THE DOMINION OF CANADA GENERAL INSURANCE COMPANY ANNUAL REPORT

THE DOMINION OF CANADA GENERAL INSURANCE COMPANY ANNUAL REPORT 2006 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY FINANCIAL HIGHLIGHTS (dollars in thousands) 2006 GROSS PREMIUMS WRITTEN .................................... NET PREMIUMS EARNED ........................................... $ 1,058,726 $ 1,026,997 2005 Change $ 1,080,535 $ 1,062,156 (2.0%) (3.3%) NET INCOME ................................................................ RETURN ON EQUITY ................................................... $ 149,523 22.3 % $ 139,196 25.2 % LOSS RATIO ................................................................. EXPENSE RATIO .......................................................... COMBINED RATIO ...................................................... 62.7 % 30.8 % 93.5 % 60.8 % 30.0 % 90.8 % 1.9% 0.8% 2.7% TOTAL ASSETS ............................................................ $ 2,629,599 $ 2,516,012 4.5% 1 PRESIDENT’S MESSAGE At The Dominion, our mandate and obligations are clear. We work hard to achieve profitability, consistency, stability, and transparency at all levels and for all stakeholders. The Dominion has a proactive and progressive approach to achieving these outcomes, working with staff and business partners. Corporate governance and strong related practices are a priority for The Dominion, in addition to requirements imposed by various regulators. Thank you to our employees and business partners for another very successful year. The combined ratio increased to 93.5% in 2006 from 90.8% in 2005. This deterioration is inevitable as the insurance cycle takes hold. Further deterioration is expected in 2007. Over each insurance cycle, we seek to provide our brokers and policyholders with stability and reliability in product, price and service and we seek to deliver a superior return to our shareholder. Although there is always room for improvement, we are achieving our objectives and appreciate the contribution and support we receive from staff and business partners. Levels of new business writings are ahead of expectations thanks to their efforts and commitment. The important questions facing the insurance industry remain: where are we in the cycle; will the cycle be longer or shorter than the historic norm of approximately seven years; and how deep will it be. The Dominion’s approach in 2007 will be steady as it goes, rising to the challenge of achieving stability, given that the insurance products we sell are priced without the ultimate cost being known. Their actual cost will develop over a period of years. During that time, actions by governments, regulators and courts can dramatically impact the cost of the product which was sold years before at the price fixed at that time. This residual and ongoing uncertainty contributes to the undulations in the industry’s profit. With a mindset focused on the long term, we intend our practices to be consistent and our decisions to be made with good judgement and common sense, and directed by ‘doing the right thing’ – a term you hear often at The Dominion. Having a shareholder with a longer-term focus on building the value of the business allows The Dominion to consistently ‘do the right thing’. ‘Doing the right thing’ is not just about meeting our coverage obligations to policyholders. It also means growing our business responsibly, writing business we want to keep, making decisions that stand up well to the scrutiny of our brokers and policyholders, and making those decisions as close to both the policyholder and the broker as possible. It also means that our management team is not distracted by short-term rewards. Our performance is measured across a cycle and based on building the value of the business. Auto insurance reform is an area where the real story appears to have been missed; that being how well insurers have estimated the actual cost of the various auto products across the country. The Dominion has taken a conservative approach and we will continue to do so. Having said this, however, The Dominion has reduced auto rates in all jurisdictions where reforms were introduced. Recently, a Fraser Institute insurance study compared the cost of delivery of auto insurance against ownership, public or private; and by province. It concluded that private delivery provides better value for consumers. Certain media and politicians, however, have quite incorrectly used this research to suggest auto rates in Ontario, for example, are too high. This of course is a conclusion that simply should not be made without regard to the construction of the auto insurance product sold in Ontario. All provinces mandate different coverage and the Ontario product includes benefits that are far richer than those in other provinces. As a consumer, if I were unlucky enough to experience a serious injury in an auto accident, I would want the coverage offered in Ontario ahead of any other province. Not surprisingly, increased benefits mean higher costs and price. Regulators, politicians and others that purport to represent consumer interests will undoubtedly seek expanded recognition in 2007. Increased bureaucracy, intervention and more rules are truly not in order. Consumers win when the elements of competition exist and the corresponding benefits flow to them. This month, Canadian market conduct regulators acting cooperatively through the Canadian Council of Insurance Regulators, articulated three principles they feel are important to consumers. They are: priority of interest (placing the consumers’ interests ahead of the intermediaries); disclosure of conflicts of interest (real or perceived); and product suitability (matching consumer needs to the product provided). We support these principles and believe that our industry owes consumers the facts relevant to their interests. 2 PRESIDENT’S MESSAGE (continued) The independence of brokers and intermediaries will continue to be at issue in 2007 and likely in the years beyond. The Dominion has chosen to distribute its products solely through independent insurance brokers and uses a control based definition to determine independence. Consumers value true independence, product choice, professional advice and advocacy. The Dominion values the opportunity to earn its way in business relationships that are not controlled by competitors. The age old saying “forget about consumers and they will eventually forget about you” is still relevant today. The Dominion understands this message and so the interests of policyholders and consumers drive our approach and our advocacy efforts. Trust matters. In 2006 through the use of a new slogan, we started to convey to employees, business partners and consumers that “trust matters” to The Dominion. I feel very strongly that trust and transparency are critical to our ongoing success and that by enhancing both we will be even more successful. While we have accomplished much over the past year and we are proud of our results, going forward we will accomplish more with a completely open, honest and transparent environment. To achieve such an environment, we must ensure that our actions consistently and continually demonstrate our commitment to these values. This will be an ongoing process requiring persistence and discipline. With more than $1.0 billion in premiums, many would consider The Dominion to be a big company. We have not, however, forgotten the values that laid the foundation for our growth. We listen: • our employees are engaged, informed and trained to apply judgement and common sense; • our collaborative business approach involves and relies upon feedback from policyholders, employees and brokers, to ensure we maintain our focus and the motivation to “do the right thing”; • claims personnel are rewarded for delivering outstanding service; • brokers are true partners who are encouraged to share their views, concerns and ideas; • our broker relationships are based on trust and mutual respect; and • we are committed to meaningful communication with policyholders to help them engage in and understand our business because we believe an informed consumer is the best policyholder for The Dominion. I encourage readers to visit our website www.thedominion.ca. It informs and assists while incorporating new ideas and events of interest. Among the information featured are a consumer code of rights and responsibilities; a disclosure summary of commission structures and rates and an informational ‘storyboard’ that provides some of the reasons why consumers should choose The Dominion. 3 MANAGEMENT’S DISCUSSION AND ANALYSIS The Dominion of Canada General Insurance Company (“The Dominion”) is a wholly owned subsidiary of E-L Financial Corporation Limited and is licensed to underwrite property and casualty (“P&C”) insurance in all jurisdictions in Canada. Overview The Dominion’s net income for 2006 was $149.5 million compared to $139.2 million in the prior year. Return on average equity was 22.3% in 2006 compared to 25.2% in 2005. The increase in 2006 net income reflects higher realized investment gains and investment income, which more than offset a reduction in underwriting income, compared to 2005. Underwriting results, at a combined ratio (total expenses divided by net premiums earned) of 93.5 in 2006, deteriorated 2.7 points from 90.8 in 2005. A lower level of catastrophe claims was more than offset by declining average earned premiums and an increase in claims severity and frequency. Realized investment gains before tax were $55.9 million in 2006, compared to $25.1 million in 2005. The excess of the market value of investments over their carrying value also increased by $30.9 million in 2006, bringing the ending market value excess to $155.4 million ($124.5 million in 2005). Cash flow from operations of $150.9 million in 2006 ($288.9 million in 2005) generated an increase of $157.1 million (8.1%) in year end cash and investments. Total assets increased $113.6 million (4.5%) to $2.6 billion at the end of 2006. Net income for the fourth quarter was $50.2 million compared to $58.7 million in 2005. The decrease versus last year reflects a reduction in underwriting income, partially offset by higher investment income and gains. The decrease in underwriting income reflects higher storm loss claims in the fourth quarter of 2006 compared to the fourth quarter of 2005, as well as the trend, continuing throughout 2006, of declining earned premiums and rising claims costs. In addition to increasing claims costs in 2006, the fourth quarter of 2005 was benefited by a reduction in estimates for 2005 accident year claims, versus estimates at the third quarter of 2005. Page 34 provides an overview of financial results and position for the five-year period from 2002 to 2006. Analysis of financial results and condition The following table and commentary analyze The Dominion’s financial results for 2006 and 2005: (millions of dollars) Automobile 2006 Gross premiums written Growth rate % Mix of business % Loss ratio % Revenue Net premiums earned Premium finance fee Investment income Realized investment gains Expenses Claims expense Other expenses Income taxes Net income $ 650 (1.6) 61 68.2 2005 $ 660 (6.2) 61 62.5 Personal Property 2006 $ 202 (4.7) 19 66.3 2005 $ 212 (1.3) 20 62.8 Commercial Property & Casualty 2006 $ 207 (0.7) 20 39.6 2005 $ 209 0.5 19 52.2 2006 Total 2005 $ 1,081 (4.0) 100 60.8 $ 1,059 (2.0) 100 62.7 $ 1,027 14 77 56 1,174 644 316 64 1,024 $ 150 $ $ 1,062 14 67 25 1,168 645 319 65 1,029 139 4 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) The Dominion underwrites standard general insurance products through eight territories which are concentrated in four geographic areas. The geographic mix of premiums in 2006 is largely unchanged from the prior year and is as follows: Ontario 68%, Western region 15%, Atlantic provinces 11% and Pacific region 6%. Product mix is fairly consistent across the regions, except that Pacific region’s business is mostly property and casualty, due to the government monopoly on most automobile business in British Columbia. The loss ratio (claims divided by net premiums earned) is a key indicator of underwriting performance and management monitors loss ratios by product line. Total gross premiums written decreased by 2.0% in 2006 (decrease of 4.0% in 2005) consisting of a 3.5% decrease in policies written (1.2% decrease in 2005), a 0.5% increase in average premiums (0.7% decrease in 2005) and a 1.0% increase from Facility Association premiums (2.1% decrease in 2005). Despite declines in premium rates in all lines in 2006, The Dominion’s average premiums increased modestly due to an increase in the mix of commercial property policies, which have a higher average premium than other lines, and an increase in the average insured value of personal property policies. The 3.5% decrease in 2006 policies written reflects the net effect of a 6.7% decrease due to cancellations of competitor-controlled brokers and 3.2% growth with existing and newly appointed brokers. As reported in last year’s annual MD&A, after The Dominion’s largest broker was acquired by a competitor insurance company to which most of the personal lines business would be concentrated, The Dominion terminated relationships with its brokers that were owned or controlled by its competitors. Last year’s MD&A reported that the total of these cancellations amounted to approximately $75.0 million in gross premiums written. Due to developments regarding ownership of certain brokers since 2005, additional terminations bring the total of all such terminations to approximately $101.1 million in gross premiums written. Based on current analysis, management has no plans for further terminations. Of the total $101.1 million, $65.4 million non-renewed in 2006 ($7.2 million in 2005). Approximately $26.3 million of the remainder will non-renew in 2007, which represents a decrease in gross premiums written of approximately 2.5%. The Dominion confirmed its strategy to distribute solely through independent brokers because they work in the best interests of their customers, free of conflict, by providing independent advice, personalized service and a competitive choice of products, pricing, service and financial strength from multiple insurers. Net premiums earned reflects the earning of written premiums on a straight-line basis over the terms of the related policies. Approximately half of the premiums written in a calendar year are earned in that year and the rest are deferred as unearned premium, to be earned in the following year. Automobile Gross premiums written for automobile declined 1.6% in 2006 (decrease of 6.2% in 2005) consisting of a 0.8% decrease in average premium (2.6% decrease in 2005) and a 2.3% decrease in policies written (0.2% decrease in 2005), partly offset by a 1.5% increase from Facility Association premiums (3.4% decrease in 2005). The decrease in average premiums reflects the impact of rate decreases in every jurisdiction in which The Dominion writes automobile insurance. The decrease in policies written reflects the net effect of a 7.3% decrease from cancelled competitor-controlled brokers (0.6% decrease in 2005) and a 5.0% increase from policies written with existing brokers (0.4% increase in 2005). Facility Association is a mandatory insurance pool that is funded by all private automobile insurers to provide insurance to drivers who cannot obtain coverage from private insurers. Facility also operates risk sharing pools (“RSP”) in some provinces into which insurers may transfer qualifying policies which they have issued directly. The insurer services its RSP policies and settles any claims but the financial results are combined in the risk sharing pools. Facility determines the results of its operations based on its own actuarial valuations and allocates its results to private insurers, mainly based on market share. Insurers rely on Facility’s reports in recording their share of Facility results. Given the nature of Facility’s business, its results are volatile and can have a material effect on The Dominion’s net income. The deterioration in the 2006 automobile loss ratio is mainly due to increases in both claims frequency (relative number of claims) and higher claims severity (average cost per claim), particularly for personal injury claims of our own policyholders. Other factors include declining earned premiums and lower favourable development on prior year claims recognized in 2006 versus 2005. Prior year development 5 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) reduced automobile claims expense by $12.5 million in 2006, compared to a reduction of $22.4 million in 2005. The favourable development in 2006 relates mainly to reduced estimates for third party bodily injury claims (paid to parties injured by The Dominion’s at-fault policyholders) arising mainly for 2005 claims. The 2005 decreases in prior year claims provisions were mainly for 2004 accident benefits for our insureds and third party bodily injury claims. Management expects earned premiums to continue to decline and claims costs to continue to rise, resulting in a higher loss ratio in 2007. Personal property Personal property premiums decreased 4.7% in 2006 (decrease of 1.3% in 2005) consisting of a 0.5% increase in average premium (1.0% increase in 2005), offset by a 5.2% decrease in policies written (decrease of 2.3% in 2005). The increase in average premiums reflects an increase in insured values partly offset by a reduction in rates. The decrease in written policies consists of a 6.0% reduction from cancelled competitor-controlled brokers and an increase of 0.8% from growth with existing brokers. The deterioration in the 2006 loss ratio reflects unfavourable prior year claims development, an increase in claims severity and declining earned premiums, partly offset by lower storm losses. In contrast to modest favourable development in 2005, modest unfavourable development in 2006 resulted in an increase in the loss ratio of 3.8 points. The 2006 development is mainly driven by higher than expected personal liability claims on homeowners’ policies of recent years. The lower level of storm losses in 2006 reduced the loss ratio 2.2 points versus the prior year. Declining earned premiums and rising claims costs are expected to increase the loss ratio in 2007. Commercial property and casualty Commercial coverages are generally sold together in package policies. The Dominion’s commercial business is typically main-line small to mid-sized exposures and on the conservative end of the risk spectrum. Gross premiums written declined by 0.7% (increase of 0.5% in 2005) consisting of an average premium decrease of 2.6% (decrease of 0.3% in 2005), partly offset by an increase in policies written of 1.9% (increase of 0.8% in 2005). “Soft market” competitiveness drove the decrease in average premiums. Policies increased 6.6% from growth with existing brokers and decreased 4.7% from cancellations of competitor-controlled brokers. The 12.6 point decrease in the loss ratio is due to significant favourable development on prior year claims in 2006 (reduction of 12.4 points) in contrast to moderately unfavourable development recognized in 2005 (increase of 3.3 points). Favourable development of $22.8 million in 2006 is mainly derived from reduced estimates for sexual abuse claims arising from 1959 to 1967. During 2006, court sanctioned settlements reached between the federal government and victims of sexual abuse at residential schools reduced the associated claims estimates. A smaller portion of the 2006 favourable development arose from reduced provisions for general liability and commercial property claims of recent accident years. In 2005, provisions for prior year claims were increased $6.0 million (3.3 points) relating to environmental pollution and for sexual abuse claims arising in the years 1950 to 1980 (including those related to the aforementioned residential schools). Estimating liability claim provisions is highly judgmental. These cases tend to be complicated and subject to a lengthy legal process. Management regularly assesses legal and other relevant developments in determining appropriate provisions. Excluding the effects of prior year development, the 2006 loss ratio increased versus 2005 due to a trend of declining earned premiums and increasing claims severity. In 2007, average rates are expected to continue to decline and increase the loss ratio. 6 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) Expenses Broker commissions and premium taxes comprise approximately two thirds of expenses and vary directly with premiums. The remaining third, operating expenses, mainly consist of salaries and benefits and information technology costs. The expense ratio (the sum of commissions, operating expenses and premium taxes, divided by net premiums earned) is a useful metric for analyzing delivery costs. The industry’s expense ratio tends to decrease when average premiums are increasing and vice versa. Included in commissions are contingent profit bonuses which are earned by brokers, based on their business’ profitability to The Dominion, and which can produce variation in annual expense ratios. The Dominion’s expense ratio increased in 2006 by 0.8 points to 30.8, from 30.0 in 2005, due mainly to a decrease in earned premiums, which added 1.0 point to the expense ratio. Salaries and benefits increased, adding 0.3, as a result of annual salary increases and hiring to resource technology projects and expanding compliance activities. Contingent profit bonuses were lower in 2006, as a result of reduced underwriting profit, which reduced the expense ratio. Declining earned premiums are expected to result in a further increase in the expense ratio in 2007. Investments Investment income (interest and dividends) before income tax was $77.6 million in 2006, compared to $67.3 million in 2005. The increase reflects an increase in both portfolio size and investment yield. The average portfolio balance grew 12.4% in 2006 (18.0% increase in 2005) as a result of relatively strong cash flow from operations. The average investment yield increased in 2006 to 3.8% from 3.6% in 2005. Realized gains before taxes were $55.9 million in 2006, compared to $25.1 million in 2005. Realized investment gains and losses result from trading decisions which are intended to maximize the ongoing economic return of The Dominion’s portfolios and, accordingly, do not follow a predictable pattern from year to year. Included in the 2006 gains was $20.3 million which was generated as a result of selling a portion of Canadian common equity fund units in order to achieve an approximately 50/50 split between foreign and Canadian common stock exposure. The Dominion’s exposure to common shares consists of units in pooled funds of a third party investment manager. Unrealized gains also increased by $30.9 million during 2006 as a result of strong capital market returns. Liquidity and capital resources For a P&C insurer, adequate liquidity requires generating sufficient cash and investments to fund policy liabilities, maintaining sufficient shareholder capital to act as a buffer for any shortfall, and managing the asset maturity profile (or ability to sell investments) to pay liabilities as they come due. Cash flow from operations remained high in 2006 at $150.9 million, compared to $288.9 million in 2005. The Dominion paid dividends of $40.0 million in 2006 (2005 – $15.0 million). At December 31, 2006, the investment portfolio mix included 7% in cash and short-term investments (2005 - 14%), 62% in bonds (2005 - 58%) and 29% in common and preferred stocks (2005 - 27%). As at December 31, 2006, 28% of the bond portfolio matures within two years. Over the last five years, bonds maturing within two years have averaged 27% of the ending bond portfolio. The Dominion’s capital consists mainly of retained earnings and is supported 70% by the investment in common stock fund units and the remainder is supported by bonds. The Dominion has maintained capital throughout the year well in excess of the requirements of the Insurance Companies Act and regulations. The federal regulator has also established a supervisory minimum to provide a safety buffer above the legally required minimum. At December 31, 2006, The Dominion held over $300 million of capital above the regulator’s supervisory minimum. The Dominion’s capital ratio (capital available divided by capital required) is 257% for 2006, compared to 238% in 2005. The increase reflects another year of strong earnings and the unrealized gain on investment values. Management regularly monitors the sensitivity of existing capital to potential threats from negative claims development, declines in investment values and operating leverage (ratio of premiums to capital). 7 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) Industry dynamics and management’s strategy The function of a P&C insurer is to pool the risks of its policyholders, collecting a premium from each in order to fund the covered claims of the few. Premiums, less underwriting expenses (commissions, operating expenses and premium taxes), are held and invested (the “insurance float”) until they are eventually repaid in the form of claims payments. The annual “cost of borrowing” on the insurance float is the insurer’s underwriting loss for the year, which is the excess of claims and underwriting expenses over net premiums earned. An insurer generates a margin by earning an investment return on the insurance float that exceeds the underwriting loss. At the peak of the insurance cycle, such as in recent years, positive underwriting income actually adds to the investment income earned on the float. This margin on the insurance float is in addition to the investment return earned on other investments which are held in support of shareholder capital. Typically, P&C insurers require relatively little working capital and, as a result of collecting premiums in advance of paying claims, can enjoy a high degree of liquidity, if well managed. The function of shareholder capital is to provide a buffer for large unusual losses or in the event that existing provisions for net unpaid claims prove to be inadequate. Regulators establish minimum capital requirements for insurers to maintain. The industry’s profitability improves and deteriorates in a wave-like fashion, in multi-year cycles. The key drivers of the industry’s business cycle are (i) the lag in measuring the ultimate cost of each year’s claims, and the resultant challenge in setting appropriate prices, (ii) changing investment returns, which subsidize underwriting results, and (iii) the relentless downward pressure on margins from a high level of price competition in this mature industry. Price competitiveness intensifies when profits are high, or expected to be, and when capital is strong, provided any uncertainty has subsided. The average duration of a cycle in Canada is seven years. The majority of insurers, like The Dominion, are price-takers and are not immune from the underwriting cycle. Insurers must balance pricing throughout each cycle to retain and attract the higher-margin risks to generate a superior underwriting result. P&C insurer’s results, therefore, must be assessed over the course of a cycle, and not strictly annually. A new cycle commenced in Canada in 2005, signalled by a downturn in industry return on equity. Price competition continued throughout 2006, but remained moderate. Insurers remain cautious as a result of continued regulatory pressure on automobile insurance rates and due to concern over being able to maintain rate adequacy when claims frequency begins to increase. The Dominion’s growth strategy is not focused on market share or absolute size, as an end. Our strategy is to maintain sufficient size and presence in the marketplace in order to be relevant to brokers so that they continue to grow their business with us. Accordingly, premium growth is subject to optimizing earnings growth over time, while maintaining a relevant presence with independent brokers, our sole distribution channel. The Dominion’s relationship with brokers is important for success. Management seeks to grow its goodwill with brokers by being a supportive partner in supplying their customers with reliable, consistent service at a fair price. The Dominion monitors its relative position with its brokers and actively seeks to be a top-three supplier, if not the primary one, within a broker’s operation. The majority of The Dominion’s technology development consists of initiatives to improve brokers’ ease of doing business with The Dominion. Our brokers have also appreciated The Dominion’s responsive, regionally-sensitive, “made-in-Canada” decision-making, which reflects the benefits of being Canadian-owned and managed. We seek to deliver high quality claims service in order to attract and retain good policyholders and preserve the support of our brokers. Our claims settlement philosophy is to provide the same degree of quality service in every interaction with a policyholder, regardless of the size or type of claim. We emphasize pro-active communication to claimants regarding the claims process and what they can expect, and to provide an empathetic and comfortable experience. However, we will not overpay a claim in the name of service, since that unfairly increases the cost of insurance to all policyholders. The Dominion engages an independent firm to conduct a claims satisfaction survey annually; our claimants consistently report being satisfied with The Dominion’s service. To meet ever-increasing service expectations, claims management continues to build a culture where quality service and continuous improvement are valued and rewarded. 8 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) Risk management The key risk exposures and performance drivers of a P&C insurer are appropriate pricing, competent and efficient distribution, effective underwriting (the acceptance of “risks” and properly classifying them), product management (policy terms and conditions), appropriate response to political and regulatory developments, customer service to policyholders and claimants, conservative claims provisioning, skilled human resources, cost control, sensible use of technology, and successful management of capital, comprising investments, reinsurance and liquidity. Some insurers write specialized, less understood risks and generate their margin from being a niche supplier. The majority of insurers, including The Dominion, focus on standard price-sensitive products and generate a margin from strong risk selection and efficient execution. One notable complication to the otherwise commodity nature of automobile insurance is that the product is frequently changed by provincial governments, making it more difficult to estimate claims and determine pricing assumptions. The Dominion’s strategies and results for the key performance drivers are discussed in the relevant sections in this report. Management continuously reassesses and adapts its strategies in response to industry dynamics and in anticipation of emerging trends. For personal lines and some commercial products, The Dominion sets premium rates based on actuarial analysis and consideration of competitive market forces. Personal automobile premium rates are subject to provincial regulatory approval which in most provinces involves varying degrees of review of supporting assumptions. Some commercial products are priced by individual underwriters, as part of the underwriting process. Our pricing strategy is to maintain stable prices for our policyholders, as much as possible. We also seek to set fair prices for our policyholders, while obtaining price adequacy in each segment, as the market allows. Standard P&C products are, however, very price sensitive and management carefully considers the impact of price increases on our best policyholders whom we seek to retain. The Dominion distributes solely through independent brokers, being the channel that distributes the majority of P&C insurance products in Canada. Accordingly, The Dominion’s success in the short-term is contingent on the ongoing success of brokers and on management’s strategic foresight and ability to respond to threats to the broker distribution channel. Independent brokers continue to be the preferred channel of consumers and we expect brokers to continue to dominate the Canadian insurance market. The Dominion is responding to some competitors’ strategy of acquiring brokers by terminating those brokers, appointing truly independent brokers to replace them and by promoting the importance of independence in our dealings with brokers and their customers. Management believes the majority of consumers will continue to prefer to be served by an independent broker who advocates their interest and offers true product choice versus a captive agent or broker working for, or owned by, a single insurer. Management’s provisions for Unpaid and unreported claims and Reinsurance recoverable are based on actuarially determined estimates for all costs of investigation and settlement of claims occurring prior to year end. Many assumptions underlie these estimates such as claims frequency and severity, claims payment trends, inflation and interest rates, potential changes in legislation and the interpretation of liability by the courts. Ultimate costs incurred will inevitably vary from current estimates. The provisions are discounted using discount rates that reflect expected book yields from supporting investments and include provisions for adverse deviation, in accordance with accepted actuarial practice in Canada. As a result of discounting, claims expense for claims arising in prior years includes an interest cost which arises from the aging of discounted balances. The interest cost is notionally offset by the portion of investment income that is derived from those investments which are held to eventually pay claims. When discount rates decrease (increase), the net unpaid claims balance increases (decreases) and this adjustment is included in claims expense in the period the discount rate is changed. In 2006, the discount rate was increased which reduced claims expense for prior year claims by $5.4 million. In 2005, the discount rate was decreased resulting in additional prior year claims expense of $7.9 million. Aside from these discounting effects, previous discounted provisions for claims arising in prior years are also changed as a result of ongoing actuarial re-evaluations of expected ultimate payments and such changes are reflected in the year they are determined. Excluding interest cost and the impact of reducing the discount rate, during 2006, provisions for The Dominion’s unpaid claims arising in prior years were decreased by $30.9 million, which is included as a decrease in claims expense in 2006 ($19.4 million decrease to claims expense in 2005). The major components of the 2006 favourable development are reported above under the analyses of the results of the three lines of business: $12.5 million favourable in automobile lines, 9 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) mainly for improved third party bodily injury estimates from claims occurring mostly in 2005; $4.4 million unfavourable in personal property for homeowners’ personal liability estimates of recent years; and $22.8 million favourable in commercial property and casualty, roughly half of which derives from reduced estimates for sexual abuse claims from residential schools from mainly 1959 to 1967 and the other half from better than expected experience on recent years for commercial property and general liability claims. The 2006 development relates to claims arising in many accident years, however, approximately three quarters of the total development derives from claims occurring in 2005. The 2005 favourable development of $19.4 million consisted of: $22.4 million favourable for automobile claims, mainly 2004; $3.0 million favourable for personal property; and $6.0 million unfavourable in commercial property and casualty claims, mainly related to environmental and sexual abuse claims occurring from 1950 to 1980. The reinsurers’ portion of The Dominion’s provision for Unpaid and unrecorded claims is recorded in the Balance sheet as Reinsurance recoverable. This balance decreased by $57.2 million in 2006 mainly due to the reduction in the provision for certain older casualty claims. Most of the provision for these claims was recoverable under reinsurance agreements. The reduction in the gross provision for these claims resulted in a corresponding reduction in Reinsurance recoverable. The Dominion settles certain claims involving a long-term payment stream by purchasing an annuity from a life insurer that will pay out the claim to the claimant. Most of these claims involve long-term payments for those injured in an automobile accident. These “structured settlements” result in the removal of the liability from The Dominion’s balance sheet. However, The Dominion retains a residual off-balance sheet contingent liability in that it guarantees to pay the remaining obligations of the annuity in the event that the life insurer cannot. The Dominion uses only credit-worthy federally-regulated insurers and considers this credit risk to be negligible. The Property and Casualty Insurance Compensation Corporation (PACICC) is a regulated entity that funds losses sustained by policyholders, within limits, in the event of an insurer insolvency. The Dominion has ongoing exposure to fund its portion, based on market share, of covered losses of an insolvent insurer. The Dominion accrues its obligations at the time they become known. Occasionally PACICC refunds to insurers recoveries from the assets of entities in liquidation, which are recorded as reductions to expenses. The Dominion’s contingent obligation to PACICC results in an ongoing exposure that could have a material impact on net income. The Dominion enters into reinsurance agreements with other insurers in order to limit its exposure to significant losses. Reinsurance does not relieve The Dominion of its primary liability as the originating insurer. The Dominion’s reinsurance coverage is in the form of excess of loss treaties that provide coverage above a deductible (“retention”) up to the treaty limits, per claim or, in the case of the catastrophe treaty, for the aggregate loss of series of claims arising from a single event. The catastrophe limit was increased to $500 million in 2006 from $400 million in 2005. Management increased the limit due to increased uncertainty with catastrophe modelling assumptions, as highlighted by the wide ranges of model predictions for the severe US hurricanes in 2005. The limit remains at $500 million for 2007. Reinsurance treaties typically renew annually and the terms and conditions are reviewed by the reinsurance committee and reported to The Dominion’s Board. Only reinsurers that have an ‘A’ credit rating, or better, are accepted on our reinsurance program as it renews each year. The Dominion writes personal and commercial property business in British Columbia and, accordingly, is exposed to loss from a major earthquake. Management mitigates this exposure through appropriate reinsurance coverage and conservative measurement and management processes, including strict underwriting guidelines, effective use of deductibles, adequate pricing and management of the earthquake exposure capacity allocated to each broker. The Dominion’s financial preparedness for an earthquake, through its catastrophe reinsurance and through its own capital, exceeds the federal regulator’s requirements. The majority of other expenses consists of base commissions and premium taxes which are both based on fixed percentages of the applicable premiums and provide no economies of scale. Managing the insurer’s internal operating costs is therefore important in this competitive industry. Salaries comprise over two thirds of operating expenses. P&C insurance is a knowledge-based service and, accordingly, skilled, experienced and effective human resources are The Dominion’s most important internal resource. Staff levels were increased in 2006 mainly to address increasing regulatory requirements and to resource 10 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) more technology projects. The Dominion’s human resource management practices focus on providing a positive work experience and maintaining a performance-based compensation program that is in line with the industry. Annual performance appraisals, annual salary reviews and bonus programs covering all levels of staff are geared toward promoting and rewarding employees who truly “Make a Difference.” After salaries, technology is the most significant operating cost. Approximately half of the 2006 technology expenditure is the cost of running existing system operations. Regarding the other half, system development, The Dominion follows a technology strategy of making incremental improvements within a disciplined budget. In general, our development effort is focused on enhancing “ease of doing business” for brokers and enhancing operating efficiency. The Dominion manages its investments to provide for the payment of policy liabilities and to provide a return on shareholder’s equity. Investing activities are subject to the Insurance Companies Act and to investment guidelines established by the Investment Committee of The Dominion’s Board. Investment managers report on their performance and outlook quarterly to the Investment Committee. Policy liabilities are supported by fixed income investments, predominantly government bonds and some high quality corporate bonds. High quality preferred shares are also held because of their superior after-tax yields, since their dividends are fully deductible. Given the uncertainty in the quantum and timing of claims payments for property and casualty claims, strict asset and liability matching is neither feasible nor necessarily optimal. The Dominion manages the duration of its bond portfolio within a broad range, between 50% to 300% of the duration of claims liabilities, which is typically between two to four years. The Dominion normally maintains its bond duration between 100% to 200% of the duration of its claims liabilities in order to pursue the higher yields which are usually available in the longer portion of a normal yield curve. At December 31, 2006, the bond duration of 4.2 years is 102% of the net unpaid claims duration (2005 - 103%). During 2006, bonds rallied as the central bank paused on increasing the bank rate. The Dominion deployed its cash to acquire more bonds as they rallied. As a result, The Dominion’s bond duration was increased to 4.2 years, from 3.8 years in 2005. Maintaining sufficient liquidity is essential to fund the ongoing payment of claims, including the increased requirements of a sudden catastrophe. In order to generate sufficient cash and investments to fund policy liabilities on an ongoing basis, premium rates must adequately incorporate reasonable projections of claims, investment return and expense levels. With adequate premium rates, cash flow from premium collection and from interest and dividends is typically more than adequate for meeting claims payments. In addition to maintaining adequate cash and short-term investments on hand, the ability to more easily dispose of risk-free government bonds, which comprise the majority of the bond portfolio, provides additional liquidity if necessary. Given The Dominion’s significant mix of fixed income investments and deliberate exposure to a longer asset duration, volatility in the financial markets, particularly in interest rates, can have a significant impact on the market value of the investment portfolio. The Dominion’s fixed income investment managers proactively monitor market conditions and make mix adjustments in anticipation of significant market changes. The Dominion’s usual maturity profile also allows for ongoing liquidity to be maintained such that The Dominion can operate for some time with minimal need to liquidate securities and thus minimize realized losses from disposal at unfavourable market values. The Dominion’s common stocks and some fixed income securities are considered to be in support of shareholder capital and are therefore managed from a longer term perspective. Emphasis is on quality and capital appreciation for stocks and on quality and higher yields for bonds. Management regularly monitors and reports to The Dominion’s Board of Directors on the potential impact on capital adequacy of the main threats to financial condition, mainly, increases in market interest rates, declines in common stock market values, deterioration in underwriting results and growth above plan. Annually, the Appointed Actuary performs an analysis of the impact of severe adverse scenarios as required by the federal regulator. This report is reviewed by management and The Dominion’s Board of Directors and is filed with the regulator. These analyses demonstrate that The Dominion has sufficient resources to withstand significant adverse events. Management incorporates their implications regarding changing risk factors in annual planning and ongoing forecasting. 11 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) Critical accounting estimates The financial statements are prepared in accordance with generally accepted accounting principles in Canada which require estimates and assumptions in determining amounts reported in the financial statements. Note 3 to the financial statements describes the significant accounting policies. The most important accounting estimates arising from The Dominion’s business are the provisions for claims liabilities, consisting of the provisions for unpaid claims and for reinsurance recoverable. The provision for unpaid claims reflects an estimate of the net present value of the ultimate cost of claims that have happened by the balance sheet date and the related expenses expected to be incurred to settle those claims. Reinsurance recoverable represents the amounts expected to be recovered from reinsurers for their share of The Dominion’s claims costs, in accordance with the terms and conditions of The Dominion’s reinsurance contracts. On a case-by-case basis, our claims adjusters use their experience and judgement and follow The Dominion’s documented claims reserving philosophy to enter a “case” reserve for each claim in our claims system (for certain claims the system automatically applies an average reserve established by our actuaries). The claims reserving philosophy also addresses the timing of entering reserves. Reserves are adjusted promptly as additional information becomes known that changes the adjuster’s view. The terms of our reinsurance treaties are then applied to the case reserves, where applicable. The Dominion’s Appointed Actuary performs ongoing valuations to establish the provisions for Unpaid claims and Reinsurance recoverable. The actuarial valuations include analyzing case and average reserves, historical settlement patterns, estimates of trends in frequency and severity, trends in legal interpretations and other internal and external information. Projection techniques are applied to the company’s claims data to determine the ultimate costs, including a provision for claims that have occurred but have not yet been reported. The actuary’s valuation work is governed by accepted actuarial practice as established by the Canadian Institute of Actuaries. The provisions are discounted to take into account the time value of money. As required by the federal regulator, the Appointed Actuary’s valuation work is reviewed by an external actuary at least once every three years. Measurement uncertainty in these estimates arises from many internal and external factors, including changes to the product, regulations, internal claims handling procedures, economic inflation and legal trends. The knowledge and judgement of senior management on these factors is taken into account in the actuary’s selection of assumptions where appropriate. A 5% variation in the net unpaid and unreported claims is a reasonably likely net change that could result from changes in the many assumptions that underlie this critical accounting estimate. A 5% change in the net unpaid claims balance (that is, Unpaid and unreported claims net of Reinsurance recoverable) would result in a change in claims expense of $61.4 million ($39.6 million after tax). One assumption with a pervasive effect on the net claims balance is the assumed discount rate. A 1% change in the selected average discount rate results in a change in net unpaid claims of $30.9 million. Another important accounting uncertainty is the possible existence and magnitude of a “premium deficiency” associated with premium liabilities. Premium liabilities are the claims and related expenses which will occur, after the balance sheet date, during the remaining terms of the policies currently in force (i.e. claims incurred in a subsequent financial reporting period on policies now in force). Premium liabilities are not directly provided for in the financial statements, which recognize only claims that have occurred by the balance sheet date. Nevertheless, the provision for unearned premiums is an indirect provision to cover premium liabilities since it is the revenue that has been deferred for matching against the claims and expenses that will occur over the remaining terms of in-force policies. The Appointed Actuary determines whether unearned premiums is a sufficient provision for premium liabilities. If not, a “premium deficiency” provision would be recognized as an expense in the income statement and, on the balance sheet, as a reduction to unamortized deferred policy acquisition expenses plus a separate liability for the amount of the deficiency, if any, that exceeded deferred policy acquisition expenses. No premium deficiency exists in 2006 and 2005. 12 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) Outlook Management’s discussion and analysis contains certain forward-looking statements that are subject to risks and uncertainties that may cause the results or events mentioned to differ materially from actual results or events. No assurance can be given that results, performance or achievement expressed in, or implied by, forward-looking statements within this disclosure will occur, or if they do, that any benefits may be derived from them. As expected in last year’s MD&A, underwriting income declined in 2006 as a result of declining premium levels and increasing claims costs. Management expects these trends to continue into 2007. Investment gains buoyed the 2006 underwriting results. Looking forward, however, investment gains and losses are not easily predicted. Net income is expected to return to a historically normal level in 2007. This soft phase of the cycle is not expected to be long or severe, given the moderating effect of regulatory price pressure on automobile insurance rates. Our strategy is to outperform our competitors by maintaining our underwriting discipline, retaining our best business and reacting quickly in areas that are deteriorating beyond our tolerance. We place long-term earnings growth above short-term premium growth. New accounting rules for financial instruments will affect The Dominion’s reporting of investment balances and gains beginning in the first quarter of 2007. In 2007, realized investment gains will continue to be reported in “net income.” However, for most of The Dominion’s investments, unrealized gains and losses (which presently are off-balance sheet) will also be reported in a new financial statement, the Statement of Comprehensive Income. Most of The Dominion’s investments will be carried at fair value on the balance sheet. As a result of the new accounting standard, unpaid claims will be discounted using the market yield of investments that are held in support of claims liabilities. To the end of 2006, unpaid claims are discounted using the book yield of supporting investments which is generally based on cost and amortized cost. February 9, 2007 13 MANAGEMENT REPORT The accompanying financial statements and all information in the annual report are the responsibility of management and have been approved by the Board of Directors. The financial statements necessarily include amounts that are based on judgements and estimates applied consistently and considered appropriate in the circumstances. The financial statements have been prepared by management in accordance with Canadian generally accepted accounting principles. Financial and operating data elsewhere in the annual report are consistent with the information contained in the financial statements. The Company maintains a system of internal control which is designed to provide reasonable assurance that assets are safeguarded, transactions are properly recorded and the financial records are reliable for preparing the financial statements. The Board of Directors carries out its responsibility for the financial statements in this annual report principally through its Audit Committee, consisting solely of non-executive directors. The Audit Committee meets periodically with management, the head of Risk and Control Services and the independent auditors to discuss the scope and results of audit examinations with respect to internal controls and financial reporting of the Company. The Audit Committee also meets periodically with the Appointed Actuary. The Appointed Actuary is appointed by the Board of Directors pursuant to the Insurance Companies Act. The Appointed Actuary is responsible for ensuring that the assumptions and methods used in the valuation of policy liabilities are in accordance with accepted actuarial practice, applicable legislation and associated regulations or directives (except as noted in the Appointed Actuary’s opinion). The Appointed Actuary is also required to provide an opinion regarding the appropriateness of the provisions in the financial statements for policy liabilities at the balance sheet date to meet all policyholder obligations of the Company. Examination of supporting data for accuracy and completeness and consideration of company assets are important elements of the work required to form this opinion. Policy liabilities include unearned premiums, unpaid claims and adjustment expenses, the reinsurers’ share of unearned premiums and unpaid claims and adjustment expenses and deferred policy acquisition expenses. The Appointed Actuary uses the work of the independent auditors in verifying data used for valuation purposes. The Appointed Actuary also relies on the assessment of the control environment of the Company, performed by the Company’s Risk and Control Services department. The independent auditors have been appointed by the shareholder pursuant to the Insurance Companies Act. Their responsibility is to conduct an audit of the financial statements in accordance with Canadian generally accepted auditing standards and to report thereon to the shareholder regarding the fairness of presentation of the Company’s financial statements in accordance with Canadian generally accepted accounting principles. In carrying out their audit, the independent auditors also consider the work of the Appointed Actuary and her report on the policy liabilities. The reports of the Appointed Actuary and the independent auditors follow. George L. Cooke President and Chief Executive Officer R. Doug Hogan Senior Vice President and Chief Financial Officer 14 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY AUDITORS’ AND ACTUARY’S REPORTS 2006 Auditors’ Report To the Shareholder of The Dominion of Canada General Insurance Company We have audited the balance sheet of The Dominion of Canada General Insurance Company as at December 31, 2006 and the statements of income and retained earnings and of cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these financial statements present fairly, in all material respects, the financial position of the Company as at December 31, 2006 and the results of its operations and its cash flows for the year then ended in accordance with Canadian generally accepted accounting principles. Chartered Accountants Toronto, Ontario February 9, 2007 APPOINTED ACTUARY’S REPORT To the Shareholder of The Dominion of Canada General Insurance Company I have valued the policy liabilities of The Dominion of Canada General Insurance Company for its balance sheet at December 31, 2006 and their change in the statement of income and retained earnings for the year then ended in accordance with accepted actuarial practice, including selection of appropriate assumptions and methods. In my opinion, the amount of policy liabilities makes appropriate provision for all policyholder obligations, and the financial statements fairly present the results of the valuation. Nathalie Bégin Fellow, Canadian Institute of Actuaries Toronto, Ontario February 9, 2007 15 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY BALANCE SHEET DECEMBER 31, 2006 (dollars in thousands) 2006 ASSETS Investments (Note 4) .................................................................................... Cash and cash equivalents .......................................................................... Investment income accrued ......................................................................... Premiums receivable ................................................................................... Due from Facility Association ....................................................................... Reinsurance recoverable (Notes 8 and 9) ................................................... Due from reinsurance companies ................................................................ Reinsurers’ portion of unearned premiums .................................................. Deferred policy acquisition expenses ........................................................... Capital assets (Note 5) ................................................................................ Other assets (Note 6) ................................................................................... Future income taxes (Note 11) .................................................................... $ 2,023,477 83,741 12,020 253,267 19,726 68,860 2,427 8,265 97,637 25,134 12,801 22,244 $ 2,629,599 LIABILITIES Unpaid and unreported claims (Note 9) ....................................................... Unearned premiums .................................................................................... Premium taxes ............................................................................................. Due to reinsurance companies .................................................................... Other liabilities (Note 10) ............................................................................. $ 1,297,275 507,572 5,214 3,006 91,665 1,904,732 SHAREHOLDER’S EQUITY Share capital Authorized - 800 common shares without par value Issued - 404 common shares .................................................................. Contributed surplus ...................................................................................... Retained earnings ........................................................................................ $ 1,246,963 518,114 7,575 2,566 125,450 1,900,668 $ 1,787,639 162,475 10,843 253,632 17,862 126,105 5,598 7,945 97,526 17,490 3,306 25,591 $ 2,516,012 2005 1,010 9,710 714,147 724,867 $ 2,629,599 1,010 9,710 604,624 615,344 $ 2,516,012 Approved by the Board: Duncan N.R. Jackman Chairman of the Board George L. Cooke President and Chief Executive Officer 16 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY STATEMENT OF INCOME AND RETAINED EARNINGS YEAR ENDED DECEMBER 31, 2006 (dollars in thousands) 2006 UNDERWRITING REVENUE Gross premiums written (Note 7) ................................................. Reinsurance ceded ....................................................................... Net premiums written .................................................................... Decrease in unearned premiums .................................................. Net premiums earned .................................................................... Premium finance fee income ........................................................ $1,058,726 (42,590) 1,016,136 10,861 1,026,997 13,888 1,040,885 EXPENSES Claims .......................................................................................... Commissions ................................................................................ Operating ...................................................................................... Premium taxes .............................................................................. 644,017 186,928 94,544 35,040 960,529 UNDERWRITING INCOME ................................................................ INVESTMENT INCOME Interest and dividends .................................................................... Gain on sale of investments ........................................................... 80,356 77,578 55,924 133,502 Net income before income taxes .......................................................... Income tax provision (Note 11) Current .......................................................................................... Future ............................................................................................ 213,858 60,988 3,347 64,335 NET INCOME (Note 12) ................................................................... 149,523 2005 $1,080,535 (40,031) 1,040,504 21,652 1,062,156 13,754 1,075,910 645,448 197,651 85,168 36,282 964,549 111,361 67,274 25,080 92,354 203,715 70,550 (6,031) 64,519 139,196 RETAINED EARNINGS Beginning of year ........................................................................... Dividends paid ............................................................................... End of year .................................................................................. 604,624 (40,000) $ 714,147 480,428 (15,000) $ 604,624 17 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY STATEMENT OF CASH FLOWS YEAR ENDED DECEMBER 31, 2006 (dollars in thousands) 2006 2005 OPERATING ACTIVITIES Net income ........................................................................................... $ 149,523 Items not affecting cash Increase in unpaid and unreported claims ....................................... 50,312 Decrease (increase) in reinsurance recoverable .............................. 57,245 (Decrease) in unearned premiums .................................................. (10,542) (Increase) decrease in reinsurers' portion of unearned premiums .. (320) (Increase) decrease in deferred policy acquisition expenses .......... (111) Gain on sale of investments ............................................................ (55,924) Future income taxes ......................................................................... 3,347 Amortization ..................................................................................... 2,328 195,858 Net change in other non-cash items ..................................................... Net cash provided by operating activities ............................................. INVESTING ACTIVITIES Purchase of investments ...................................................................... Proceeds from sale of investments ...................................................... Net purchase of capital assets ............................................................. Net sale (purchase) of short-term investments ..................................... Net cash used in investing activities ..................................................... FINANCING ACTIVITIES Dividends paid ....................................................................................... (DECREASE) IN CASH AND CASH EQUIVALENTS .............................. NET CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR ........... NET CASH AND CASH EQUIVALENTS, END OF YEAR ....................... Comprised of: CASH ............................................. .. .................................................... CASH EQUIVALENTS .......................................................................... BANK INDEBTEDNESS (Note 10) ....................................................... NET CASH AND CASH EQUIVALENTS .............................................. $ 665 83,076 (23,049) $ 60,692 (44,949) 150,909 (927,330) 693,502 (11,075) 55,017 (189,886) (40,000) (78,977) 139,669 $ 60,692 $ 139,196 151,409 (35,234) (21,697) 45 2,061 (25,080) (6,031) 1,752 206,421 82,482 288,903 (680,799) 413,974 (9,706) (16,899) (293,430) (15,000) (19,527) 159,196 $ 139,669 $ 1,087 161,388 (22,806) $ 139,669 18 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 1. DESCRIPTION OF COMPANY AND SUMMARY OF OPERATIONS The Dominion of Canada General Insurance Company (the “Company”) was incorporated by a special act of parliament in 1887 and is continued under the federal Insurance Companies Act. The Company underwrites property and casualty insurance focused in Ontario, Alberta, British Columbia and the Atlantic provinces. 2. GOVERNMENT REGULATION OF AUTOMOBILE INSURANCE The Company’s generation of revenue from underwriting automobile risks is impacted by the regulation of certain automobile premium rates by the governments of Alberta, Ontario, Nova Scotia, New Brunswick, Prince Edward Island and Newfoundland. Provincial government rate regulatory approval processes can result in the prescription of premium rates other than those the Company deems appropriate for the risks to be underwritten. The Company’s exposure to such prescribed rates is increased in the provinces of Ontario, Alberta and Newfoundland where the Company is required to provide coverage for substantially all risks presented to it, commonly referred to as the “all comers rules”. The Company is also required by regulation to assume a share of automobile insurance underwritten through the Facility Association, which operates insurance pools in several provinces. Such pools are designed to insure higher risk drivers that might otherwise be unable to obtain insurance. The Company’s share of pool premiums and costs are generally determined in relation to its share of total automobile premiums written by all insurers in each relevant province. Pool premium rates are regulated by provincial governments. The Company’s net written automobile insurance premiums are $644,575 (2005 - $654,985), the majority of which are subject to rate regulation. The extent to which net premiums written would have differed in the absence of regulation is not determinable. Amounts related to premiums subject to rate regulation are accounted for in these financial statements in the same manner as amounts related to other premiums. The Company’s claims costs are influenced by provincial governments to the extent they pass legislation or regulations that specify the nature and extent of benefits and other requirements that impact claims costs and the settlement process. 3. SIGNIFICANT ACCOUNTING POLICIES These financial statements are prepared in accordance with Canadian generally accepted accounting principles and also comply with the accounting requirements of the Office of Superintendent of Financial Institutions (Canada). Use of estimates The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as at the date of the financial statements and the reported amounts of revenue and expenses during the year. Actual results could differ from those estimates and changes in estimates are recorded in the accounting period in which they are determined. 19 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 3. SIGNIFICANT ACCOUNTING POLICIES (continued) Investments Investments in bonds and debentures are carried at amortized cost. Investments in common and preferred shares, pooled fund units and commercial loans are carried at cost. Rental properties are carried at cost, less accumulated amortization on buildings. Investments with other than temporary impairments in value are written down to their estimated net realizable value. Gains and losses on disposal of investments are recognized on the date of disposal. Short-term investments consist of treasury bills, commercial paper and bankers’ acceptances with maturities of greater than three months and less than one year when acquired. Treasury bills, commercial paper and bankers’ acceptances with maturities of three months or less from the date of acquisition are classified as cash equivalents. These investments are carried at cost plus accrued interest, which approximates fair value. Premiums earned and deferred policy acquisition expenses The Company’s premiums are earned on a straight-line basis over the term of the related policies. Deferred policy acquisition expenses, comprised primarily of commissions and premium taxes, are amortized on the same basis as the related premiums are earned. The amount deferred is limited to the amount recoverable. Premium finance fee income The Company earns a finance fee on those premiums which it collects directly from policyholders under its instalment billing plans. Premium finance fee income is earned on a straight-line basis over the term of the related policies. The Company pays fees to credit card issuers for premiums collected from policyholders on their credit cards and these fees are netted against the Company’s premium finance fee income. Due from Facility Association The Facility Association is an automobile insurance market of last resort for higher risk drivers. Results are pooled and mandatorily shared among automobile insurers. Due from Facility Association represents the Company’s share of the net assets held by Facility Association. The Company also holds investments which are available to fund the Company’s share of Facility Association policy liabilities which are included in Unpaid and unreported claims, Unearned premiums and Deferred policy acquisition expenses. The Facility Association determines the results of its operations based on its own actuarial valuations and allocates its results to private insurers, mainly based on market share. The Dominion relies on Facility Association’s reports in recording its share of Facility Association's results. Reinsurance The Company enters into reinsurance agreements with other insurers in order to limit its exposure to significant losses and records this expense as Reinsurance ceded in the Statement of Income and Retained Earnings. Reinsurance does not relieve the Company of its primary liability as the originating insurer. The change in unearned reinsurance premiums ceded is included in Decrease in unearned premiums in the Statement of Income and Retained Earnings. Reinsurance recoveries on claims incurred are recorded as a reduction in Claims in the Statement of Income and Retained Earnings. The reinsurers' share of Unpaid and unreported claims is recorded as Reinsurance recoverable in the Balance Sheet. Reinsurance recoverable is valued on a discounted basis in accordance with 20 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 3. SIGNIFICANT ACCOUNTING POLICIES (continued) accepted actuarial practice in Canada. The unearned portion of Reinsurance ceded is recorded as Reinsurers’ portion of unearned premiums in the Balance Sheet. Capital assets Capital assets are carried at cost less accumulated amortization. Amortization commences when capital assets are put into productive use. The Company amortizes its building on a five percent declining balance basis and furniture and equipment on a straight-line basis over periods ranging from three to five years. Leasehold improvements are amortized over the related remaining lease term. Computer software, related licenses and software development costs are capitalized and amortized on a straight-line basis ranging from three to seven years. Unpaid and unreported claims Unpaid and unreported claims are based on an actuarially determined provision for all costs of investigation and settlement of insurance losses that have occurred prior to the year end. Estimates for salvage and subrogation recoveries are not significant and are included as reductions in Unpaid and unreported claims. Unpaid and unreported claims are valued on a discounted basis, in accordance with accepted actuarial practice, as prescribed by the Canadian Institute of Actuaries. Determination of the ultimate costs of investigation and settlement of insurance claims is inherently subject to uncertainty. Estimates must be made of the ultimate costs for known or reported claims as well as an estimate for those claims incurred but not yet reported. Many assumptions underlie these estimates such as claims frequency and severity, claims payment trends, inflation and interest rates, as well as potential changes in legislation and in the interpretation of liability by the courts. Ultimate costs incurred will inevitably vary from current estimates. Estimates are adjusted as additional information affecting the estimated amounts becomes known during the course of claims settlement. All changes in estimates are recorded as Claims expense in the Statement of Income and Retained Earnings in the period in which they occur. Employee future defined benefit plans The Company accrues its obligations for its employee defined benefit plans, net of plan assets. The cost of defined benefit pensions and other retirement benefits earned by employees is actuarially determined using the projected benefit method pro-rated on services and using management’s best estimate of expected plan investment performance, salary escalation, retirement ages of employees and expected health care costs. For the purpose of calculating the expected return on plan assets, those assets are valued at fair value. Actuarial gains (losses) arise from the difference between actual long-term rates of return on plan assets for a period and the expected long-term rates of return on plan assets for that period or from changes in actuarial assumptions used to determine the accrued benefit obligation. The excess of the net actuarial gain (loss) over 10% of the greater of the accrued benefit obligation and the fair value of plan assets is amortized over the average remaining service period of active employees. On January 1, 2000, the Company adopted the new accounting standard on employee future benefits using the prospective application method. The Company is amortizing the transition asset on a straight-line basis over the average remaining service period of employees expected to receive benefits under the benefit plan as of January 1, 2000. 21 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 3. SIGNIFICANT ACCOUNTING POLICIES (continued) Income taxes Future income tax assets and liabilities are recorded for the expected future income tax consequences of events that have been included in the financial statements or income tax returns. Future income taxes are provided for using the asset and liability method. Under the asset and liability method, future income taxes are recognized for all significant temporary differences between tax and financial statement bases for assets and liabilities and for certain carry-forward items. Future income tax assets are recognized only to the extent that, in the opinion of management, it is more likely than not that the future income tax assets will be realized. Future income tax assets and liabilities are adjusted for the effects of changes in tax laws and rates, on the date of their enactment or substantive enactment. 4. INVESTMENTS 2006 Gross Unrealized Gains Losses $ 26,891 123,847 5,643 – 3,623 – 160,004 $ 4,606 – – – – – 4,606 Market Value $ 1,338,321 634,093 104,738 37,643 5,095 58,985 $ 2,178,875 Cost Bonds and debentures Common shares Preferred shares Commercial loans Rental properties Short-term investments $ 1,316,036 510,246 99,095 37,643 1,472 58,985 $ 2,023,477 $ $ Cost Bonds and debentures Common shares Preferred shares Commercial loans Rental properties Short-term investments $ 1,122,209 429,168 98,670 22,002 1,588 114,002 $ 1,787,639 $ 2005 Gross Unrealized Gains Losses 34,052 85,700 6,325 – 2,678 – 128,755 $ 4,248 – – – – – 4,248 Market Value $ 1,152,013 514,868 104,995 22,002 4,266 114,002 $ 1,912,146 $ $ 22 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 4. INVESTMENTS (continued) Canadian federal and provincial bonds comprise 46% (2005 - 52%) of the Company’s bonds and debentures. The remainder are corporate bonds, predominantly from Canadian issuers with a rating of BBB or better. Bonds and debentures have the following maturity profile: 21% within one year (2005 - 17%), 46% between one and five years (2005 - 56%), 33% five years and over (2005 - 27%). The average effective interest rate on bonds and debentures is 4.5% (2005 – 4.5%) and the portfolio duration is 4.2 years (2005 - 3.8 years). The estimated impact of a 1% increase (decrease) in the market yield would be a $56,850 decrease (increase) in the market value of bonds and debentures. The estimated impact of a 1% increase (decrease) in the effective interest rate on bonds and debentures maturing and reinvested in the next twelve months would be a $1,202 increase (decrease) in investment income in 2007. Commercial loans are made to certain independent insurance brokers with whom the Company conducts business. Substantially all of these loans are secured and have an average term to maturity of 7.2 years (2005 – 5.0 years). Interest rates are generally fixed for the term and average 5.5% (2005 – 5.7%). The investment in common shares consists of units in four pooled funds which are managed by an independent investment manager. These pooled funds contain a minor cash component in addition to the common share holdings. The carrying value of these units is the cost of the units to the Company. Market values for bonds and debentures and common and preferred shares are based on publicly quoted prices. In the absence of an active market for the commercial loans, the carrying value of the loans provides a reasonable approximation of market value. The book value of Rental properties is net of accumulated amortization of $1,860 (2005 - $1,946). 5. CAPITAL ASSETS 2006 Accumulated Amortization $ 7,586 1,562 1,421 4,842 15,411 Net Book Value $ 5,689 2,547 511 16,387 2005 Net Book Value $ 5,429 2,211 275 9,575 Cost Office properties Furniture and equipment Computer hardware Software $ 13,275 4,109 1,932 21,229 $ 40,545 $ $ 25,134 $ 17,490 Office properties consist of the portion of the land and building occupied by the Company for its own use and leasehold improvements on leased office space. Amortization of capital assets of $3,557 (2005 - $2,480) is included in the Statement of Income and Retained Earnings. Included in software is $8,285 (2005 - $4,204) that has not yet commenced being amortized as it is still under development. 23 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 6. OTHER ASSETS Other assets consist of the following: Income taxes receivable Pension asset (Note 16) Other $ 2006 7,501 2,455 2,845 12,801 $ 2005 – 1,632 1,674 3,306 $ $ 7. GROSS PREMIUMS WRITTEN Gross premiums written were derived from the following principal lines of business: Gross premiums written Automobile Property Casualty 2006 $ 649,637 317,839 91,250 $1,058,726 2005 $ 659,961 328,256 92,318 $1,080,535 The Company writes all of its business in Canada and its operations are concentrated in four geographic regions: the Atlantic Provinces, Ontario, Alberta and British Columbia. Ontario automobile accounts for approximately 44% of the Company’s gross premiums written. Automobile gross premiums written include $49,325 representing the Company’s share of Facility Association business (2005 - $40,423). 8. REINSURANCE In the normal course of business, the Company enters into excess of loss treaty and facultative reinsurance agreements in order to limit its exposure to unusual losses. Under these agreements the Company’s exposure to claims occurring in 2006 was limited as follows: $3,000 for an automobile claim; $1,500 for a personal or commercial property claim; $1,250 for a casualty claim; and $2,500 for a surety claim. The Company’s catastrophe reinsurance arrangements provided coverage up to $500,000, in the event of a series of claims arising out of a single occurrence, under which the Company is responsible for the first $15,000 plus 2.5% of the first $60,000 of claims exceeding that retention level. Reinsurance premiums on an earned basis are $42,270 (2005 - $40,076) and are included as reductions in Net premiums earned. 24 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 9. UNPAID AND UNREPORTED CLAIMS AND REINSURANCE RECOVERABLE Unpaid and unreported claims and Reinsurance recoverable can be classified as follows: 2006 Reinsurance Recoverable $ 14,229 43,008 11,623 – 68,860 2005 Reinsurance Recoverable $ 30,762 86,291 9,052 – 126,105 Gross Short term Medium term Long term Facility Association $ 155,103 740,531 319,760 81,881 $1,297,275 Gross $ 139,720 758,080 269,035 80,128 $1,246,963 $ $ Short term claims are those which are expected to be substantially paid within a year and primarily relate to property and automobile damage coverage. Long term claims relate to automobile accident benefits and have an expected duration of approximately seven years. Medium term claims comprise all other claims, consisting primarily of automobile bodily injury and general liability and have an expected duration of three years. The weighted average duration of the Company’s Unpaid and unreported claims is approximately 4.1 years. Unpaid and unreported claims and Reinsurance recoverable are discounted in accordance with accepted actuarial practice in Canada. The discount rate used for short term claims is 4.00% (2005 – 2.50%), for medium term claims is 4.50% (2005 – 4.25%) and for long term claims is 4.75% (2005 – 4.75%). The average discount rate used by the Facility Association was 3.79% (2005 – 3.26%). The impact of a 1% decrease (increase) in the weighted average discount rate is an increase (decrease) in the 2006 net Unpaid and unreported claims carrying value of $30,872 (2005 – $26,284). In the absence of an active market for the sale of claims liabilities, the actuarially discounted carrying values provide a reasonable approximation of fair value for Unpaid and unreported claims and Reinsurance recoverable. 25 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 9. UNPAID AND UNREPORTED CLAIMS AND REINSURANCE RECOVERABLE (continued) Changes in Unpaid and unreported claims and Reinsurance recoverable and their impact on claims expense are summarized as follows: 2006 Balances, beginning of year: Unpaid and unreported claims, gross Less Reinsurance recoverable Unpaid and unreported claims, net of reinsurance Changes during the year, net of reinsurance: Add net claims incurred: Current year claims on the Company’s insurance policies Prior year claims on the Company’s insurance policies: Interest cost Impact of change in discount rate Change in claims estimates 612,816 39,218 (5,350) (30,917) 2,951 Net claims incurred on the Company’s insurance policies Share of Facility Association claims incurred 615,767 28,250 644,017 Less net claims payments: Current year claims payments on the Company’s insurance policies Prior year claims payments on the Company’s insurance policies Net claims payments on the Company’s insurance policies Share of Facility Association claims payments 265,096 244,866 509,962 26,498 536,460 Balances, end of year: Unpaid and unreported claims, net of reinsurance Add Reinsurance recoverable Unpaid and unreported claims, gross 1,228,415 68,860 $ 1,297,275 590,758 37,808 7,946 (19,385) 26,369 617,127 28,321 645,448 285,736 215,934 501,670 27,603 529,273 1,120,858 126,105 $ 1,246,963 $ 1,246,963 126,105 1,120,858 2005 $ 1,095,554 90,871 1,004,683 26 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 9. UNPAID AND UNREPORTED CLAIMS AND REINSURANCE RECOVERABLE (continued) The 2006 favourable prior year claims development of $30,917 consists of: $12,558 favourable in automobile lines, mainly for improved third party bodily injury estimates from claims occurring mostly in 2005; $4,431 unfavourable in personal property for homeowners’ personal liability estimates of recent years; and $22,790 favourable in commercial property and casualty, roughly half of which derives from reduced estimates for sexual abuse claims from residential schools from mainly 1959 to 1967 and the other half from better than expected experience on recent years for commercial property and general liability claims. Prior year development recognized in 2006 relates to many prior accident years, however, approximately three quarters of the total development derives from claims occurring in 2005. The favourable development of $19,385 recognized in 2005 consisted of: $22,435 favourable for automobile accident benefits and bodily injury claims mostly occurring in 2004; $2,997 favourable for personal property; and $6,047 unfavourable in commercial property and casualty claims, mainly related to environmental and sexual abuse claims occurring from 1950 to 1980. From time to time the Company purchases annuities from life insurance companies to settle certain obligations to claimants. The Company guarantees the life insurers’ obligations under these annuities, which are estimated to be $179,878 based on the net present value of the projected future cash flows of these guarantees in 2006 (2005 - $176,748). The Company acquires these annuities from reputable credit-worthy life insurance companies whose obligations are insured, within limits, by the Canadian Life and Health Insurance Compensation Corporation. Accordingly, the Company considers its credit risk to be nil. Reinsurance agreements are negotiated with reinsurance companies that have an independent credit rating of “A” or better and that the Company considers credit-worthy. Based on ongoing monitoring of independent credit ratings, the Company assesses the credit risk associated with reinsurance recoverable to be insignificant. 10. OTHER LIABILITIES Other liabilities consist of the following: Accrued expenses and accounts payable Income taxes payable Bank indebtedness Unearned premium finance fee income Accrued other employee future benefits (Note 16) Premiums on deposit Pension liability (Note 16) Other $ 2006 48,386 – 23,049 7,281 6,861 3,857 629 1,602 91,665 $ 2005 56,081 27,050 22,806 8,009 5,569 3,927 256 1,752 $ $ 125,450 27 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 11. INCOME TAXES The Company applies the asset and liability method of accounting for income taxes whereby temporary differences between the tax bases of assets and liabilities and their carrying amounts in the balance sheet are measured at the substantively enacted tax rates for the periods in which the temporary differences are expected to reverse. The future income tax asset is comprised of the following main components: 2006 2005 Portion of net Unpaid and unreported claims not currently deductible Mark-to-market taxation of unrealized gains on investments in shares Deferral and amortization of realized bond gains, for tax purposes Policy acquisition expenses not currently deductible Other Future income taxes $ 19,831 1,668 (3,745) 3,315 1,175 $ 22,244 $ 19,994 2,071 (2,937) 4,149 2,314 $ 25,591 For tax purposes, only 95% of the carrying value of Unpaid and unreported claims, net of Reinsurance recoverable, may be deducted, resulting in prepaid taxation on 5% of the net provision. As a financial institution, the Company is taxed on 100% of the net change in the market value of stocks held directly by the Company. This results in prepaid taxation (advance deduction) of unrealized investment gains (losses) on the Company’s preferred share investments prior to their recognition in reported earnings. As a financial institution, the Company’s realized gains (losses) on disposal of bonds, having a term to maturity of greater than two years or an amount in excess of $5, are deferred and amortized over the disposed bonds’ terms to maturity, for tax purposes. During 2005, Canada Revenue Agency (CRA) adopted the position that it would no longer accept the Company’s deductions of policy acquisition expenses as calculated for accounting purposes. This results in a future tax asset for the prepaid taxation on the difference between the expenses deductible for tax purposes versus accounting purposes. The income tax provision reflects an effective tax rate which differs from the statutory tax rate as follows: 2006 Provision for income taxes based on the combined federal and provincial statutory rate Increase (decrease) due to: Tax-paid dividend income Non-deductible (non-taxable) portion of capital losses (gains) Effect of differences between current and future enacted tax rates on temporary differences Large corporations tax (surtax credit) Other Income tax provision $ 76,090 (4,108) (9,135) 1,832 (459) 115 $ 64,335 35.5% (1.9) (4.3) 0.9 (0.2) 0.1 30.1% 2005 $ 72,767 (4,161) (4,237) 100 93 (43) $ 64,519 35.7% (2.0) (2.1) 0.1 – – 31.7% During 2006, the Company paid income tax instalments and assessments of $96,772 (2005 - $63,579) and received refunds of $1,234 (2005 - $634). Included in the 2006 refund is a loss carry-back recovery of $591. Included in the 2005 refund is a loss carry-back recovery of $63. 28 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 12. ANALYSIS OF NET INCOME Net income is comprised of the following components, net of income tax: 2006 Underwriting income Interest and dividends Gain on sale of investments 2005 $ 49,889 $ 71,430 54,083 47,405 45,551 20,361 $ 149,523 $ 139,196 13. CAPITAL ADEQUACY The Company is required to maintain capital in excess of minimums established through regulatory tests applied by the Office of the Superintendent of Financial Institutions (Canada). The Company has capital and surplus in excess of the required minimum levels. 14. COMMITMENTS AND CONTINGENCIES Future minimum payments under operating leases and other commitments are as follows: 2007 2008 2009 2010 2011 Thereafter $ 13,521 12,402 9,766 8,555 7,155 17,060 $ 68,459 The Company’s leases of office space account for $50,422 of the total commitments. In the normal course of its business, the Company has entered into agreements that include indemnities in favour of third parties, such as purchase and sale agreements, confidentiality agreements, engagement letters with advisors and consultants, outsourcing agreements, leasing contracts, information technology agreements, financing agreements and service agreements. These indemnification agreements may require the Company to compensate the counterparties for damages, losses or costs incurred by the counterparties as a result of breaches in representation, changes in regulations (including tax matters) or as a result of litigation claims or statutory sanctions that may be suffered by the counterparty as a consequence of the transaction. The Company has also agreed to indemnify its current and former directors and certain of its officers and employees in accordance with the Company’s by-laws. These indemnification provisions will vary based upon the nature and terms of the agreements. In many cases, these indemnification provisions do not contain limits on the Company’s liability and the occurrence of contingent events that will trigger payment under these indemnities is difficult to predict. As a result, the Company cannot estimate its maximum potential liability under these indemnities. The Company believes that the likelihood of conditions arising that would trigger these indemnities is remote and, historically, the Company has not made any significant payments under such indemnification provisions. 29 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 14. COMMITMENTS AND CONTINGENCIES (continued) From time to time, the Company is a party to legal proceedings relating to claims, or alleged claims, with respect to insurance policies issued by the Company. Provision has been made in unpaid claims for the expected costs, including legal fees, expected to be payable by the Company as a result of these proceedings. At the present time, the Company is not a party to any significant legal proceedings that are not related to claims. The Company believes the resolution of its legal proceedings will not have a material adverse effect on the Company's financial position. 15. RELATED PARTY TRANSACTIONS In the normal course of business, the Company enters into transactions with its Shareholder and other companies under common control or common influence involving the leasing of office property, investment management services, printing services and miscellaneous office services. Some directors and officers have insurance policies underwritten by the Company. These transactions are made on the same basis and terms as with unrelated parties, and are recorded at exchange amounts. Management has established procedures to review and approve transactions with related parties and reports annually to the Conduct Review Committee of the Board of Directors on the procedures followed and the results of the review. 16. EMPLOYEE FUTURE BENEFIT PLANS The Company has a defined contribution staff pension plan which is available to all employees. Each employee is required to contribute 4.0% of salary and may voluntarily contribute an additional amount up to 1.5% of salary (to a maximum of 5.5% of salary in total). Under the plan, the Company matches all employee contributions. Through representation on a Pension Investment Committee, employees monitor the management of the assets of the plan. Pension expense for the staff defined contribution plan was $2,873 (2005 - $2,654). Total cash payments for employee future benefits for 2006, consisting of cash contributed by the Company to its defined benefit pension plans, cash payments directly to beneficiaries for its unfunded other benefit plans, cash contributed to its defined contribution plan and payment to third party service providers on behalf of the employees were $4,424 (2005 - $6,246). Effective May 1, 1994 the Company converted its former defined benefit staff pension plan to the existing defined contribution pension plan with all defined benefit accruals ceasing on that date. Most employees elected to convert their defined benefit commuted values to the defined contribution plan. Employees who retained their defined benefit entitlement are entitled to receive a pension from the Company or have their commuted values transferred out of the plan. The Company also provides a defined benefit final average earnings pension plan for executives. In addition, the Company provides retirement health care coverage and other future benefits to qualifying retired employees, on an unfunded basis. The Company measures its accrued benefit obligations and the fair value of plan assets for accounting purposes as at December 31 of each year. The most recent and next required actuarial valuations of the staff and executive pension plans are as follows: Recent Valuation Date Staff Pension Plan Retiree Health Benefits Executive Pension Plan January 1, 2006 January 1, 2006 December 31, 2006 30 Next Valuation Date January 1, 2009 January 1, 2009 December 31, 2007 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 16. EMPLOYEE FUTURE BENEFIT PLANS (continued) In the following table, Pension Benefit Plans encompass the remaining curtailed defined benefit obligations under the staff plan and the executive pensions: Other Employee Pension Benefit Plans Future Benefit Plans 2006 2005 2006 2005 Accrued benefit obligation Balance at beginning of year $ 14,822 $ 14,302 $ 11,078 $ 9,220 Current service cost 569 424 366 417 Employee contributions – 299 – – Interest cost 719 792 564 522 Benefits paid (560) (193) (301) (337) Actuarial loss (gain) (1,710) 824 (2,138) 1,256 Settlement – (1,626) – – Balance at end of year $ 13,840 $ 14,822 $ 9,569 $ 11,078 Plan assets Fair value at beginning of year Actual return on plan assets Employer contributions Employee contributions Benefits paid Settlement Fair value at end of year Funded status – plan surplus (deficit) Unamortized net actuarial loss (gain) Unamortized past service cost Unamortized transitional obligation (asset) Accrued benefit asset (liability) $ 11,530 897 1,237 – (560) – $ 13,104 $ (736) 4,389 – (1,827) $ 10,935 460 1,655 299 (193) (1,626) $ 11,530 $ (3,292) 5,897 – (1,229) $ 1,376 $ 424 792 (460) 824 2,055 $ – – – – – – – $ – – – – – – – $ $ $ (9,569) 1,219 – 1,489 $ (6,861) $ 366 564 – (2,138) – $ (11,078) 3,594 – 1,915 $ (5,569) $ 417 522 – 1,256 – 2,195 $ 1,826 Net benefit cost (income) Current service cost $ 569 Interest cost 719 Actual return on plan assets (897) Actuarial loss (gain) (1,710) Settlement loss (gain) – Employee future benefit cost (income) prior to adjustments to recognize long-term nature of employee future benefit costs $ (1,319) Adjustments to recognize long-term nature of employee future benefit costs: Difference between expected return and actual return on plan assets Difference between net actuarial loss (gain) recognized and actual actuarial loss (gain) Amortization of transitional obligation (asset) Net benefit cost (income) $ $ 3,635 $ (1,208) $ 485 1,023 598 787 26 (328) (142) $ 3,191 $ – 2,375 426 1,593 $ – (1,107) 426 1,514 31 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 16. EMPLOYEE FUTURE BENEFIT PLANS (continued) The accrued benefit asset (liability), net of valuation allowance, is included in the Company’s Balance Sheet as follows: Pension Benefit Plans 2006 2005 $ 2,455 $ 1,632 (629) (256) $ 1,826 $ 1,376 Other Employee Future Benefit Plans 2006 2005 $ – $ – (6,861) (5,569) $ (6,861) $ (5,569) Other assets Other liabilities Included in the above are the following accrued benefit obligations and fair values of plan assets for those plans that are not fully funded: Pension Benefit Plans 2006 2005 $ (4,618) $ (5,496) 2,522 2,593 $ (2,096) $ (2,903) Other Employee Future Benefit Plans 2006 2005 $ (9,569) $ (11,078) – – $ (9,569) $ (11,078) Accrued benefit obligation Fair value of plan assets Funded status – plan deficit Defined benefit plan assets consist of: Percentage of Plan Assets 2006 2005 Equity securities Debt securities Refundable tax deposits and cash 36.1% 21.7 42.2 100.0% 36.2% 21.1 42.7 100.0% The average remaining service period of the active employees covered by the pension benefit and other benefit plans as at December 31 is as follows: 2006 Staff Pension Plan Executive Pension Plan Retiree Health Benefits 7.5 years 17.0 years 10.5 years 2005 8.5 years 18.0 years 10.5 years 32 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2006 (dollars in thousands) 16. EMPLOYEE FUTURE BENEFIT PLANS (continued) The following weighted average assumptions were used in actuarial calculations: Other Employee Future Benefit Plans 2006 2005 5.0% n/a 5.0% n/a n/a 5.0% n/a 5.5% n/a n/a Pension Benefit Plans 2006 2005 Accrued benefit obligation as of December 31: Discount rate 5.0% Rate of compensation increase 4.3% Benefit costs for years ended December 31: Discount rate Expected long-term rate of return on plan assets Rate of compensation increase 4.8% 3.6% 4.3% 4.8% 4.9% 5.5% 3.7% 4.9% Assumed health care cost trend rates at December 31: 2006 Initial health care cost trend rate Cost trend rate declines to Year that the rate reaches the rate it is assumed to remain at 6.0% 4.0% 2008 2005 7.0% 4.0% 2008 A one-percentage-point-change in assumed health care cost trend rates would have the following effects for 2006: Increase Accrued benefit obligation Total service and interest cost $ 1,312 $ 149 Decrease $ 1,048 $ 118 33 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY FIVE YEAR FINANCIAL SUMMARY (dollars in thousands) 2006 GROSS PREMIUMS WRITTEN Automobile Property Casualty $ 649,637 317,839 91,250 $ 2005 659,961 328,256 92,318 $ 2004 703,521 330,635 91,687 $ 2003 675,869 306,958 80,001 $ 2002 507,243 246,635 57,666 811,544 $ 1,058,726 STATEMENT OF INCOME Net premiums earned Premium financing fee income Claims Operating expenses, commissions and premium taxes UNDERWRITING INCOME (LOSS) Investment income Gain (loss) on sale of investments INCOME BEFORE INCOME TAXES INCOME TAX PROVISION NET INCOME RATIOS Claims ratio Expense ratio Combined ratio RETURN ON EQUITY BALANCE SHEET ASSETS Investments Other assets $ 2,023,477 606,122 $ 2,629,599 LIABILITIES Unpaid and unreported claims Unearned premiums Other liabilities $ $ 1,080,535 $ 1,125,843 $ 1,062,828 $ $ 1,026,997 13,888 (644,017) (316,512) 80,356 77,578 55,924 213,858 (64,335) 149,523 $ 1,062,156 13,754 (645,448) (319,101) 111,361 67,274 25,080 203,715 (64,519) $ 139,196 $ 1,071,274 12,630 (727,252) (312,060) 44,592 59,065 15,647 119,304 (35,613) $ 83,691 $ 914,844 $ 701,586 11,317 8,876 (663,053) (518,764) (269,106) (5,998) 52,560 (15,823) 30,739 (10,467) (218,543) (26,845) 49,181 10,645 32,981 (10,816) $ 22,165 $ 20,272 62.7% 30.8% 93.5% 22.3% 60.8% 30.0% 90.8% 25.2% 67.9% 29.1% 97.0% 18.4% 72.5% 29.4% 101.9% 5.0% 73.9% 31.2% 105.1% 5.7% $ 1,787,639 728,373 $ 2,516,012 $ 1,478,034 766,956 $ 2,244,990 $ 1,259,956 663,120 $ 1,923,076 $ 1,114,409 482,734 $ 1,597,143 $ 1,297,275 507,572 99,885 1,904,732 $ 1,246,963 518,114 135,591 1,900,668 615,344 $ 2,516,012 $ 1,095,554 539,811 118,477 1,753,842 491,148 $ 2,244,990 $ 879,254 519,498 106,867 1,505,619 417,457 $ 717,464 406,025 76,469 1,199,958 397,185 CAPITAL AND SURPLUS 724,867 $ 2,629,599 $ 1,923,076 $ 1,597,143 34 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY BOARD OF DIRECTORS DUNCAN N.R. JACKMAN President and Chief Executive Officer Chairman OFFICERS President and Chief Executive Officer GEORGE L. COOKE GEORGE L. COOKE Vice President and Chief Information Officer JANET E. BABCOCK Vice President and Chief Actuary Executive Vice President & Chief Operating Officer ONTARIO PENSION BOARD MARK J. FULLER, LL.B. NATHALIE BÉGIN Vice President, Business Process, Delivery and Information ROBERT G. LONG, F.C.A. Corporate Director Counsel Corporate Director JAMES W. McCUTCHEON, Q.C. JERRY DALLA CORTE ALAN J. HANKS Vice President, Field Operations President, RICHARD E. ROONEY, C.A., C.F.A. DEANNA ROSENSWIG Corporate Director BURGUNDY ASSET MANAGEMENT Senior Vice President and Chief Financial Officer R. DOUG HOGAN Partner, S L S CAPITAL Executive Vice President and Chief Financial Officer E-L FINANCIAL CORPORATION LIMITED CLIVE P. ROWE Vice President, Claims Operations NORA P. HOHMAN MARK M. TAYLOR Vice President, Chief Compliance Officer and Corporate Secretary WENDY E. MILLS DOUGLAS C. TOWNSEND, F.S.A., F.C.I.A. President, TOWNSEND ACTUARIAL CONSULTING LTD. Senior Vice President BRIGID MURPHY MANON R. VENNAT, C.M. MANON VENNAT & ASSOCIATES Vice President, Human Resources SHELLY A. RAE THE HONOURABLE HENRY N.R. JACKMAN THE RIGHT HONOURABLE JOHN N. TURNER, P.C., C.C., Q.C. Partner, MILLER THOMSON LLP Honorary Chairman Honorary Director Vice President, Product Development STEVE WHITELAW 35 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY 165 University Avenue Toronto, Ontario M5H 3B9 www.thedominion.ca