Royal Bank of Scotland suffered a setback to its plans to beef up its balance sheet after Zurich Financial pulled out of the auction for its insurance arm yesterday.

RBS hopes to raise as much as £7 billion from the sale of the business, which includes the bestselling Direct Line and Churchill brands.

However, analysts' forecasts of the expected proceeds have been dwindling alongside falling share markets and concerns about the UK economy.

Zurich, a Swiss insurer with large UK operations, announced it had decided to withdraw from further negotiations after a “detailed review”.

Zurich was regarded as one of the most serious contenders for the assets. The German insurers Allianz and the US insurers Allstate and Travelers may still be interested.

Allianz yesterday faced its own setback when Lloyds TSB ended its interest in buying Dresdner, its banking subsidiary. Lloyds is also understood to have backed out of further talks on buying German bank Postbank.

Sir Fred Goodwin, chief executive of RBS, said at the bank's trading update a month ago that talks on selling the insurance arm were ongoing. But he emphasised then that RBS would not deal at fire-sale prices and would not be held to a timetable.

Plans to sell the the insurance division were unveiled alongside RBS's £12 billion rights issue. which was completed last month. RBS, which is being advised by Merrill Lynch, declined to comment.

Lloyds TSB is thought to have pulled back from its German ambitions because the value to be extracted from a deal was less than it had originally thought.

Lloyds, which has been less damaged by the credit crunch than most of its peers, has been exploring acquisition opportunities thrown up by the banking crisis.

It is considered unlikely to be interested in Bradford & Bingley, but has not ruled an opportunistic bid for Alliance & Leicester. The bank has been pushing into UK mortgages and midmarket corporate loans as more challenged rivals pull back.

Dresdner's retail banking business is thought to be worth about €8 billion (£6.3 billion), while Postbank could fetch more. Dresdner is exploring a deal with fellow German bank Commerzbank.

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