THE DOMINION OF CANADA GENERAL INSURANCE COMPANY ANNUAL REPORT

THE DOMINION OF CANADA GENERAL INSURANCE COMPANY ANNUAL REPORT 2005 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY FINANCIAL HIGHLIGHTS (dollars in thousands) 2005 2004 Change GROSS PREMIUMS WRITTEN .................................... NET PREMIUMS EARNED ........................................... $ 1,080,535 $ 1,062,156 $ 1,125,843 $ 1,071,274 (4.0%) (0.9%) NET INCOME ................................................................ RETURN ON EQUITY ................................................... $ 139,196 25.2% $ 83,691 18.4 % LOSS RATIO ................................................................. EXPENSE RATIO .......................................................... COMBINED RATIO ...................................................... 60.8% 30.0% 90.8% 67.9 % 29.1 % 97.0 % (7.1%) 0.9% (6.2%) TOTAL ASSETS ............................................................ $ 2,516,012 $ 2,244,990 12.1% 1 PRESIDENT’S MESSAGE The Dominion’s profit for 2005 is record setting, exceeding the level established last year. The return on equity is 25.2%, a significant accomplishment for which we thank our broker partners and employees. It reflects our discipline and focus on consistent underwriting and risk selection, as well as our concentration on customer service and independent broker relations. 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. We rise 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, it follows that our practices are consistent and our decisions are made with good judgement and common sense and are directed at ‘doing the right thing’ – a term you hear a lot around 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 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. You won’t see The Dominion squandering the opportunity to pick up good, well-priced business because we are busy re-underwriting the policies we piled on in our enthusiasm to grow as prices declined. As we look forward to 2006 and beyond, our challenge will be to remain transparent, while balancing stability and consistency in a market that is constantly changing. In my view, if we could answer the following four questions, we could make very bold and accurate predictions as to what kind of market we will face and what issues we will need to resolve. 1. Will the commercial market continue to soften or are the fundamentals such that we’ve already hit the bottom of a shallow slide? 2. Will the insurance industry be able to restore the confidence of consumers and how can this be accomplished in a changing market? 3. Will the more optimistic projections about the results of auto reforms prove to be correct, or are we enjoying the deceptive honeymoon period experienced with previous legislative changes? 4. To what extent will Independent Brokers participate in the survival of their own channel? Regulatory pressure is containing competitors’ willingness to decrease auto rates. Some may even be planning increases. There are, however, other factors shaping the 2006 market. Economic indicators do not support a return to cash flow underwriting. Casualty trends remain problematic in most classes, while commercial property pricing continues to be perceived as having some redundancy. 2 PRESIDENT’S MESSAGE (continued) The type of market conditions that were experienced in the latter part of 2005 are likely to continue through 2006. Most insurers will continue to take a measured, disciplined approach to commercial pricing. Others will continue to write business they will regret later, for two reasons: because their prices are below the ‘watermark’; and, because they don’t have the expertise to properly underwrite some of this new business. The recent hard market conditions were more extreme and far-reaching than anyone in the industry had experienced previously. When discussing this phenomenon, most industry pundits focus on consumer confidence as being the primary casualty, which is a very important and problematic legacy from that time. We’ll be paying off that debt to the consumer for some time to come. There was, however, a significant and fundamental shift that escaped scrutiny. Brokers and consumers are behaving differently, having endured the difficult experience caused by underwriting and price volatility. They are not ignoring price, but there is an emphasis on value, on stability, and on consistency that is new. That hard market – the one we’d all like to forget – taught consumers more about insurance than all their experience in the last 20 years. We underestimate this new and welcome awareness at our peril. Consumers have a low tolerance for pricing spikes. The Dominion has placed price stability high on its list of ‘must haves’ going forward. We will not squander consumer goodwill by putting ourselves in a position where we come up short on claims reserves and need policyholders to bail us out. Our attitude will make the difference in helping to restore consumer confidence. I am proud to work in this industry for an amazing Canadian company with outstanding employees and business partners. Our industry is woefully misunderstood. Worse, some of us in the industry are presumed to be just like the rest. It is up to each one of us to highlight our value to Canadian consumers. Continued success will come only if those who have the opportunity to lead do so. Auto reform is another 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. This isn’t just an interesting question. Those companies who get it right will have a material advantage over those who do not, assuming there are some of each. Are we enjoying the honeymoon-type post-reform claims activity seen before, where companies can’t believe their good luck and release claim reserves and push hard to get even more business (only to rush just as quickly to get rid of it later as they struggle to fill what appears to be an endless black hole called adverse development in claims reserves)? In the past, the situation was limited to Ontario: just think what kind of market would exist if the misestimates seen following earlier reforms in Ontario were multiplied across the country. Will this turn out to be the case, or are the current reforms really producing much better numbers? It is unwise to conclude without more actual experience. The Dominion has taken a conservative approach and we will continue to do so. However, having said this, The Dominion has reduced auto rates in all jurisdictions where reforms were introduced. For example, in Ontario, The Dominion has filed and received approval for rate reductions of over 17% on average through 2004 and 2005. Rates were reduced in 2005 in Nova Scotia by an average of 17.3% and over 10% on average in Newfoundland and Labrador. In Alberta we successfully opposed the mandatory rate reductions of 6% and 4% for compulsory auto coverages. We subsequently reduced rates for non-compulsory coverages by 10%. The predicted demise of the independent broker channel caused by direct writers and banks has not materialized – quite the opposite in fact – and consumer surveys continue to demonstrate that this is their preferred channel. Consumers overwhelmingly pick an independent advisor 3 PRESIDENT’S MESSAGE (continued) who offers choice. The Canadian market has simply failed to replicate distribution changes seen in other jurisdictions. This has resulted even though banks, direct writers and variations of both have made valiant efforts to lead consumers in this direction. Among the substantive issues related to banks retailing insurance is the segmentation of customer lists on the basis of information that is either prohibited for insurance rating and risk selection or not available to other insurers because of federal versus provincial market conduct regulation differences. As well, a robust opportunity for coercive tied selling presents, particularly given that this term is yet to be satisfactorily defined. Abstinence is thought to be the only effective way to protect the consumers’ interest in this environment. Recently, Canadian market conduct regulators, acting co-operatively through the Canadian Council of Insurance Regulators (CCIR), released a third paper on the subject of managers’ actual or potential conflicts of interest in the insurance industry. Their paper sets out three principles and asks for comment as to how they can best be achieved. The three principles 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). When The Dominion first articulated its strategy in 1992 to distribute solely through independent brokers, we were seen as a dinosaur by some, tagged as being in denial by others, and our rapid demise was predicted widely. Well, like the channel itself, here we are – thriving and growing – and our strategy does not seem to attract the derision it did back then. And, because our broker partners are truly independent and offer choice and professional advice, we are well-positioned to respond to the regulatory concerns of CCIR, in the consumers’ interest. By committing to 'do the right thing', The Dominion is ahead of the regulators. We already conduct business with a true focus on the consumers’ best interests. In 2005, we were approached by Canada Brokerlink (CBL), our largest broker, with the news that our personal lines business would be moved as part of an overall strategy to concentrate CBL’s personal lines business with its new owner, ING Canada Inc. (ING). As a result, The Dominion declined to continue doing business with CBL. Following this decision, The Dominion proceeded to identify and address the issue of independence with other Dominion brokers. Clearly, it doesn’t make sense, nor is it in our shareholder's best interest, to utilize our expertise, human resources and capital to build business that is owned and controlled by a competitor, like ING. We earn the return for our shareholder each year if our broker relationships are profitable, and over time as we provide our brokers access to our capital, human resources and goodwill. Our total return is the combination of period returns and growth derived from the growth of our brokers. If the broker is not independent, and a competitor can and will interfere to deprive our shareholder of the ongoing benefit of the resources we have employed, then that broker relationship makes no sense. We have chosen, for sound economic reasons, to deal only with independent brokers, using a definition of independence relating to control, not the number of markets a broker may represent. An important issue for 2006 is how independent brokers will respond to markets that support them and to those that challenge them. The challenge, of course, is not only from the direct response writers, but it is also from those supporting or creating a competing captive broker or agency distribution mechanism. The Dominion approach is clear and consistent, economically sound and based on a commitment to listen to and respond to consumers while respecting the loyalty and trust shared with our broker partners. 4 PRESIDENT’S MESSAGE (continued) A passive approach to their own survival by independent brokers will undoubtedly lead to a rebranding of what was the independent broker channel that consumers have come to know and trust. This rebranding will resemble a hybrid where independence is forsaken and the strength of the truly independent broker channel is seriously undermined. Nevertheless, I am very optimistic that the entrepreneurial spirit that has made this independent channel so strong, healthy and valued by consumers remains alive, well and vibrant. Early indications are very encouraging. The Dominion continues to invest in its employees, relationships and the infrastructure that allows the company to work to support strong relationships with consumers. An example, but only one of many, is a multi-year investment beginning in 2005 in a new claims management system. When fully implemented, this system will support improved service levels and a better understanding of the costs of our business. With more than $1-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. • 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 aims to inform and assist while incorporating new ideas and events of interest to policyholders, employees and business partners. Among the information featured are a consumer code of rights and responsibilities; a disclosure summary of commission structures and rates and a new informational ‘storyboard’ talking about why consumers should choose The Dominion. Peter Gooderham, former Chairman from 1972-1999, and great-grandson of George Gooderham, a founder of The Dominion, resigned as an Honorary Director of the company in 2005. His dedication, commitment and generous spirit were always appreciated and will be missed. Paul Cantor and Michael White resigned from the Board of Directors in 2005, Mr. Cantor having served for 10 years. We extend our thanks for their advice and guidance. 5 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 2005 was $139.2 million compared to $83.7 million in the prior year. Return on average equity was 25.2% in 2005 compared to 18.4% in 2004. The increased rate of return reflects improved underwriting results and higher realized investment gains in 2005. Underwriting results, at a combined ratio (total expenses divided by net premiums earned) of 90.8 in 2005, improved 6.2 points from 97.0 in the prior year. Despite record catastrophe claims for The Dominion, claims frequency remained historically low and regulatory auto reforms appear to be successfully containing certain claims costs. Strong capital markets in 2005 allowed for realized investment gains of $25.1 million, compared to $15.6 million in 2004. The excess of the market value of investments over their carrying value increased by $34.6 million in 2005, bringing the ending market value excess to $124.5 million ($89.9 million in 2004). Cash flow from operations of $288.9 million in 2005 ($259.8 million in 2004) produced the increase of $290.4 million (17.5%) in year end cash and investments. Total assets increased $271.0 million (12.1%) to $2.5 billion at the end of 2005. Net income for the fourth quarter was $58.7 million compared to $28.6 million in 2004. The increase reflects a significantly lower claims expense and higher investment income and gains compared to the fourth quarter of 2004. The improvement in underwriting results in the fourth quarter of 2005 was mainly due to reductions in provisions for automobile claims, as determined in the year end claims provision analysis. Page 37 provides an overview of financial results and position for the five-year period from 2001 to 2005. Analysis of financial results and condition The following table and commentary analyze The Dominion’s financial results for 2005 and 2004: Commercial Property & Casualty 2005 $ 209 0.5 19 $ 185 $ (96) 52.2 2004 $ 207 9.9 18 $ 181 $ (124) 68.5 2005 $ 1,081 (4.0) 100 $ 1,062 $ (645) 60.8 (319) 14 112 67 25 (65) $ 139 $ Automobile Dollars in millions Personal Property 2005 $ 212 (1.3) 20 $ 202 $ (127) 62.8 2004 $ 215 8.4 19 $ 196 $ (126) 64.3 Total 2004 $ 1,126 5.9 100 $ 1,071 $ (727) 67.9 (312) 13 45 59 16 (36) 84 2005 $ 660 (6.2) 61 $ 675 $ (422) 62.5 2004 $ 704 4.1 63 $ 694 $ (477) 68.8 Gross premiums written Growth rate % Mix of business % Net premiums earned Claims expense Loss ratio % Other expenses Premium finance fee Underwriting income Investment income Realized investment gains Income taxes Net income 6 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 2005 is largely unchanged from the prior year and is as follows: Ontario 69%, Western region 15%, Atlantic provinces 10% and Pacific region 6%. Product mix is fairly consistent across the regions, except that Pacific region’s business is mostly property, due to the government monopoly on 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 in 2005 by 4.0% (growth of 5.9% in 2004) as a result of a 2.1% decrease from Facility Association premiums (negligible in 2004), a 1.2% decrease in policies written (1.5% increase in 2004) and a 0.7% decline in average premiums (4.4% increase in 2004). Premium rates for personal auto have continued to decline in 2005 and average commercial premiums began to decrease in 2005, reflecting competitive price softening. After three consecutive years of policy growth, the 1.2% decrease in 2005 policies written reflects three factors. Two of the factors, decreases in automobile and personal property policies, are discussed below under those headings. The other factor accounts for 0.6% of the 2005 decrease and will have a greater effect on 2006 premiums. A large brokerage, Canada Brokerlink, was recently acquired by ING Canada Inc., and initiated the concentration of its personal lines volume to ING. As a result, The Dominion’s broker agreement with Canada Brokerlink was terminated. This results in the loss (non-renewal) of $45 million in annual written premiums, of which $7.2 million began to be non-renewed with The Dominion in the fourth quarter of 2005. The remaining $37.8 million is expected to run off in 2006. (Some non-renewed policyholders moved their business to other Dominion brokers and obtained a new policy with The Dominion. These “win-backs” returned to The Dominion $1.6 million of the cancelled $7.2 million written premium in the fourth quarter of 2005.) In response to termination of this broker agreement, management investigated the status of the ownership of its brokerforce and terminated agreements with 10 other brokers who were competitor owned/controlled, counting for an additional $30 million in annualized written premium. 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. Management deems it futile to continue relationships with competitor-owned distributors, only to lose the volume when the competitor turns the broker into a quasi-captive agent. The total reduction in annualized premium volume from all such terminations is $75 million, including the volume lost in 2005, but not including any business that returns to The Dominion. The remaining $67.8 million that will not renew in 2006 equates to a decrease of approximately 6% of premium volume. The Dominion is appointing new brokers (43 in 2005), intending to more than replace the lost policies within a couple years. Adequate profit margin will continue to be the overriding requirement as The Dominion pursues growth opportunities. 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. Gross catastrophe claims amounted to $46.3 million in 2005 ($27.7 million in 2004). The 2005 losses were dominated by one event, the August 19 storm in southern Ontario, which resulted in gross claims of $30.4 million. Due to the size of the loss, The Dominion is recovering a large amount of these claims under its reinsurance treaties. The 2004 gross claims consisted of several storms in Edmonton, Peterborough and southern Ontario, which were each below The Dominion’s catastrophe retention. As a result, the net claims expense to The Dominion was $20.8 million for 2005, compared to $27.7 million in 2004. In addition to the net claims cost, The Dominion paid a reinstatement premium in 2005 of $2.1 million (included as a reduction in Net Premiums Earned) to reinstate, for the remainder of the year, the portion of the catastrophe coverage that was used for the August 19 storm claims. 7 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) Automobile Gross written premiums for automobile declined 6.2% in 2005 as a result of declining Facility Association premiums (3.4%), premium rate decreases on The Dominion’s policies (an average decrease of 2.6%) and a decrease in policies written of 0.2%. Facility Association is a government-mandated insurance pool that is funded by all private auto insurers to provide insurance to drivers who cannot obtain coverage from private insurers. Facility also operates “risk sharing pools” in some provinces into which insurers may transfer qualifying policies which they have issued directly. The insurer services the policy and settles any claims but the financial results are borne by the risk sharing pool. 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. Facility’s 2005 premiums decreased from rate decreases. The Dominion reduced its own auto rates in 2005 in every jurisdiction as regulators continued to manage rates downward, concurrent with recent regulatory controls on claims costs and in light of insurers’ current high profits. The Dominion’s written policy decrease of 0.2% includes a 0.6% decrease from the net non-renewed Canada Brokerlink policies and is net of a further reduction resulting from policies that are ceded by The Dominion into Facility Risk Sharing Pools. On a gross basis, before ceding and excluding the terminated relationship, The Dominion’s written auto policies increased 2.5%, mainly from Alberta. However, The Dominion ceded to Facility’s Alberta Risk Sharing Pool a large number of policies because, in management’s view, their premiums were capped below adequate levels by the Alberta government’s new rating “grid” that caps premium rates, generally for younger or higher risk drivers. The large improvement in the 2005 auto loss ratio is mainly due to reductions in provisions for prior year claims, especially 2004 claims, in light of favourable emerging experience with the recent regulatory changes. Included in the net reductions for prior year claims are increases for Ontario accident benefits claims mostly occurring prior to the Ontario government’s 2003 reforms. Facility Association business allocated to The Dominion decreased The Dominion’s auto loss ratio by 0.6 points in 2005 (decrease of 0.2 points in 2004). Most of the improvement in Facility results also reflects favourable development of prior year provisions. The loss ratio for accident year 2005 (claims that have occurred in 2005, divided by 2005 net earned premiums) deteriorated from the 2004 accident year loss ratio (as re-measured in 2005), showing an underlying deterioration on auto business. Average premiums earned have declined slightly in 2005. Although still low, claims frequency increased slightly in 2005 after many years of decline. The increase in frequency was lower than expected and management believes frequency was contained by the sharp increase in fuel costs which reduces vehicle usage. More smaller value claims are beginning to be submitted as consumers see the industry easing rates and offering “accident forgiveness” in response to recent regulatory measures to contain certain claim costs. The Dominion expanded its “accident forgiveness” program in the fourth quarter of 2005. In 2006, average earned premiums will continue to decline. Management expects the loss ratio to increase in 2006 due to reduced rate levels, continued claims cost inflation and increased claims frequency. Personal property Personal property premiums decreased 1.3% in 2005 (compared to growth of 8.4% in 2004) consisting of a 1.0% increase in average premium (8.5% increase in 2004), offset by a 2.3% decrease in policies written (decrease of 0.1% in 2004). The net non-renewals from the termination of the relationship with Canada Brokerlink account for approximately one quarter of the decrease in 2005. The Dominion’s personal property rates are on the high side of the market range which resulted in reduced retention across all regions. British Columbia’s policies declined by 9% because of pricing and because The Dominion is 8 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) holding to its minimum deductible for earthquake coverage while some competitors are offering lower deductibles. Competitive conditions contained rate increases in 2005 but a decrease in average written premiums is expected for 2006. The improvement in the 2005 loss ratio reflects reduced catastrophe claims, net of reinsurance, in 2005 versus 2004. The 2005 net catastrophe claims added $16.2 million to personal property claims (8.0 points of loss ratio). Last year’s claims included $22.8 million (11.7 points) of catastrophe claims. Also, reductions in prior year claims estimates (compared to increases in 2004) reduced the 2005 loss ratio by a further 3.1 points. These favourable effects were largely offset by an underlying increase in claims frequency of 8% in 2005. Declining earned premiums and an increasing trend in claims frequency are expected to increase the loss ratio in 2006. Commercial property, casualty and surety 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. Growth of 0.5% consists of an average premium decrease of 0.3% (increase of 7.3% in 2004) and an increase in policies of 0.8% (increase of 2.6% in 2004). Ongoing competitive price pressure has flattened rates in 2005 and is expected to reduce average rates in 2006. The 16.3 point decrease in the loss ratio is mostly due to the level of increases made to prior year provisions; they were much lower in 2005 than in 2004. In addition, average earned premiums increased slightly and frequency decreased slightly in 2005 compared to 2004. Provisions for prior year claims were increased $6.0 million in 2005 (3.3 points) compared to $31.3 million (17.2 points) in 2004. (These amounts are stated on a discounted basis. Last year’s Management’s Discussion and Analysis stated the 2004 effect as approximately 20 points, which was on an undiscounted basis.) The increases in prior year provisions mainly relate to environmental pollution and sexual molestation liability claims occurring from 1950 to 1980. Estimating these provisions is highly judgemental. These cases tend to be complicated and subject to a lengthy legal process. Recent developments on some cases have caused management to increase estimates in the last several years. In 2006, average rates are expected to decline which would increase the loss ratio. Expenses Broker commissions and premium taxes comprise approximately two thirds of expenses and vary directly with premiums. 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. Contingent profit bonuses vary with profitability and can produce variation in annual expense ratios. After decreasing in six out of the last seven years, The Dominion’s expense ratio increased in 2005 by 0.9 points to 30.0%, from 29.1% in 2004. Expenses increased by $7.0 million (2.3%) whereas net premiums earned decreased by 0.9%. Contingent profit bonus (CPB) expense is higher than last year producing an increase of 0.9 points in the expense ratio. A cap to the total CPB payout had been instituted in 2004 but this put The Dominion’s program out of line with competitors; the cap was removed in 2005 resulting in the higher payout. Salaries and benefits are also higher, producing an increase of 0.8 points of net premiums earned. Base commission expense as a percent of net premiums earned is lower in 2005 because the 2004 expense included the one-time effect of a reduction in the level of commissions being deferred on the balance sheet, compared to previous years. 9 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) Investments Investment income (interest and dividends) before income tax was $67.3 million in 2005, compared to $59.1 million in 2004. The increase reflects an 18.0% increase in the average portfolio balance (17.6% increase in 2004). The average yield in 2005 was 3.6% compared to 3.7% in 2004. Portfolio growth came from net income, growth in unpaid claims and a reduction in Due from Facility Association (The Dominion’s share of a return of funds from Facility). With volume stabilizing, The Dominion’s average portfolio balance is expected to grow modestly next year. The average yield is expected to decrease slightly. Realized gains and losses result from trading decisions which intend to maximize the ongoing economic return of The Dominion’s portfolios and, accordingly, do not follow a predictable pattern from year to year. Strong stock markets allowed for a healthy level of realized investment gains of $25.1 million in 2005, mostly from stocks, compared to a realized net investment gain of $15.6 million in 2004. The Dominion’s exposure to common shares consists of units in pooled funds of a third party investment manager. Unrealized gains also increased by $34.7 million during 2005 as a result of rising share prices. Liquidity and capital resources For a P&C insurer, adequate liquidity requires generating sufficient cash and investments to fund policy liabilities, including sufficient shareholder capital to act as a buffer for any shortfall, and managing the maturity profile (or ability to sell investments) to pay liabilities as they come due. Cash flow from operations remained high in 2005 at $288.9 million, compared to $259.8 million in 2004. The Dominion paid dividends of $15.0 million in 2005 (2004 – $10 million). As explained in the “Risk management” section, the duration of investments and unpaid claims are on the conservative end of management’s range for managing liquidity and maturity profile. At December 31, 2005 the investment portfolio mix included 14% in cash and short-term investments (2004 - 17%), 58% in bonds (2004 - 53%) and 27% in common and preferred stocks (2004 - 29%). As at December 31, 2005, 40% of the bond portfolio is scheduled to mature 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 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, 2005, The Dominion held over $200 million of capital above the regulator’s supervisory minimum. The Dominion’s capital ratio (capital available divided by capital required) increased to an estimated 237% for 2005, from 206% in 2004, as a result 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). 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 paid out 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 10 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) 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 latest cycle ended in 2004 (or may prove to have lasted until 2005), marked by a downturn in cyclical results. Profits and capital are very strong, but are expected to decline as price competitiveness is emerging moderately. The moderation seems to stem from continued regulatory pressure and from a lack of consensus regarding the extent to which auto reforms will prove to contain costs as intended. Regulators continue to suppress auto rates through the rate approval process. Concern over maintaining rate adequacy and a return of claims frequency is helping temper the price competitiveness that is emerging. The majority of insurers, like The Dominion, are price-takers. No insurer is 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. The Dominion’s growth strategy is not focused on market share or absolute size, as an end. Economies of scale are elusive in the P&C market and there continues to be many players, causing excessive competition and extreme soft/hard market swings. 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, management’s annual growth targets are established with a view 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 continue to build a culture where quality service and continuous improvement are valued and rewarded. 11 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 the fact that it is frequently changed by the 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, subject to targets established by management. Our pricing strategy is to be fair to our policyholders, while obtaining price adequacy in each segment, as the market allows. Standard P&C products are, however, very price sensitive and management considers carefully 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. As discussed above in the “Analysis of financial results and condition”, The Dominion is responding to 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 both 2005 and 2004, the discount rate was reduced, resulting in additional prior year claims expense of $7.9 million and $10.9 million, respectively. As of December 31, 2005, the impact of an additional 1% decrease (increase) in the weighted average discount rate would result in an increase (decrease) in the 2005 net Unpaid and 12 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) unreported claims carrying value of $26.3 million and a decrease (increase) in net income of $16.9 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 2005, provisions for The Dominion’s unpaid claims arising in prior years were decreased by $19.4 million, which is included as a decrease in claims expense in 2005 ($32.9 million increase to expense in 2004). The net reduction in estimates in 2005 results from the release (decrease) of margins for adverse development, which are standard components of actuarial claims provisions, which exceeded increases (deterioration) in the underlying ‘best estimates’ of claims provisions. Best estimates were increased mainly for general liability, as explained above under the heading “Commercial property, casualty and surety” and for Ontario accident benefit claims, as discussed above under the heading “Automobile”. 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 auto 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. At December 31, 2005, the net present value of remaining obligations under The Dominion’s structured settlements is estimated to be $176.7 million ($182.0 million in 2004). 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 $400 million in 2005. Given increased uncertainty with catastrophe modelling assumptions, as highlighted by the wide ranges of model predictions for the severe US hurricanes in 2005, management increased the catastrophe limit to $500 million for 2006. Reinsurance treaties typically renew annually and the terms and conditions are reviewed by the reinsurance committee and reported to the Board. Only reinsurers who 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 13 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) levels have been increased in recent years to maintain service levels for our increased customer base and to staff important technology projects. Staff levels were increased in 2005 mainly to address increasing regulatory requirements and to resource more technology projects. The Dominion’s human resource management practices focus on providing a positive work experience and maintaining a performancebased compensation program that is in line with the industry. Annual performance appraisals, annual salary review, and bonus programs covering all levels 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 2005 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, improving access to decision-valuable information for staff and 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, 2005, the bond duration of 3.8 years is 103% of the net unpaid claims duration (2004 - 132%). The bond duration decreased to 3.8 years, from 4.5 years in 2004, due to defensive positioning in light of an expected increase in the market yield curve. 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. A 1% increase (decrease) in the market yield would result in an estimated decrease (increase) of $44.2 million in the market value of bonds and debentures as of December 31, 2005. 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 $0.3 increase (decrease) in net income in 2006. 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. 14 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) 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. 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 “peer 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 claim balance (that is, unpaid and unreported claims net of reinsurance recoverable) would result in a change in claims expense of $56.0 million ($36.4 million after tax). In addition to claims liabilities are 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 15 MANAGEMENT’S DISCUSSION AND ANALYSIS (continued) 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. 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. The exceptional results of 2005 reflected the tail end of the hard market phase of the cycle. Rate levels remained adequate and claims frequency continued to be low. Continued strong stock markets buoyed the investment return. Nevertheless, the industry’s profit drivers have turned downward: average premiums continue to decline, the multi-year decline in claims frequency has bottomed out and the capital markets are not likely to maintain their strong performance. Earnings are expected to remain acceptable but decline in 2006, for the industry and for The Dominion. This soft phase of the cycle is not expected to be long or severe, given the moderating effect of regulatory price pressure on automobile and global reinsurance pricing on commercial 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. February 10, 2006 16 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 Vice President, 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 make use of 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 17 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY AUDITORS’ AND ACTUARY’S REPORTS 2005 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, 2005 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, 2005 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 10, 2006 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, 2005 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 10, 2006 18 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY BALANCE SHEET DECEMBER 31, 2005 (dollars in thousands) 2005 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) .................................................................... $ 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 LIABILITIES Unpaid and unreported claims (Note 9) ....................................................... Unearned premiums .................................................................................... Premium taxes ............................................................................................. Due to reinsurance companies .................................................................... Other liabilities (Note 10) ............................................................................. $ 1,246,963 518,114 7,575 2,566 125,450 1,900,668 SHAREHOLDER’S EQUITY Share capital Authorized - 800 common shares without par value Issued - 404 common shares .................................................................. Contributed surplus ...................................................................................... Retained earnings ........................................................................................ $ 1,095,554 539,811 9,020 2,481 106,976 1,753,842 $ 1,478,034 181,677 9,581 254,266 86,144 90,871 4,352 7,990 99,587 10,337 2,591 19,560 $ 2,244,990 2004 1,010 9,710 604,624 615,344 $ 2,516,012 1,010 9,710 480,428 491,148 $ 2,244,990 Approved by the Board: Duncan N.R. Jackman Chairman of the Board George L. Cooke President and Chief Executive Officer 19 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY STATEMENT OF INCOME AND RETAINED EARNINGS YEAR ENDED DECEMBER 31, 2005 (dollars in thousands) 2005 UNDERWRITING REVENUE Gross premiums written (Note 7) ................................................. Reinsurance ceded ....................................................................... Net premiums written .................................................................... Decrease (increase) in unearned premiums ................................. Net premiums earned .................................................................... Premium finance fee income ........................................................ 2004 $1,080,535 (40,031) 1,040,504 21,652 1,062,156 13,754 1,075,910 $1,125,843 (35,571) 1,090,272 (18,998) 1,071,274 12,630 1,083,904 EXPENSES Claims .......................................................................................... Commissions ................................................................................ Operating ...................................................................................... Premium taxes .............................................................................. 645,448 197,651 85,168 36,282 964,549 727,252 197,323 80,204 34,533 1,039,312 44,592 UNDERWRITING INCOME ................................................................ INVESTMENT INCOME Interest and dividends .................................................................... Gain on sale of investments........................................................... 111,361 67,274 25,080 92,354 59,065 15,647 74,712 119,304 Net Income before income taxes .......................................................... Income tax provision (Note 11) Current .......................................................................................... Future ............................................................................................ 203,715 70,550 (6,031) 64,519 41,627 (6,014) 35,613 83,691 NET INCOME (Note 12) ................................................................... 139,196 RETAINED EARNINGS Beginning of year ........................................................................... Dividends paid ............................................................................... End of year .................................................................................. 480,428 (15,000) $ 604,624 406,737 (10,000) $ 480,428 20 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY STATEMENT OF CASH FLOWS YEAR ENDED DECEMBER 31, 2005 (dollars in thousands) 2005 2004 OPERATING ACTIVITIES Net income ........................................................................................... Items not affecting cash Increase in unpaid and unreported claims ....................................... Increase in reinsurance recoverable ................................................ Decrease (increase) in unearned premiums .................................... Decrease (increase) in reinsurers' portion of unearned premiums .. Decrease in deferred policy acquisition expenses ........................... Gain on sale of investments ............................................................ Future income taxes ........................................................................ Amortization ..................................................................................... $ 139,196 151,409 (35,234) (21,697) 45 2,061 (25,080) (6,031) 1,752 206,421 $ 83,691 216,300 (21,751) 20,313 (1,314) 2,902 (15,647) (6,014) 1,200 279,680 (19,908) 259,772 Net change in other non-cash items ..................................................... Net cash provided by operating activities ............................................. INVESTING ACTIVITIES Purchase of investments ...................................................................... Proceeds from sale of investments ...................................................... Proceeds from repayment of mortgage receivable ............................... Net purchase of capital assets ............................................................. Net (purchase) sale of short-term investments ..................................... Net cash used in investing activities ..................................................... FINANCIAL ACTIVITIES Dividends paid ....................................................................................... 82,482 288,903 (680,799) 413,974 – (9,706) (16,899) (293,430) (405,962) 191,694 4,701 (4,742) 7,220 (207,089) (15,000) (10,000) (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS ........... NET CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR ........... NET CASH AND CASH EQUIVALENTS, END OF YEAR ....................... (19,527) 159,196 $ 139,669 42,683 116,513 $ 159,196 Comprised of: CASH AND CASH EQUIVALENTS ...................................................... BANK INDEBTEDNESS (Note 10) ....................................................... NET CASH AND CASH EQUIVALENTS .............................................. $ 162,475 (22,806) $ 139,669 $ 181,677 (22,481) $ 159,196 21 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (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 $654,985 (2004 - $698,811), 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 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. 22 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (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, 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 auto insurers. Due from Facility Association represents the Company’s share of the assets of the Facility Association 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. 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. The Dominion relies on Facility’s reports in recording its share of Facility results. Reinsurance The Company enters into reinsurance agreements with other insurers in order to limit its exposure to significant losses. Reinsurance does not relieve the Company of its primary liability as the originating insurer. Reinsurance recoveries on claims incurred are recorded as a reduction in Claims in the Statement of Income and Retained Earnings with the unpaid portion recorded as Reinsurance recoverable in the Balance Sheet. Reinsurance recoverable is valued on a discounted basis in accordance with accepted actuarial practice in Canada. Reinsurance premiums are recorded as a reduction in Net premiums earned in the Statement of Income and Retained Earnings with the unearned portion recorded as Reinsurers’ portion of unearned premiums in the Balance Sheet. 23 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (dollars in thousands) 3. SIGNIFICANT ACCOUNTING POLICIES (continued) 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 over their estimated useful life. Unpaid and unreported claims Unpaid and unreported claims is 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, accordingly, 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 straightline basis over the average remaining service period of employees expected to receive benefits under the benefit plan as of January 1, 2000. 24 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (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 the enactment or substantive enactment. 4. INVESTMENTS 2005 Gross Unrealized Gains Losses $ 34,052 85,700 6,325 – 2,678 – 128,755 $ 4,248 – – – – – 4,248 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 Market Value $ 1,152,013 514,868 104,995 22,002 4,266 114,002 $ 1,912,146 $ $ Cost Bonds and debentures Common shares Preferred shares Commercial loans Rental properties Short-term investments $ 877,412 378,831 104,197 19,075 1,416 97,103 $ 2004 Gross Unrealized Gains Losses 32,685 46,050 8,352 – 3,497 – 90,584 $ 731 – – – – – 731 $ Market Value 909,366 424,881 112,549 19,075 4,913 97,103 $ 1,478,034 $ $ $ 1,567,887 25 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (dollars in thousands) 4. INVESTMENTS (continued) Canadian federal and provincial bonds comprise 52% (2004 - 56%) of the Company’s bonds and debentures. Bonds and debentures have the following maturity profile: 17% within one year (2004 - 13%), 56% between one and five years (2004 - 44%), 27% five years and over (2004 - 43%). The average effective interest rate on bonds and debentures is 4.5% (2004 – 4.9%) and the portfolio duration is 3.8 years (2004 - 4.5 years). The estimated impact of a 1% increase (decrease) in the market yield would be a $44,250 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 $494 increase (decrease) in investment income in 2006. 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 5.0 years (2004 – 5.0 years). These loans generally commit the borrower to maintain a minimum premium volume with the Company subject to the best interests of their customers. Interest rates are generally fixed for the term but, in some cases, vary with volume commitments. The average interest rate of these loans is 5.7% (2004 – 5.9%). The investment in common shares consists of units in three 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 $1,946 (2004 - $1,746). 5. CAPITAL ASSETS 2005 Accumulated Amortization $ 6,320 1,445 6,345 14,110 2004 Net Book Value $ 4,029 1,056 5,252 $ 10,337 Cost Office properties Furniture and equipment Computer systems and applications $ 10,869 4,536 16,195 $ 31,600 Net Book Value $ 4,549 3,091 9,850 $ $ 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 $2,480 (2004 - $1,396) is included in the Statement of Income and Retained Earnings. 26 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (dollars in thousands) 6. OTHER ASSETS Other assets consist of the following: 2005 Pension asset (Note 16) Other $ $ 1,632 1,674 3,306 $ $ 2004 1,312 1,279 2,591 7. GROSS PREMIUMS WRITTEN Gross premiums written was derived from the following principal lines of business: 2005 Gross premiums written Automobile Property Casualty $ 659,961 328,256 92,318 $1,080,535 2004 $ 703,521 330,635 91,687 $1,125,843 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 $40,423 representing the Company’s share of Facility Association business (2004 - $65,851). 8. REINSURANCE In the normal course of business, the Company enters into excess of loss and facultative reinsurance agreements in order to limit its exposure to unusual losses. Under these agreements the Company’s exposure to claims occurring in 2005 was limited as follows: $3,000 for an automobile claim; $1,000 for personal and commercial property claims; $1,250 for a casualty claim; and $2,500 for a surety claim. The Company’s catastrophe reinsurance arrangements provided coverage up to $400,000, 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 $40,076 (2004 - $34,257) and are included as reductions in Net premiums earned. 27 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (dollars in thousands) 9. UNPAID AND UNREPORTED CLAIMS AND REINSURANCE RECOVERABLE Unpaid and unreported claims and Reinsurance recoverable can be classified as follows: Gross Short term Medium term Long term Facility Association $ 139,720 758,080 269,035 80,128 $1,246,963 2005 Reinsurance Recoverable $ 30,762 86,291 9,052 – 126,105 Gross 2004 Reinsurance Recoverable $ 12,851 65,581 12,439 – 90,871 $ 121,009 661,077 234,058 79,410 $1,095,554 $ $ 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 3.7 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 2.50% (2004 - 2.50%), for medium term claims is 4.25% (2004 – 4.50%) and for long term claims is 4.75% (2004 – 5.50%). The average discount rate used by the Facility Association was 3.26% (2004 – 3.65%). The impact of a 1% decrease (increase) in the weighted average discount rate is an increase (decrease) in the 2005 net Unpaid and unreported claims carrying value of $26,284 (2004 – $21,247). Given the absence of an active market for the sale of claims liabilities, the actuarially discounted carrying values for Unpaid and unreported claims and Reinsurance recoverable provide an appropriate representation of fair value. 28 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (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: 2005 2004 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 $ 1,095,554 90,871 1,004,683 $ 879,254 69,120 810,134 590,758 37,808 7,946 (19,385) 26,369 605,284 34,944 10,870 32,886 78,700 683,984 43,268 727,252 Net claims incurred on the Company’s insurance policies Share of Facility Association claims incurred 617,127 28,321 645,448 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 285,736 215,934 501,670 27,603 529,273 279,333 221,505 500,838 31,865 532,703 Balances, end of year: Unpaid and unreported claims, net of reinsurance Add Reinsurance recoverable Unpaid and unreported claims, gross 1,120,858 126,105 $ 1,246,963 1,004,683 90,871 $ 1,095,554 The change in prior year claims estimates of $19,385 consists of decreases in estimates for automobile claims of $22,435, mainly for 2004 accident year estimates, decreases in estimates of personal property of $2,997, partially offset by an increase of $6,047 in estimates for commercial property and casualty claims. 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 $176,748 based on the net present value of the projected future cash flows 29 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (dollars in thousands) 9. UNPAID AND UNREPORTED CLAIMS AND REINSURANCE RECOVERABLE (continued) of these guarantees in 2005 (2004 - $181,986). 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: 2005 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 $ 56,081 27,050 22,806 8,009 5,569 3,927 256 1,752 $ 2004 44,460 18,881 22,481 8,192 4,392 4,146 – 4,424 $ 125,450 $ 106,976 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: 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 2004 $ 19,994 2,071 (2,937) 4,149 2,314 $ 25,591 $ 17,986 2,914 (3,492) – 2,152 $ 19,560 30 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (dollars in thousands) 11. INCOME TAXES (continued) 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 on disposal of bonds, having a term to maturity of greater than two years or more than $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: 2005 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) Large corporations tax Other Income tax provision 2004 $ 72,767 (4,161) (4,237) 93 57 $ 64,519 35.7% (2.0) (2.1) 0.1 – 31.7% $ 42,795 (3,774) (2,389) (112) (907) $ 35,613 35.9% (3.2) (2.0) (0.1) (0.7) 29.9% During 2005, the Company paid income tax instalments and assessments of $63,579 (2004 - $33,488) and received refunds of $634 (2004 - $4,131). Included in the 2005 refund is a loss carry-back recovery of $63. Included in the 2004 refund is a loss carry-back recovery of $3,852. 12. ANALYSIS OF NET INCOME Net income is comprised of the following components, net of income tax: 2005 Underwriting income Investment income Gain on sale of investments $ 71,430 47,405 20,361 $ 139,196 2004 $ 29,825 41,640 12,226 $ 83,691 31 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (dollars in thousands) 13. CAPITAL ADEQUACY The Company is required to maintain adequate capital in excess of minimums established through regulatory tests applied by the Office of the Superintendent of Financial Institutions. 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: 2006 $ 11,035 2007 10,283 2008 8,272 2009 6,182 2010 4,441 Thereafter 11,575 $ 51,788 The Company’s leases of office space account for $36,060 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 payment under such indemnification provisions. From time to time, in the normal course of the general insurance business, 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 material legal proceedings that are not in the normal course of its insurance business. 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. 32 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (dollars in thousands) 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. 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 membership on a Pension Investment Committee, employees monitor the management of the assets of the plan. Pension expense for the staff defined contribution plan was $2,654 (2004 - $2,374). Total cash payments for employee future benefits for 2005, 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 $6,246 (2004 - $4,087). 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 Executive IPPs January 1, 2003 January 1, 2003 December 31, 2005 January 1, 2002 to January 1, 2004 Next Valuation Date January 1, 2006 January 1, 2006 December 31, 2006 — The IPPs were curtailed at December 31, 2004 and their assets have been transferred into individual accounts in the staff pension plan and the executive pension plan during 2005. 33 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (dollars in thousands) 16. EMPLOYEE FUTURE BENEFIT PLANS (continued) In the following table, Pension Benefit Plans encompasses the remaining curtailed defined benefit obligations under the staff plan and the executive pensions: Other Employee Pension Benefit Plans Future Benefit Plans 2005 2004 2005 2004 Accrued benefit obligation Balance at beginning of year $ 14,302 $ 10,807 $ 9,220 $ 8,030 Current service cost 424 380 417 339 Employee contributions 299 24 – – Interest cost 792 649 522 494 Benefits paid (193) (269) (337) (261) Actuarial loss (gain) 824 4,826 1,256 618 Settlement (1,626) (2,115) – – Balance at end of year 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) $ 14,822 $ 10,935 460 1,655 299 (193) (1,626) $ 11,530 $ (3,292) 5,897 – (1,229) $ 1,376 $ 14,302 $ 11,015 828 1,452 24 (269) (2,115) $ 10,935 $ (3,367) 6,132 – (1,453) $ 1,312 $ 11,078 $ – – – – – – – $ $ 9,220 – – – – – – – $ $ $ (11,078) 3,594 – 1,915 $ (5,569) $ (9,220) 2,487 – 2,341 $ (4,392) Net benefit cost (income) Current service cost $ 424 Interest cost 792 Actual return on plan assets (460) Actuarial loss (gain) 824 Settlement loss (gain) 2,055 Employee future benefit cost (income) prior to adjustments to recognize long-term nature of employee future benefit costs $ 3,635 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) 26 (328) (142) $ 3,191 $ 380 649 (828) 4,826 236 $ 417 522 – 1,256 – $ 339 494 – 618 – $ 5,263 $ 2,195 $ 1,451 346 (4,692) (157) $ 760 $ – (1,107) 426 1,514 $ – (506) 425 1,370 34 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (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: Other Employee Pension Benefit Plans Future Benefit Plans 2005 2004 2005 2004 Other assets Other liabilities $ 1,632 (256) $ 1,376 $ $ 1,312 – 1,312 $ – (5,569) $ – (4,392) $ (5,569) $ (4,392) Included in the above are the following accrued benefit obligations and fair values of plan assets for those plans that are not fully funded: Other Employee Future Benefit Plans 2005 2004 $ (11,078) – $ (11,078) $ (9,220) – $ (9,220) Pension Benefit Plans 2005 2004 Accrued benefit obligation Fair value of plan assets Funded status – plan deficit $ (5,496) 2,593 $ (2,903) $ (6,326) 2,625 $ (3,701) Defined benefit plan assets consist of: Percentage of plan assets 2005 2004 Equity securities Debt securities Refundable tax deposits and cash 36.2% 21.1 42.7 100.0% 38.3% 25.0 36.7 100.0% 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: 2005 Staff Pension Plan Executive Pension Plan Retiree Health Benefits 8.5 years 18.0 years 10.5 years 2004 9.5 years 16.0 years 10.5 years 35 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 2005 (dollars in thousands) 16. EMPLOYEE FUTURE BENEFIT PLANS (continued) The following weighted average assumptions were used in actuarial calculations: Other Employee Future Benefit Plans 2005 2004 Pension Benefit Plans 2005 2004 Accrued benefit obligation as of December 31: Discount rate Rate of compensation increase Benefit costs for years ended December 31: Discount rate Expected long-term rate of return on plan assets Rate of compensation increase 4.8% 4.9% 5.5% 5.1% 5.0% n/a 5.0% n/a 5.5% 3.7% 4.9% 6.0% 4.1% 5.1% 5.5% n/a n/a 6.0% n/a n/a Assumed health care cost trend rates at December 31: 2005 Initial health care cost trend rate Cost trend rate declines to Year that the rate reaches the rate it is assumed to remain at 7.0% 4.0% 2008 2004 8.0% 4.0% 2008 A one-percentage-point-change in assumed health care cost trend rates would have the following effects for 2005: Increase Accrued benefit obligation Total service and interest cost $ 1,784 $ 206 Decrease $ 1,419 $ 159 17. COMPARATIVE FIGURES Certain of the prior year figures have been reclassified to conform to the presentation adopted in the current year. 36 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY FIVE YEAR FINANCIAL SUMMARY (dollars in thousands) 2005 GROSS PREMIUMS WRITTEN Automobile Property Casualty 2004 2003 2002 2001 $ 659,961 328,256 92,318 $ 703,521 330,635 91,687 $1,125,843 $ 675,869 306,958 80,001 $1,062,828 $ 507,243 246,635 57,666 811,544 $ 414,389 202,103 44,245 $ 660,737 $ 1,080,535 $ 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 $ 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 11,317 (663,053) (269,106) (5,998) 52,560 (15,823) 30,739 (10,467) $ 20,272 $ 701,586 8,876 (518,764) (218,543) (26,845) 49,181 10,645 32,981 (10,816) $ 625,500 7,823 (474,611) (194,755) (36,043) 52,122 40,581 56,660 (22,431) $ 34,229 $ 22,165 RATIOS Claims Ratio Expense Ratio Combined Ratio 60.8% 30.0% 90.8% 67.9% 29.1% 97.0% 72.5% 29.4% 101.9% 73.9% 31.2% 105.1% 75.9% 31.1% 107.0% RETURN ON EQUITY 25.2% 18.4% 5.0% 5.7% 9.5% BALANCE SHEET ASSETS Investments Other assets $ 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 $ 1,030,397 396,832 $ 1,427,229 LIABILITIES Unpaid and unreported claims Unearned premiums Other liabilities $ 1,246,963 518,114 135,591 1,900,668 $ 1,095,554 539,811 118,477 1,753,842 $ 879,254 519,498 106,867 1,505,619 $ 717,464 406,025 76,469 1,199,958 $ 669,008 324,034 59,167 1,052,209 CAPITAL AND SURPLUS 615,344 $ 2,516,012 491,148 $ 2,244,990 417,457 $ 1,923,076 397,185 $ 1,597,143 375,020 $ 1,427,229 37 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY BOARD OF DIRECTORS Chairman OFFICERS President and Chief Executive Officer DUNCAN N.R. JACKMAN President and Chief Executive Officer GEORGE L. COOKE Vice President and Chief Information Officer GEORGE L. COOKE JANET E. BABCOCK MARK J. FULLER, LL.B. Executive Vice President & COO, ONTARIO PENSION BOARD Vice President and Chief Actuary NATHALIE BÉGIN Vice President, General Counsel and Corporate Secretary ROBERT G. LONG, F.C.A. Corporate Director JAMES W. McCUTCHEON, Q.C. Counsel Corporate Director VIVIAN BERCOVICI Vice President, Business Process, Delivery and Information RICHARD E. ROONEY, C.A., C.F.A. President, BURGUNDY ASSET MANAGEMENT JERRY DALLA CORTE Vice President, Field Operations DEANNA ROSENSWIG Corporate Director ALAN J. HANKS Senior Vice President and Chief Financial Officer CLIVE P. ROWE Partner, S L S CAPITAL R. DOUG HOGAN MARK M. TAYLOR Executive Vice President and Chief Financial Officer E-L FINANCIAL CORPORATION LIMITED Vice President, Claims Operations NORA P. HOHMAN Vice President, Risk and Control Services DOUGLAS C. TOWNSEND, F.S.A., F.C.I.A. President, TOWNSEND ACTUARIAL CONSULTING LTD. WENDY E. MILLS MANON R. VENNAT, C.M. MANON VENNAT & ASSOCIATES Senior Vice President BRIGID MURPHY Honorary Chairman THE HONOURABLE HENRY N.R. JACKMAN Vice President, Human Resources Honorary Director SHELLY A. RAE Vice President, Product Development THE RIGHT HONOURABLE JOHN N. TURNER, P.C., C.C., Q.C. Partner, MILLER THOMSON LLP STEVE WHITELAW 38 THE DOMINION OF CANADA GENERAL INSURANCE COMPANY 165 University Avenue Toronto, Ontario M5H 3B9 www.thedominion.ca