5.5) Variance between actual and expected experience 8.7 (16.1) (7.4) Other movements (8.3) – (8.3)
Loans from related parties – 247.7 Bank overdrafts with related parties 90.9 64.2 Bank overdrafts with third parties – 6.0
Defined contribution scheme DLISL operates the Group pension scheme which was established in 1988. The contributions paid by DLISL are charged to the income statement, as incurred.
The weighted average duration of the defined benefit obligation at 31 December 2012 is 20 years (2011: 19 years) using accounting assumptions.
No assumption has been made for salary growth as there are no liabilities in the scheme that are linked to future increases in salaries.
Direct Line Group Annual Report & Accounts 2012 152 33. Retirement benefits obligations continued
IAS 19 ‘Employee benefits revised’ is effective for accounting periods beginning on or after 1 January 2013. Under the revised standard, an expected rate of return will no longer be applied to assets. The interest cost to be calculated on the net pension liability or asset will be at the long-term bond rate.
Amounts charged to the statement of comprehensive income £m 2011 £m
Actual return on scheme assets (5.7) (1.1) Expected return on scheme assets 3.5 3.7 Experience (gain) / loss on scheme assets (2.2) 2.6 Experience loss / (gain) on scheme liabilities 0.1 (0.4) Changes in assumptions underlying the present value of scheme liabilities 5.5 (1.6) Actuarial loss 3.4 0.6 152 Direct Line Group Annual Report & Accounts 2012
Changes in the present value of the defined benefit obligation are as follows: £m 2011 £m
Opening defined benefit obligation 54.1 54.5 Interest cost 2.7 3.0 Actuarial losses / (gains) 5.6 (2.1) Benefits paid (1.2) (1.3) Closing defined benefit obligation 61.2 54.1
Changes in the fair value of the plan assets are as follows: £m 2011 £m
The history of the plan for the current and prior years is as follows: £m £m £m 2008 £m
Present value of defined benefit obligation (61.2) (54.1) (54.5) (60.8) (45.3) Fair value of plan assets 63.7 56.7 54.4 47.2 37.5
Experience adjustments on plan liabilities 0.1 (0.4) (0.5) (2.6) (0.7) Experience adjustments on plan assets (2.2) 2.6 (3.1) (5.4) (10.7)
Sensitivity analysis The table on page 154 provides the sensitivity analysis of the potential impact of a change in a single factor with all other assumptions left unchanged. Other potential risks beyond the ones described in the table could have an additional financial impact on the Group.
Sensitivity factor Discount rate The impact of a change in the principal actuarial assumptions on the discount rate for the present value of pension scheme obligations. This sensitivity analysis has been selected to reflect the changes to discounted cash flows as a result of changes to the discount rate. The methodology adopted involves actuarial techniques.
Inflation rate The impact of a change in the principal actuarial assumptions on the inflation rate for the present value of pension scheme obligations. This sensitivity analysis has been selected to reflect the changes to the general level of prices of goods and services over time. The methodology adopted involves actuarial techniques.
At 31 December 2011 Impact on profit before tax (£m) – – – – Impact before tax on total equity (£m) (2.6) 2.6 2.5 (2.4)
The most recent funding valuation of the defined benefit scheme took place at 1 October 2011. The Group has agreed to make contributions of £2.8 million per annum from 2013 to 2016 for the future accrual of benefits, and does not anticipate any material change to the level of funding before the next valuation, which is due on 1 October 2014.
The Group operates a number of equity-settled, share-based compensation plans, details of which and their financial effect are set out below: Free share awards During the year ended 31 December 2012, upon listing on the London Stock Exchange, the Group offered all employees a ‘free share’ award granting shares to the value of £250 to each eligible employee free of charge. These awards will be satisfied using market-purchased shares.
The details of the award are set out below: Type of arrangement Free share award Date of grant 27 November and 3 December 2012 Number granted 1,951,950 Forfeited during the period 3,718 Vested during the period 8,151 Number outstanding at 31 December 2012 1,940,081 Contractual life 3 years Vesting conditions Continuing employment or leavers in certain circumstances
The awards outstanding at 31 December 2012 have no performance criteria attached, other than the requirement that the employee remains in employment with the Group for three years. Awards granted under the plan will be exercised upon the award vesting date.
The estimated fair value of the free shares granted under the award is £3,942,939, or £2.02 per share award. The fair value of each award is based upon the market value of the award at grant date of £2.02, applicable to both grants.
Long-Term Incentive Plan In November 2012, conditional awards were made over 3,159,625 ordinary shares under the Group’s LTIP. Senior management are eligible to participate in the LTIP and awards are granted in the form of a nil-priced option.
Granted during the year 5,001,813 3,159,625 Forfeited during the year – – Exercised during the year – – Expired during the year – – At 31 December 2012 5,001,813 3,159,625
In respect of the outstanding options at 31 December 2012, the exercise price was £nil with a weighted average remaining contractual life of 2.85 years.
The estimated fair value of the LTIP share awards made during the year, at the date of grant, was £5,001,813. For awards with market-based performance conditions, this was calculated using the Monte-Carlo simulation model.
The inputs into the model were as follows: Share price (pence) 194 Exercise price (pence) 0 Volatility of Company share price (%) 27 Average comparator volatility (%) 32 Expected life (years) 3 Risk-free rate (%) 0.3 Expected dividend yields (%) 0
As historic data is not available for the Group, expected volatility was determined by calculating the median historic volatility for a group of comparable companies using daily share price data over a period commensurate with the expected life assumption. The companies chosen as comparable companies for the LTIP award were from members of the TSR comparator group (all companies in the FTSE 350 excluding investment trusts) and are classified as being in the insurance sector.
Prior to October 2012 certain employees benefited from share-based awards originally granted by RBS Group. The expense incurred in respect of awards granted by RBS Group to Direct Line Group employees is not material and has been included within operating expenses.
RBS Group has indemnified Direct Line Group for all future costs in respect of RBS Group share-based awards made to Direct Line Group staff. All costs in respect of these share awards for Direct Line Group employees have since been borne by RBS Group.
• LTIP awards in 2012 – expected to vest in March 2015
Direct Line Group Annual Report & Accounts 2012 156 35. Trade and other payables including insurance payables £m 2011 £m
Movements during the year in provisions are as follows: Regulatory levies £m Restructuring £m Other1 £m Total £m
Charged to the income statement: Note: 1. Other provisions include £11.0 million (2011: £nil) held in respect of costs associated with vacated leasehold properties.
36. Notes to the consolidated cash flow statement £m 2011 £m
Minimum lease payments under operating leases recognised as an expense in the year 7.5 7.4
Operating lease commitments where the Group is the lessor Future aggregate minimum lease payments receivable under non-cancellable operating leases are as follows: £m 2011 £m
Within one year 7.8 7.1 In the second to fifth years inclusive 26.6 28.2 After five years 41.2 27.4 158 Direct Line Group Annual Report & Accounts 2012
Derivative financial instruments 6.5 – – – – 6.5 Trade and other payables including insurance payables – – – 540.4 114.2 654.6 Deferred tax liabilities – – – – 20.9 20.9 Current tax liabilities – – – – 34.5 34.5
Direct Line Group Annual Report & Accounts 2012 160 39. Classification of financial instruments continued
Cash and cash equivalents – – 1,379.8 – – 1,379.8 Assets held for sale – – – – 1.0 1.0
On 1 December 2008, the UK Government through HM Treasury became the ultimate controlling party of The Royal Bank of Scotland Group plc and is therefore the ultimate controlling party of Direct Line Group. The UK Government’s shareholding is managed by UK Financial Investments Limited, a company wholly owned by the UK Government. This gives rise to related party transactions and balances, specifically in respect of tax with HMRC and debt security investments with the UK Government.
At 31 December 2012, The Royal Bank of Scotland Group plc heads the largest group in which Direct Line Group is consolidated. Copies of the consolidated financial statements of The Royal Bank of Scotland Group plc may be obtained from The Secretary, The Royal Bank of Scotland Group plc, Gogarburn, PO Box 1000, Edinburgh EH12 1HQ.
Parent (0.1) – Fellow subsidiaries 7.0 17.6 ii. Purchases of services £m 2011 £m
Employee costs recharged by RBS Group include the full costs of key managers and other staff in respect of share-based payments. The attribution among members of RBS Group has regard to the needs of RBS Group as a whole.
Direct Line Group Annual Report & Accounts 2012 162 40. Related parties continued iv. Year end balances arising from cash and investment transactions with members of the RBS Group £m 2011 £m
Movements in receivables from related parties were as follows: £m 2011 £m
Transactions in the year 68.0 7.3 Settled in the year (70.6) (7.2)
Movements in amounts due to related parties were as follows: £m 2011 £m
Transactions in the year 294.6 261.0 Settled in the year (418.6) (147.0)
Included in the above is an amount of £39.3 million in the year ended 31 December 2012, invoiced by and paid to RBS Group for the acquisition of furniture, fittings and IT hardware. Furthermore, also included is an amount of £31.3 million paid to the RBS Group pension scheme (see note 33 for further details).
Current tax assets 4 4.5 1.3 Cash and cash equivalents 5 268.3 32.1 Total assets 4,020.6 3,482.8
Equity Share capital 6 150.0 1,500.0 Capital redemption reserve 1,350.0 – Other reserves 100.3 100.0 Retained earnings 1,661.5 1,421.1 Total equity 3,261.8 3,021.1
Liabilities Subordinated liabilities 7 501.7 – Derivative financial instruments 8 1.7 – Borrowings 9 255.4 460.4 Trade and other payables 10 – 1.3 Total liabilities 758.8 461.7 Total equity and liabilities 4,020.6 3,482.8
Registration No. 02280426 164 Direct Line Group Annual Report & Accounts 2012
Direct Line Group Annual Report & Accounts 2012 165 £m 2011 £m
Profit for the year 1,240.4 515.9 Total comprehensive income for the year 1,240.4 515.9
Total comprehensive income attributable to: Owners of the Company 1,240.4 515.9
Parent Company statement of changes in equity For the year ended 31 December 2012
Direct Line Group Annual Report & Accounts 2012 166 £m 2011 £m
Net cash generated from / (used by) operating activities 12 7.4 (39.5) Cash flows from investing activities Interest received on loans to related parties 23.8 7.7 Dividends received from subsidiary undertakings 1,545.0 1,134.2 Acquisition of investments in subsidiary undertakings 2 (105.2) (3,510.5) Disposal of investments in subsidiary undertakings – 1,797.1 Net cash generated from / (used by) investing activities 1,463.6 (571.5) Cash flows from financing activities Dividends paid (1,000.0) – Proceeds on issue of subordinated debt 493.0 – Finance costs (23.1) – Repayments of borrowings from related parties (322.5) (1,704.8) Proceeds of borrowings from related parties 120.9 1,959.8 Net (increase) / decrease in loans advanced to subsidiary undertakings (503.1) 388.1 Net cash (used by) / generated from financing activities (1,234.8) 643.1 Net increase in cash and cash equivalents 236.2 32.1 Cash and cash equivalents at the beginning of the year 5 32.1 – Cash and cash equivalents at the end of the year 5 268.3 32.1
Direct Line Group Annual Report & Accounts 2012 167 1. Accounting policies
Basis of preparation Direct Line Insurance Group plc, incorporated in the UK, is the ultimate parent company of the Direct Line Group. The principal activity of the Company is managing its investments in subsidiaries, providing loans to those subsidiaries and the receipt and payment of dividends.
Direct Line Group Annual Report & Accounts 2012 168 4. Current tax assets £m 2011 £m
Loans from subsidiary undertakings 255.4 255.4 Loans from fellow subsidiary1 – 205.0
Note: 1. During the year ended 31 December 2012, the Company repaid the £205.0 million loan from RBS Group in preparation for operational separation from RBS Group.
Profit for the period 1,240.4 515.9 Adjustments for: Impairment in subsidiary undertakings 291.8 611.4 Investment revenues (1,578.1) (1,141.9) Other operating income 1.3 – Finance costs 41.6 6.3 Tax credit (5.5) (1.3)
The Company’s immediate parent company is The Royal Bank of Scotland Group plc which is incorporated in Great Britain and registered in Scotland.
The following transactions were carried out with related parties: i. Sales of services £m 2011 £m
Dividend income from subsidiary undertakings 1,545.0 1,134.2 ii. Purchases of services £m 2011 £m
It is expected that one third of the annual dividend will generally be paid in the third quarter as an interim dividend and two thirds will be paid as a final dividend in the second quarter of the following year. The Board may revise the dividend policy from time to time.
In addition, if the Board believes that the Group has capital that is surplus to the Board’s view of its requirements, it is intended that it will be returned to shareholders. The Company may consider a special dividend and the repurchase of its own shares as a means of distributing surplus capital to shareholders.
Shareholder enquiries Shareholders with queries on any matter relating to their shares are invited to contact our Registrar using the contact details listed on page 176 of this Annual Report & Accounts.
Shareholder warning The Group is aware that fraudsters are placing unsolicited phone calls or engaging in correspondence concerning investment matters with a view to defrauding investors. Shareholders are warned that they may receive an approach from persons purporting to be brokers or to be representatives of the Company. These fraudsters are using increasingly sophisticated means to approach shareholders, and they can be persistent and extremely persuasive. The FSA, reports that the average amount lost by investors in a share scam is around £20,000, with as much as £200 million being lost in total in the UK each year. Even seasoned investors have been caught out, with the biggest individual loss recorded by the police being £6 million.
Shareholders are also warned to consider carefully any unsolicited offers they receive to buy their shares. Some companies make offers to shareholders for their shareholdings at prices significantly below what they could expect on the market. Although it is not against the law to make an unsolicited offer to buy someone’s shares, it is illegal to mislead or deceive shareholders into accepting any offer. The offer must also comply with strict legal requirements, including prominent details of the shares’ current market value. Shareholders are urged to seek independent professional advice to protect themselves against a poor deal.
For further advice and tips on how to identify and avoid investment scams, access the FSA’s advice at: scamsandswindles/safe/boiler_room/index.shtml
Tips on how you can protect your shares • Ensure all your certificates are kept in a safe place, or consider holding your shares in the UK’s electronic registration and settlement system for equity, CREST, or via a nominee.
• Keep all correspondence from the Registrar that shows your shareholder reference number in a safe place and shred unwanted correspondence.
• If you are buying or selling shares, only deal with brokers registered in the UK or in your country of residence.
Electronic communications and voting The Group produces a range of communications which shareholders can receive in a range of formats. View online, download or receive a paper copy by contacting the Registrar. The contact details can be found on page 176.
The Registrar may be contacted regarding their share-dealing facility by telephone or by email as follows: • for telephone sales call +44 (0)870 703 0084 between 8.30 am to 5.30 pm, Monday to Friday excluding public holidays; and
• for internet sales log on to www.investorcentre.co.uk/directline. You will need your shareholder reference number as shown on your share certificate or your welcome letter from the Chairman.
Capital The funds invested in the Group, which includes funds invested by shareholders and retained profits.
Funds set aside by the Group to meet the estimated cost of claims payments and related expenses that the Group calculates will ultimately be required to be paid.
The sum of the loss, expense and commission ratios. The ratio is a measure of the amount of claims costs and expenses compared to net earned premium generated. A ratio of less than 100% indicates profitable business.
Finance costs The cost of servicing the Group’s external borrowings and subordinated liabilities.
Gross written premium The total premiums for the period from contracts incepted during the period.
Incurred loss Claims that have been paid plus claims advised by a policyholder but not paid. Does not include IBNR (see above).
In-force policies The number of policies on a given date that are active and against which the Group will pay following a valid insurance claim.
Insurance reserves This consists of general and life insurance liabilities, unearned premium reserve and liability adequacy reserve.
Investment income yield The annualised investment return earned through the income statement during the period, divided by the average assets under management (“AUM”) for each asset class during the same period. The investment return excludes realised gains, impairments and fair value adjustments whilst the average AUM for the period is derived by taking the opening and closing balances for the period.
RBS Group The Royal Bank of Scotland Group plc and its subsidiary companies.
Reinsurance Contractual arrangements whereby the Group transfers part or all of the insurance risk accepted to another insurer.
Relevant government bodies The Ogden discount rate for use in England, Wales and Northern Ireland is set by the Lord Chancellor, with the rate for Scotland set by the Scottish Ministers.
Reserves Funds that have been set aside to meet outstanding claims and IBNR.
Solvency II The proposed capital adequacy regime for the European insurance industry, which establishes a revised set of EU-wide capital requirements and risk management standards.
Underwriting profit / (loss) The profit or loss from operational activities, excluding investment performance. It is calculated as: Net earned less Net insurance less Total premium claims expenses
Cautionary statement about forward-looking statements 175Direct Line Group Annual Report & Accounts 2012
Registered office Direct Line Insurance Group plc Churchill Court Westmoreland Road Bromley BR1 1DP
Shareholder helpline: +44 (0)870 873 5880 Shareholder fax: +44 (0)870 703 6101 Telephone number for the hard of hearing: +44 (0)870 702 0005 Website: www.computershare.com
Auditors Deloitte LLP Hill House 1 Little New Street London EC4A 3TR Telephone: +44 (0)20 7936 3000 Website: www.deloitte.com
Legal advisers Allen & Overy LLP One Bishops Square London E1 6AD Telephone: +44 (0)20 3088 0000 Website: www.allenovery.com
Corporate brokers Goldman Sachs International Peterborough Court 133 Fleet Street London EC4A 2BB Telephone: +44 (0)20 7774 1000 Website: www.goldmansachs.com
Go online Our report is supplemented by a range of other information that can be found online ara2012.directlinegroup.com In conjunction with this report, we have produced a separate online version of key sections of the report for those who have opted for e-communications. This has been supplemented by video discussing our year end results.
Registered in England & Wales No 02280426. Registered Office: Churchill Court, Westmoreland Road, Bromley, BR1 1DP