S&P Updates Royal SunAlliance USA Group Members

July 17, 2003

Standard & Poor’s commented on the members of the Royal SunAlliance USA group (RSA USA): Royal Insurance Co. of America, Royal Indemnity Co., Connecticut Indemnity Co., Security Insurance Co. of Hartford, American & Foreign Insurance Co., Guaranty National Insurance Co., Fire & Casualty Insurance Co. of Connecticut, Viking Insurance Co. of WI, Safeguard Insurance Co., Globe Indemnity Co., Viking County Mutual Insurance Co., Peak Property & Casualty Insurance Corp., and Guaranty National Insurance Co. Connecticut.

On July 8, Standard & Poor’s revised its outlook on RSA USA to negative from developing. At the same time, Standard & Poor’s affirmed its ‘BBB+’ counterparty and financial strength ratings on these companies.

On July 8, Standard & Poor’s also withdrew its ‘BBB+’ counterparty and financial strength ratings on RSA USA subsidiary Landmark American Insurance Co. at RSA USA’s request. This nonadmitted shell company is expected to be sold by October 2003 to Allegheny Insurance Holdings LLC in conjunction with the group’s recent disposal of ex-managing general agent, Royal Specialty Underwriting Inc. Regulatory approval of the sale is pending.

“The outlook revision reflected Standard & Poor’s concerns that Royal & Sun Alliance Insurance Group PLC (R&SA), the ultimate parent, might not achieve the necessary recovery in operating performance or fully deliver on the group’s restructuring and capital-release program,” explained Standard & Poor’s credit analyst Frederick Loeloff. “These concerns relate primarily to RSA USA’s operations.”

Standard & Poor’s is concerned about RSA USA’s continuous weak operating performance, near-term deficiencies in its capital position, concerns over loss reserve adequacy, and execution risk associated with implementing its business strategy over the next two years. Offsetting these issues are the group’s good market position within the U.S. insurance sector, Royal & Sun Alliance Insurance PLC’s (RSA&IP; RS&A’s main operating company) support of and historical capital contributions to RSA USA, and the expectations of improved capital adequacy and managerial interaction with its U.S. affiliate.

Major Rating Factors
Strategic importance to parent – RSA USA is considered strategically important to RSA&IP’s business model and global spread of business. Although stand-alone operations have weakened considerably over the last two years, RSA USA benefits from ratings enhancement as a strategically important member of a higher rated group. As of Dec. 31, 2002, RSA USA contributed about 22 percent of its parent’s net premium volume and continues to be a modest earnings contributor.

Restructured operations – RSA USA’s continuing efforts to restructure and consolidate its business model should free trapped operating capital while reducing market risk, aggregate exposures, and writings of noncore business lines. Combined with improving pricing discipline and expenditure management, expectations are that underwriting profits and earnings stability will emerge in two to three years.
Uncertain loss-reserve adequacy. Since 1998, RSA USA’s net loss and loss adjustment expense reserves have increased 40 percent because of increased writings, reserves strengthening for asbestos liabilities, and discontinued business lines. Historically, reserves have been deficient and prone to reserve creep. Although management has taken proactive steps to improve the U.S. group’s overall reserve position during the past two years, Standard & Poor’s remains concerned that RSA USA’s loss reserves might be deficient and could take additional strengthening in 2003 or 2004.

Weak capitalization – RSA USA’s capital adequacy ratio – as measured by Standard & Poor’s model – was 70 percent at year-end 2002 and remains well below what is typically required for the rating. Continuous adverse loss-reserve development, historical susceptibility to market risk, and asbestos reserve strengthening have caused unassigned surplus to be negative 74.4 percent of policyholders’ surplus for 2002. They also caused RSA USA’s total surplus to decline $1.58 billion since 1998. To benefit from the ratings enhancement as a strategically important member of a higher-rated group, Standard & Poor’s expects the level of capitalization to improve substantially over the next 18 months.

Material leverage – RSA USA’s capital structure remains highly leveraged and susceptible to both credit and underwriting risks, as the group’s net loss and loss adjustment expense reserves are 3.6x surplus, reinsurance utilization is 41.9 percent, and net writings are 2.3x the group’s surplus base for 2002. In addition, risk-portfolio concentration exists with workers’ compensation (25.0 percent), and two other business lines (private passenger auto and other liability) combined constitute 52.2 percent of RSA USA’s net premium writings for 2002.

Weak operating cash flow – For 2002, RSA USA’s underwriting and operating cash flow ratios were 79.4 percent and 91.2 percent, respectively, which are below the group’s 80.2 percent and 93.3 percent five-year averages. Increased loss costs and high expenses, offset by flat premium collections and investment income, have strained the group’s operating cash flow and diminished its invested asset base over the last four years.

Parent’s restricted financial flexibility – The current capital market environment restricts R&SA’s ability to secure external capital on favorable terms relative to its needs for capital to fund ongoing requirements. The group has also fully utilized its hybrid debt-issuance capacity according to Standard & Poor’s criteria.

Standard & Poor’s believes that both RSA USA and its parent have refocused their efforts to improve RSA USA’s operating performance, capitalization, and business-model execution.

Nevertheless, continued adverse development, large loss events, and loss-cost inflation have all stalled the U.S. group’s ability to improve and stabilize its operating performance and remain as near-term concerns for the ratings on RSA&IP.

For 2003, Standard & Poor’s believes RSA USA will post modest underwriting and earnings improvement, with a combined ratio of about 108 percent and an ROR of about 8.0 percent.

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