Strategic report 2 Group highlights 4 Group at a glance 6 Business model 14 Chairman’s statement 16 Chief Executive Officer’s review 18 Our strategy 20 Key performance indicators 22 Risk management 28 Operating review 34 Finance review 44 Corporate social responsibility
• Combined operating ratio for ongoing operations1 of 96.1% for 2013, an improvement of 3.1 percentage points against 2012 (99.2%), and ahead of the target 98% for 2013
6. Adjusted earnings per share – diluted, excludes the Run-off segment, restructuring and other one-off costs and gain on disposal of subsidiary (using UK standard tax rate of 23.25%; 2012: 24.5%).
Pricing and underwriting Our new customer offerings, such as our telematics black box and smartphone apps, are helping us to improve our pricing models.
Property advisers attend your home and instantly send through list of damage
For more on performance rewards see our remuneration report on p.76
By enhancing our pricing capabilities we can improve the assessment of the risks we are willing to accept and price these more accurately. Our customers benefit from this through more competitive prices.
Definition The return generated on the capital shareholders have in the business. This is calculated by dividing adjusted earnings by average tangible equity.
Principal risks and uncertainties Risks are always present in our business. The key role of the Risk function is to ensure that these risks have been identified and measured and are monitored and reported throughout the business on an ongoing basis. The Risk function also monitors changes in these risks over time. We believe that these risks are broadly unchanged over the last 12 months.
• Pricing is refined through analysis of comprehensive data • Catastrophe reinsurance is purchased, limiting our exposure to large losses. We also purchase excess of loss cover on our Motor portfolio, as well as other selected reinsurance covers
Our principal area of counterparty risk is our use of reinsurance against underwriting risk, sometimes called reinsurance risk or reinsurer default risk.
Regulatory risk Regulatory risk arises if changes in law and regulations are not identified or understood, or are inappropriately and incorrectly interpreted or adopted.
• Monitoring claims costs to identify trends in the settlement of bodily injury claims
• Ensuring that the projects are managed by the right people with the ideal skills
A specific example of an emerging risk we have considered during 2013 is the failure of a competitor. A competitor failing may lead to an industry levy which we would be subject to. This risk could also impact our relationships with both investors and regulators, depending on the cause of the competitor’s failure. There is also potential upside should the failure of a competitor enable us to increase the number of policies we issue.
Operating profit from ongoing operations1 improved by 14.2% to £526.5 million (2012: £461.2 million) and COR1 by 3.1 percentage points to 96.1% (2012: 99.2%). These were driven by an improved underwriting profit, including higher prior-year reserve releases of £435.1 million (2012: £322.0 million), and were partially offset by lower investment return and instalment and other income. A lower loss ratio1, reflecting our continued choice to focus on value of business over volume and helped by pricing and claims efficiencies, together with lower costs contributed to the improved underwriting result and COR. Benefiting from the capital actions taken in 2012 and the improved operating performance, the Group achieved a RoTE for ongoing operations2 of 16.0% (2012: 11.5% and pro forma3 13.4%). Total Group profit before tax delivered of £423.9 million (2012: £249.1 million).
Outlook In a competitive UK home market, we continue to focus on maintaining our underwriting performance through further pricing and claims initiatives. Adverse weather conditions experienced in the fourth quarter of 2013 have continued in the first quarter of 2014 resulting in further storm damage and severe flooding. While it is too early to assess with accuracy, the Group’s preliminary estimate for the cost of Home claims from this event up to 22 February 2014 is in the range of £70 to £90 million. This compares to an expectation in an average year of £80 million of claims from major weather events.
In determining the appropriate level of capitalisation and solvency the Group considers capital on a number of metrics, including risk-based capital, regulatory capital and rating agency capital. The Group targets holding capital in the range of 125% to 150% of risk-based capital and holding capital sufficient to maintain a credit rating in the ‘A’ range.
Capital allocated by risk type – U K Insurance Limited (%)
Approach and priorities Working in partnership with the business-led charity Business in the Community (“BitC”), we were able to make exciting headway in rolling out our corporate social responsibility (“CSR”) initiatives. Blending input from employees at all levels, representing a wide range of stakeholder interests, together with BitC’s expertise in the issues material to our business, we advanced our CSR programme through four key strands – sustainable business practices, employee experience, community, and energy and environment. These strands continue to provide the framework for our CSR activity, against which our key performance targets and sustainability metrics are tested and monitored. An absolute priority for the Group is to sustain a high rate of employee engagement, and we were pleased that in spite of the significant amount of continuing change in the business, 71% of our employees reported themselves as favourably engaged in our Employee Opinion Survey conducted in October.
Governance To ensure the delivery of our CSR programme, we have established a robust governance structure, with clear roles and responsibilities. This comprises the CSR Committee, see page 70, which has complete oversight of our strategy, policy and programme, and a CSR Advisory Group, formed of senior managers and chaired by a member of the Executive Committee, which leads CSR within the business. The Group Communications team has functional responsibility for executing the strategy and managing the CSR programme on a day-to-day basis. In addition, a clear policy framework has been developed and, in keeping with best practice, our policies are published on our website.
Telematics In response to improving technology and customer interest, during the year Direct Line launched various telematics propositions. This technology allows us to gather information about customers’ driving, recording speed patterns and distance travelled, which can be connected to the types of roads used and at what time. It also monitors braking and cornering to build up a picture of a customer’s driving style so that we can better assess each person’s individual risk. This should lead to greater pricing granularity for drivers opting for telematics.
employee understanding of the strategic direction in which the business is travelling and how individual roles relate to that journey. At the same time, despite the significant amount of business change, our employees have maintained a strong customer focus and still want to make a positive difference to the experience we give our customers.
• Dealing with shareholders and other stakeholders We shall seek to maximise shareholder value over time, recognising that wealth generated also benefits customers and employees as well as the communities where we operate
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, 24 years in the insurance industry with AIG, Churchill and Direct Line and six years in other industries.
Meetings of the Board The Board met regularly during 2013; no further ad hoc meetings were required in addition to the 11 scheduled meetings. The Directors received Board papers and had the opportunity to comment on them in advance. Details of attendance at Board and Board Committee meetings by Directors during the year are set out below and on pages 65 to 74.
• Review the Board’s policy on gender diversity to consider how more women can be promoted to senior and executive management roles
• An independent thinker who is able to engage constructively and add real value to Board discussions
• Supportive of the executive team while being able to challenge constructively
Commitment from Board members All our Directors, including the Chairman, have indicated that they are able to allocate sufficient time to the work of the Group to enable them to discharge their respective duties and responsibilities effectively. Directors’ appointment letters contain a provision to this effect.
Board effectiveness review Review of the effectiveness of the Board and its Committees We conducted our first Board effectiveness review in 2013 to evaluate the effectiveness of the Board, its six committees and individual Directors. The evaluation process was initiated by the Chairman and facilitated by Edis-Bates Associates Limited, an independent corporate governance consultancy, with no other connection with the Company.
To improve the governance of our gender-diversity programme, the Company has 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 the selection of Directors to the Board. Further information regarding this diversity policy may be found in the Nomination Committee report on page 72.
• the Board has delegated to the Audit Committee oversight of the management of the relationship with the Company’s auditors. The Audit Committee report on page 65 provides details of its role, activities and relationship with the internal and external auditors.
• Ensure the provision of training and development within the Group, particularly in relation to new legislation and regulation
• Reviewed the comprehensive Individual Capital Adequacy Standards Plus (“ICAS+”) submission including the draft in development Own Risk and Solvency Assessment (“ORSA”)
• Reviewed and recommended the new Compliance, Whistle-blowing and Customer Conduct policies to the Board for approval
(“CSR”) strategy, measures, policies and compliance • Review performance and priorities against both internal targets and relevant external benchmarking indices • Review the extent, effectiveness and transparency of external reporting • Consider and recommend the Group’s positioning on relevant emerging CSR issues • Oversee the Group’s compliance with its health and safety statutory and regulatory requirements and overseeing the embedding of a health and safety culture across the Group
• Determined the share ownership guidelines and reviewed compliance against these by the Executive Directors and members of the Executive Committee
• Reviewed and approved the overall 2013 salary budget for Direct Line Group, including proposed salaries for Executive Directors, members of the Executive Committee and other strategic leaders
What are we focusing on in 2014? We will continue to provide detailed disclosures on the Group’s financial performance and strategic plans and host a number of events to foster engagement. The Group recognises the importance of maintaining an active dialogue with our shareholders, target investors and other important insurance sector investors. Planned activities for 2014 include: Note: 1. The conferences where the Chief Executive Officer gave a brief presentation to all delegates
Q How can you justify paying bonuses to Executive Directors when at the same time you are going through cost reduction initiatives and making redundancies? Making redundancies is a tough decision; however, we sometimes need to take steps like this, to make the business sustainable in the long run and remain competitive. Where possible, we are managing redundancy decisions through redeployment and support. Our aim is to treat respectfully and fairly all those affected.
As discussed elsewhere, the Committee has exercised its judgement in determining the final bonus levels to reduce the amount of AIP awards to the Executive Directors for 2013, to reflect its qualitative assessment of performance during the year.
Introduction The remuneration report has been prepared in accordance with the requirements of the Companies Act 2006 and The Large and Medium-sized Companies and Groups (Accounts and Reports) (Amendment) Regulations 2013 (the “Regulations”). The Company also complies with the UK Corporate Governance Code in relation to remuneration.
This section is not subject to the binding vote on remuneration policy
Valued by our people • Our people know what is expected of them. Performance is fairly rewarded against internal and external comparators • We offer one pension arrangement for everyone • We offer product discounts and build flexibility in our benefits offering • Employees are able to choose a range of other benefits to suit their lifestyle and needs
Remuneration payments agreed prior to appointment to the Board The Committee reserves the right to make any remuneration payments and payments for loss of office (including, where relevant, exercising any discretions available to it in connection with such payments) notwithstanding that they are not in line with the policy set out above where the terms of the payment were agreed (i) before the policy came into effect or (ii) at a time when the relevant individual was not a Director of the Company and, in the opinion of the Committee, the payment was not in consideration for the individual becoming a Director of the Company. For these purposes ‘payments’ include pension arrangements, the Committee satisfying awards of variable remuneration and, in relation to an award over shares, the terms of the payment are ‘agreed’ at the time the award is granted.
The Group has one consistent reward policy for all levels of employees, as outlined on page 79. Therefore, the same reward principles guide reward decisions for all Group employees, including Executive Directors, although remuneration packages differ to take into account appropriate factors in different areas of the business: • AIP – approximately 5,000 employees participate in the AIP and the corporate performance measures for all employees are consistent with those used for Executive Directors although the weighting attributable to those factors may differ. The Group’s strategic leaders also receive part of their bonus in Company shares deferred for a period of three years
The remuneration policy for the Chairman and Non-Executive Directors as set out earlier in this report will apply in relation to any recruitments to those positions.
There are no further obligations which could give rise to a remuneration or loss of office payment other than those set in the remuneration policy table and termination policy summary.
In the event of a demerger or similar event, the Committee may determine that awards vest on the same basis.
• Pension measured as the defined contribution or cash allowance in lieu of Company contributions, as a percentage of salary (25% of 2014 salary for both Executive Directors)
• AIP – consists of the on-target bonus of 60% of maximum bonus opportunity
Approval of Directors’ remuneration report 1,226,921,305 98.8% 14,419,804 1.2% 16,879,549 1.3%
Statement of implementation of policy in 2014 Executive Directors’ salaries in 2014 The current base salaries paid to the Executive Directors were set prior to the IPO. The Committee has considered the current level of salaries in the context of the need to apply restraint in executive pay whilst recognising the need to retain key executive talent in the context of a highly competitive market. It concluded that there will be no increase to Executive Directors’ salaries in 2014.
Consequently, the annual incentive awards payable to the Executive Directors in respect of the financial year ended 31 December 2013 are shown in the table below: Director Position Maximum annual incentive award (% of base salary)
Shareholdings The Executive Directors are subject to share ownership guidelines and are expected to retain all of the Ordinary Shares that they obtain from any of the Company’s share incentive plans, after any disposals necessary for the payment of personal taxes on the acquisition of such Ordinary Shares, until they have achieved the required level of shareholding. For these purposes, the holding of Ordinary Shares will be treated as including all vested but unexercised awards, valued on a basis that is net of applicable personal taxes.
Direct Line Group Long Term Incentive Plan The table below details the unvested awards held by Paul Geddes and John Reizenstein made under the Company’s LTIP.
RBS Group LTIP 2011 501,394 501,394 7 March 2011 4.45 7 March 2014
The table below details the awards held by Paul Geddes made under the RBS Group LTIP in 2010 which vested in RBS Group shares during 2013.
The rights and obligations attaching to the Company’s Ordinary Shares, together with the powers of the Company’s Directors, are set out in the Company’s Articles of Association, which can be obtained from the Company’s website, www.directlinegroup.com . Unless expressly specified to the contrary in the Articles of Association, they may only be amended by a special resolution of the Company’s shareholders at a general meeting.
The Group’s total GHG emissions for 2013 were 30,624 tonnes (see table below). This primarily comprised of emissions from purchased electricity and natural gas, diesel fuel and refrigerant gas used.
Financial instruments The Group’s companies use financial instruments to manage certain types of risk, including those relating to foreign currency exchange, cash flow, liquidity and interest rates. Details of the objectives and management of these instruments are contained in the Risk management and Capital management sections on pages 22 to 27 and 42. An indication of the exposure of Group companies to such risks is also contained in note 3 to the consolidated financial statements.
Directors’ responsibility statement The Directors are responsible for preparing the Annual Report and the financial statements in accordance with applicable law and regulations.
Statement of the Directors in respect of the Annual Report & Accounts The Directors confirm that they consider that the Annual Report & Accounts, taken as a whole, are fair, balanced and understandable and provide the information necessary for shareholders to assess the Group’s performance, business model and strategy.
David Rush (Senior Statutory Auditor) for and on behalf of Deloitte LLP Chartered Accountants and Statutory Auditor London, United Kingdom 25 February 2014
1. Accounting policies 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.
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 operating expenses. The estimated useful economic lives are as follows: Software development costs 5 years
Gains and losses arising from changes in the fair value of a derivative are recognised as they arise in the income statement unless the derivative is the hedging instrument in a qualifying hedge. The Group enters into a number of hedge relationships for cash flow and fair value hedges. Previously the Group entered into hedge relationships for net investments.
1.20 Share-based payments The Group operates a number of share-based compensation plans under which it awards Company shares and share options to its employees. Such awards are generally subject to vesting conditions that vary the amount of cash or shares to which an employee is entitled.
Had all the declines in AFS asset values met the criteria above at 31 December 2013, the Group would suffer a further £40.4 million loss (2012: £21.5 million loss), being the transfer of the total AFS reserve for unrealised losses to the income statement. These movements represent mark-to-market movements and where there is no objective evidence of any loss events that could affect future cash flows, no impairments are recorded for these movements.
2.4 Deferred acquisition costs The Group defers a proportion of acquisition costs incurred during the year to subsequent accounting periods. Management use estimation techniques to determine the level of costs to be deferred, by category of business. Judgement is used to determine the types of cost that can be deferred and these are referred to in note 1.7. The total deferred acquisition costs at 31 December 2013 amounted to £321.5 million (2012: £327.6 million). During 2013, the Group reviewed these costs included in the calculation of deferred acquisition costs and considers them to be appropriate, and has determined that they are recoverable.
2.6 Property, plant and equipment The Group does not revalue property, plant and equipment. However it takes appropriate steps to consider whether the aggregate value of property, plant and equipment exceeds the balance sheet carrying value of such items.
The Board is closely involved in the ICA process and reviews and approves its assumptions and results.
Property risk Property risk results from adverse price fluctuations on real estate investments. At 31 December 2013, the value of these investments in property was £223.4 million (2012: £128.9 million). The property investments are located in the UK and are subject to the asset admissibility rules as defined by the PRA.
Liquidity risk Liquidity risk is the potential that obligations cannot be met as they fall due as a consequence of having a timing mismatch and / or an inability to raise sufficient liquid assets or cash without suffering a substantial loss on realisation.
The table below analyses the distribution of AFS debt securities by geographical area.
Underwriting (loss) / profit (26.3) 32.7 66.2 (33.1) (11.3) 28.2 Loss ratio 74.6% 58.4% 50.9% 63.1% 78.1% 67.1% Commission ratio 2.0% 16.2% 6.0% 21.6% 12.1% 9.1% Expense ratio 25.0% 22.0% 25.8% 23.5% 13.1% 23.0% Combined operating ratio 101.6% 96.6% 82.7% 108.2% 103.3% 99.2%
Staff costs attributable to claims handling activities are allocated to the cost of insurance claims.
The table below analyses restructuring and other one-off costs included in operating expenses.
Total audit fees 2.1 1.6 Fees payable to Deloitte LLP for non-audit services: Audit-related assurance services 0.1 0.3 Taxation advisory services – 0.1 Corporate finance services1 – 4.1
Expected tax charge 98.6 61.0 Effects of: Higher tax rates on overseas earnings 0.7 3.0 Realised gains on disposal of subsidiary (2.8) – Re-measurement of deferred tax asset 3.7 – Disallowable expenses 4.7 9.6 Non-taxable items (0.5) (0.7) Effect of change in UK taxation rate (0.3) 2.7 Under / (over) provision in respect of prior year 7.0 (10.8)
Disposal of subsidiary – (0.2) (0.2) Effect of foreign currency exchange adjustment – 0.3 0.3
Impairment losses – 5.5 5.5 Disposal of subsidiary – (0.2) (0.2) Effect of foreign currency exchange adjustment – 0.1 0.1
The non-distributable reserve relates to a UK statutory claims equalisation reserve that is calculated in accordance with the rules of the PRA.
Gross life insurance Long-term insurance contracts: With fixed and guaranteed terms – 102.9 Benefits outstanding – 4.3
Reinsurers’ share of life insurance Long-term insurance contracts: With fixed and guaranteed terms – (91.1) Benefits outstanding – (3.6)
2. In accordance with IAS 19 ‘Employee benefits revised’ the net interest cost has been calculated by applying the discount rate to the deficit (2012: surplus) in the scheme. The change in IAS 19 set out in ‘Adoption of new and revised standards’ in note 1, if applied to the Group’s result for the year ended 31 December 2012, would have resulted in a decrease in the net interest income to the income statement of £0.6 million. A charge of this amount has been made to net interest income in the income statement and a credit in the statement of comprehensive income for year ended 31 December 2013.
In March 2013 awards were made over 1.1 million Ordinary Shares under this plan with an estimated fair value of £2.2 million based on the market value on the date of grant.
At 1 January 5.1 – Granted during the year 6.9 5.1 Forfeited during the year (0.4) – Exercised during the year (0.2) –
Further information on share based payments in respect of Directors is provided in the Directors’ remuneration report.
34. Trade and other payables including insurance payables £m 2012 £m
Assets Goodwill and other intangible assets – – – – 500.1 500.1 Property, plant and equipment – – – – 102.3 102.3 Investment property – – – – 223.4 223.4 Reinsurance assets – – – – 1,011.0 1,011.0 Deferred tax assets – – – – 19.3 19.3 Current tax assets – – – – 1.3 1.3 Deferred acquisition costs – – – – 321.5 321.5 Insurance and other receivables – – 1,122.0 – – 1,122.0 Prepayments, accrued income and other assets – – – – 95.7 95.7 Derivative financial instruments 40.7 – – – – 40.7
Sale and purchase of products and services are conducted on an arm’s length basis.
Current tax assets 4 1.6 4.5 Cash and cash equivalents 5 6.8 268.3 Total assets 3,718.7 4,020.6
The additional accounting policies that are specific to the separate financial statements of the Company are set out below.
The subordinated dated notes were issued on 27 April 2012 at a fixed rate of 9.25%. The nominal £500.0 million bonds have a redemption date of 27 April 2042. The Company 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%.
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.
Annual General Meeting The 2014 AGM will be held on 15 May 2014 at The Auditorium, Allen & Overy LLP, One Bishops Square, London E1 6AD, starting at 10.00 am. All shareholders will receive a separate notice convening the AGM, which will explain the resolutions to be put to the meeting.
ICAS+ Introduced by the PRA in 2013, ICAS+ is an extension of the ICAS regime to allow firms to use their developing Solvency II frameworks, in particular the internal model.
Net asset value The net asset value of the Group is calculated by subtracting total liabilities from total assets.
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. It is comprised of three pillars: Pillar I, which sets out capital requirements for an insurer, Pillar II which focuses on systems of governance and Pillar III which deals with disclosure requirements.