The following is a discussion and analysis of RAI's business, initiatives, critical accounting policies and its consolidated results of operations and financial position. Following the overview and discussion of business initiatives, the critical accounting policies disclose certain accounting policies that are material to RAI's results of operations and financial position for the periods presented in this report. The discussion and analysis of RAI's results of operations is presented in two comparative sections, 2008 compared with 2007, and 2007 compared with 2006. Disclosures related to liquidity and financial position complete management's discussion and analysis. You should read this discussion and analysis of RAI's consolidated financial position and results of operations in conjunction with the consolidated financial statements and the related notes as of December 31, 2008 and 2007, and for each of the years in the three-year period ended December 31, 2008.

Overview and Business Initiatives

RAI's reportable operating segments are RJR Tobacco and Conwood. The RJR Tobacco segment consists of the primary operations of R. J. Reynolds Tobacco Company. The Conwood segment consists of Conwood Holdings, Inc., the primary operations of the Conwood companies and Lane. RAI's wholly owned subsidiaries, Santa Fe and GPI, among others, are included in All Other. Some of RAI's wholly owned operating subsidiaries have entered into intercompany agreements for products or services with other RAI operating subsidiaries. As a result, certain activities of an operating subsidiary may be included in a different segment of RAI.

RAI's largest reportable operating segment, RJR Tobacco, is the second largest cigarette manufacturer in the United States. RJR Tobacco's largest selling cigarette brands, CAMEL, KOOL, PALL MALL, DORAL and WINSTON, were five of the ten best-selling brands of cigarettes in the United States as of December 31, 2008. Those brands, and its other brands, including SALEM, MISTY and CAPRI, are manufactured in a variety of styles and marketed in the United States. RJR Tobacco also manages contract manufacturing of cigarettes and tobacco products through arrangements with BAT affiliates. As of January 1, 2008, the contract manufacturing business of GPI was transferred to RJR Tobacco.

RAI's other reportable operating segment, Conwood, is the second largest smokeless tobacco products manufacturer in the United States. Conwood's primary brands include its largest selling moist snuff brands, GRIZZLY and KODIAK, two of the seven best-selling brands of moist snuff in the United States as of December 31, 2008. Conwood's other products include loose leaf chewing tobacco, dry snuff, plug and twist tobacco products. Conwood's products held the first or second position in market share in each category as of December 31, 2008. As a result of combining certain operations of Lane with the Conwood companies in 2007, Conwood began distributing a variety of other tobacco products, including WINCHESTER and CAPTAIN BLACK little cigars, and BUGLER roll-your-own tobacco.

Santa Fe manufactures and markets cigarettes and other tobacco products under the NATURAL AMERICAN SPIRIT brand. On January 1, 2008, the management of RJR Tobacco's super premium brands, including those licensed from BAT, including DUNHILL and STATE EXPRESS 555, was transferred to Santa Fe. During 2008, GPI sold NATURAL AMERICAN SPIRIT in Europe and Japan, as well as exported tobacco products to U.S. territories, U.S. duty-free shops and U.S. overseas military bases. In January 2009, the activities of GPI were transitioned to other operating subsidiaries of RAI. The management and export of tobacco products sold to certain U.S. territories, U.S. duty-free shops and U.S. overseas military bases was transferred to RJR Tobacco and other indirect subsidiaries of RAI began selling NATURAL AMERICAN SPIRIT in Europe and Japan.

RJR Tobacco

RJR Tobacco primarily conducts business in the highly competitive U.S. cigarette market, which has a few large manufacturers and many smaller participants. The U.S. cigarette market is a mature market in which overall consumer demand has declined since 1981 and is expected to continue to decline. Trade inventory adjustments may result in short-term changes in demand for RJR Tobacco's products when wholesale and retail tobacco distributors adjust the timing of their purchases of product to manage their inventory levels. RJR Tobacco believes it is not appropriate for it to speculate on other external factors that may impact the purchasing decisions of the wholesale and retail tobacco distributors.

RJR Tobacco's brand portfolio strategy is based upon three brand categories:
growth, support and non-support. During 2008, RJR Tobacco refined its brand portfolio strategy and reclassified KOOL from a growth brand to a support brand. As a result, the growth brands consist of a premium brand, CAMEL, and a value brand, PALL MALL. Although both of these brands are managed for long-term market share and profit growth, CAMEL will continue to receive the most significant investment support. The support brands include four premium brands, KOOL, WINSTON, SALEM and CAPRI, and two value brands, DORAL and MISTY, all of which receive limited marketing support. The non-support brands, consisting of all other brands, are managed to maximize near-term profitability. The key objectives of the portfolio strategy are to ensure the long-term market share growth of the growth brands while managing the support brands for long-term sustainability and profitability.

Competition is based primarily on brand positioning, including price, product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. Cigarette brands produced by the major manufacturers generally require competitive pricing, substantial marketing support, retail programs and other incentives to maintain or improve market position or to introduce a new brand style. Expanding beyond the cigarette market as an innovative tobacco company, in 2006, RJR Tobacco entered into a category of smokeless, spitless tobacco, known as snus. CAMEL Snus is pasteurized tobacco that is sold in a small pouch that provides convenient tobacco consumption. CAMEL Snus was launched in lead markets beginning in 2006, and is being expanded nationally during the first quarter of 2009. In addition, during 2008, RJR Tobacco announced new smoke-free tobacco products called CAMEL Dissolvables. CAMEL Dissolvables include CAMEL Orbs, Sticks and Strips, all of which are made of finely milled tobacco and dissolve completely in the mouth. CAMEL Dissolvables will be launched in lead markets beginning in the first half of 2009.

RJR Tobacco is committed to building and maintaining a portfolio of profitable brands. RJR Tobacco's marketing programs are designed to strengthen brand image, build brand awareness and loyalty, and switch adult smokers of competing brands to RJR Tobacco brands. In addition to building strong brand equity, RJR Tobacco's marketing approach utilizes a retail pricing strategy, including discounting at retail, to defend certain brands' shares of market against competitive pricing pressure. RJR Tobacco's competitive pricing methods may include list price changes, discounting programs, such as retail buydowns, periodic price reductions, free product promotions and consumer coupons. Retail buydowns refer to payments made to the retailer to reduce the price that consumers pay at retail. Consumer coupons generally are distributed by a variety of methods, including in, or on, the cigarette pack and by direct mail. Free product promotions include offers such as "Buy 2 packs, Get 1 pack free." The cost of free product promotions, including federal excise tax, is recorded in cost of goods sold.

Conwood

Conwood offers a range of differentiated smokeless and other tobacco products to adult consumers. The moist snuff category is divided into premium and price-value brands. The moist snuff category has developed many of the characteristics of the larger, cigarette market, including multiple pricing tiers with intense competition, focused marketing programs and significant product innovation.

In contrast to the declining U.S. cigarette market, U.S. moist snuff volumes grew over 7% in 2008 and have grown at an average rate of approximately 6% per year over the last four years, driven by the accelerated growth of price-value brands. Profit margins on moist snuff products are generally higher than on cigarette products. Moist snuff's growth is partially attributable to cigarette smokers switching from cigarettes to smokeless tobacco products or using both. Within the moist snuff category, premium brands have lost market share to price-value brands, led by the growth of GRIZZLY, in recent years.

Conwood faces significant competition in the smokeless tobacco categories. Similar to the cigarette market, competition is based primarily on brand positioning and price, as well as product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. The parent company of RJR Tobacco's largest competitor in the cigarette market, Philip Morris USA, Inc., completed its acquisition of Conwood's largest competitor, UST, in January 2009.

Critical Accounting Policies and Estimates

Accounting principles generally accepted in the United States, referred to as GAAP, require estimates and assumptions to be made that affect the reported amounts in RAI's consolidated financial statements and accompanying notes. Some of these estimates require difficult, subjective and/or complex judgments about matters that are inherently uncertain, and as a result, actual results could differ from those estimates. Due to the estimation processes involved, the following summarized accounting policies and their application are considered to be critical to understanding the business operations, financial position and results of operations of RAI and its subsidiaries. For information related to these and other significant accounting policies, see Item 8, note 1 to consolidated financial statements.

Litigation

RAI discloses information concerning litigation for which an unfavorable outcome is more than remote. RAI and its subsidiaries record their legal expenses and other litigation costs and related administrative costs as selling, general and administrative expenses as those costs are incurred. RAI and its subsidiaries will record any loss related to litigation at such time as an unfavorable outcome becomes probable and the amount can be reasonably estimated. When the reasonable estimate is a range, the recorded loss will be the best estimate within the range. If no amount in the range is a better estimate than any other amount, the minimum amount of the range will be recorded.

As discussed in Item 8, note 16 to consolidated financial statements, RJR Tobacco, the Conwood companies and their affiliates, including RAI, and indemnitees, have been named in a number of tobacco-related legal actions, proceedings or claims seeking damages in amounts ranging into the hundreds of millions or even billions of dollars. Unfavorable judgments have been returned in a number of tobacco-related cases and state enforcement actions. As of February 6, 2009, RJR Tobacco had paid approximately $12 million since January 1, 2006, related to unfavorable judgments.

RAI and its subsidiaries believe that they have valid bases for appeal of adverse verdicts against them and have valid defenses to all actions and they intend to defend all actions vigorously. RAI's management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, including B&W, or the loss of any particular claim concerning the use of smokeless tobacco against the Conwood companies, when viewed on an individual basis, is not probable or estimable. RJR, including its subsidiary RJR Tobacco, have liabilities totaling $94 million that were recorded in connection with certain indemnification claims, not related to smoking and health, asserted by JTI against RJR and RJR Tobacco, relating to the activities of Northern Brands and related litigation.

Litigation is subject to many uncertainties, and it is possible that some of the tobacco-related legal actions, proceedings or claims could ultimately be decided against RJR Tobacco, the Conwood companies or their affiliates, including RAI, and indemnitees. Any unfavorable outcome of such actions could have a material adverse effect on the consolidated results of operations, cash flows or financial position of RAI or its subsidiaries. For further discussion of the litigation and legal proceedings pending against RAI or its affiliates or indemnitees, see Item 8, note 16 to consolidated financial statements.

Settlement Agreements

RJR Tobacco, Santa Fe and Lane are participants in the Master Settlement Agreement, and RJR Tobacco is a participant in other state settlement agreements related to governmental health-care cost recovery actions. Their obligations and the related expense charges under the MSA are subject to adjustments based upon, among other things, the volume of cigarettes sold by the operating subsidiaries, their relative market share and inflation. Since relative market share is based on cigarette shipments, the best estimate of the allocation of charges to RJR Tobacco under these

agreements is recorded in cost of products sold as the products are shipped. Adjustments to these estimates are recorded in the period that the change becomes probable and the amount can be reasonably estimated. The Conwood companies are not participants in the MSA. For more information related to historical and expected settlement expenses and payments under the MSA, see "- Litigation Affecting the Cigarette Industry- Health-Care Cost Recovery Cases - MSA" and "- MSA - Enforcement and Validity" in Item 8, note 16 to consolidated financial statements.

Intangible Assets

Intangible assets include goodwill, trademarks and other intangibles and are accounted for under Statement of Financial Accounting Standards, referred to as SFAS, No. 142, "Goodwill and Other Intangible Assets." The determination of fair value involves considerable estimates and judgment. In particular, the fair value of a reporting unit involves, among other things, developing forecasts of future cash flows, determining an appropriate discount rate, and when goodwill impairment is implied, determining the fair values of individual assets and liabilities, including unrecorded intangibles. Although RAI believes it has based its impairment testing and impairment charges on reasonable estimates and assumptions, the use of different estimates and assumptions could result in materially different results. Generally, if the current competitive or regulatory environment worsens or RAI's operating companies' strategic initiatives adversely affect their financial performance, the fair value of goodwill, trademarks and other intangibles could be impaired in future periods. See Item 8, note 3 to consolidated financial statements for a discussion of the impairment charges in connection with RAI's ongoing application of SFAS No. 142.

Fair Value Measurement

On January 1, 2008, RAI adopted SFAS No. 157, "Fair Value Measurements," for financial assets and financial liabilities. SFAS No. 157 provides a definition of fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. SFAS No. 157 establishes a fair value hierarchy that distinguishes between market participant assumptions developed based on market data obtained from sources independent of the reporting entity, and the reporting entity's own assumptions about market participant assumptions developed based on the best information available in the circumstances.

On October 10, 2008, the Financial Accounting Standards Board, referred to as FASB, issued FASB Staff Position, referred to as FSP, No. FAS 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active." FSP No. FAS 157-3 clarifies the application of SFAS No. 157, "Fair Value Measurements," in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active.

SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, essentially an exit price.

The levels of the fair value hierarchy established by SFAS No. 157 are:

Level 1: inputs are quoted prices, unadjusted, in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2: inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. A Level 2 input must be observable for substantially the full term of the asset or liability.

Level 3: inputs are unobservable and reflect the reporting entity's own assumptions about the assumptions that market participants would use in pricing the asset or liability.

Investments

As of December 31, 2008, RAI held investments primarily in money market funds, auction rate securities and mortgage-backed securities. During 2008, certain money market funds were reclassified to short-term investments from cash equivalents due to the liquidity restrictions by the fund managers preventing immediate withdrawal. Adverse changes in financial markets caused certain auction rate securities and mortgage-backed securities to

revalue lower than carrying value and become less liquid. Auction rate securities and mortgage-backed securities will not become liquid until a successful auction occurs or a buyer is found. These investments will be evaluated on a quarterly basis to determine if it is probable that RAI will realize some portion of the unrealized loss.

RAI reviews impairments associated with the above in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," FSP No. FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," and FSP No. EITF 99-20-1, "Amendments to the Impairment Guidance of EITF Issue No. 99-20," to determine the classification of the impairment as temporary or other-than-temporary. For additional information relating to these investments, see Item 8, note 9 to consolidated financial statements.

Pension and Postretirement Benefits

RAI and certain of its subsidiaries sponsor a number of non-contributory defined benefit pension plans covering most of their employees, and also provide certain health and life insurance benefits for most of their retired employees and their dependents. These benefits are generally no longer provided to employees hired on or after January 1, 2004. For additional information relating to pension and postretirement benefits, see Item 8, note 19 to consolidated financial statements.

Pension and postretirement expenses and reporting are determined in accordance with the provisions of SFAS No. 87, "Employers' Accounting for Pensions," SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106, and 132(R)." Because pension and other postretirement obligations ultimately will be settled in future periods, the determination of annual expense and liabilities is subject to estimates and assumptions. RAI reviews these assumptions annually based on historic experience and expected future trends or coincidental with a major event and modifies them as needed. Demographic assumptions such as termination of employment, mortality or retirement are reviewed periodically as expectations change.

Gains or losses are annual changes in the amount of either the benefit obligation or the market-related value of plan assets resulting from experience different from that assumed or from changes in assumptions. The minimum amortization of unrecognized gains or losses, as described in SFAS No. 87, is included in pension expense. Prior service costs, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the average remaining service period for active employees, or average remaining life expectancies for inactive employees if most of the plan obligations are due to inactive employees.

The minimum amortization of unrecognized gains or losses, as described in SFAS No. 106, is also included in the postretirement benefit expense. Prior service costs, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the service to expected full eligibility age for active employees, or average remaining life expectancies for inactive employees if most of the plan obligations are due to inactive employees.

Differences between actual results and actuarial assumptions are accumulated and amortized over future periods. In recent years, actual results have varied significantly from actuarial assumptions. In particular, pension and postretirement assets have decreased due to significant decreases in fair value. These changes have resulted in an increase in charges to other comprehensive income (loss). These changes are expected to result in an increase in pension and postretirement expense in future years. The Pension Protection Act may require additional cash funding of the pension obligations in the future.

The most critical assumptions and their sensitivity to change are presented below:

Assumed asset return and discount rates have a significant effect on the amounts reported for the benefit plans. A one-percentage-point change in assumed discount rate for the pension plans and other postretirement plans would have had the following effects:

                                                    1-Percentage Point
                                                         Increase                       1-Percentage Point Decrease
                                              Pension         Postretirement          Pension             Postretirement
                                               Plans              Plans                Plans                  Plans

Effect on 2008 net periodic benefit cost     $     (26 )     $             (6 )    $          16         $              5
Effect on December 31, 2008, projected
benefit obligation and accumulated
postretirement benefit obligation                 (485 )                 (127 )              538                      139

A one-percentage point change in assumed asset return would have had the following effects:

                                                       1-Percentage Point Increase                    1-Percentage Point Decrease
                                                     Pension             Postretirement            Pension              Postretirement
                                                      Plans                  Plans                  Plans                    Plans

Effect on 2008 net periodic benefit cost          $       (51 )           $        (3 )          $      51                 $       3

Income Taxes

Tax law requires certain items to be excluded or included in taxable income at different times than is required for book reporting purposes under SFAS No. 109, "Accounting for Income Taxes." These differences may be permanent or temporary in nature. FASB Interpretation, referred to as FIN, No. 48, "Accounting for Uncertainty in Income Taxes," clarifies SFAS No. 109 by providing guidance for consistent reporting of uncertain income tax positions recognized in a company's financial statements.

RAI determines its annual effective income tax rate based on forecasted pre-tax book income and forecasted permanent book and tax differences. The rate is established at the beginning of the year and is evaluated on a quarterly basis. Any changes to the forecasted information may cause the effective rate to be adjusted. Additional tax, interest and penalties associated with uncertain tax positions are recognized in tax expense on a quarterly basis.

To the extent that any book and tax differences are temporary in nature, that is, the book realization will occur in a different period than the tax realization, a deferred tax asset or liability is established as required under SFAS No. 109. To the extent that a deferred tax asset is created, management evaluates RAI's ability to realize this asset. Management currently believes it is more likely than not that the deferred tax assets recorded in RAI's consolidated balance sheets will be realized. To the extent a deferred tax liability is established under SFAS No. 109, it is recorded, tracked and, once it becomes currently due and payable, paid to the taxing authorities.

The financial statements reflect management's best estimate of RAI's current and deferred tax liabilities and assets. Future events, including but not limited to, additional resolutions with taxing authorities could have an impact on RAI's current estimate of tax liabilities, realization of tax assets and upon RAI's effective income tax rate.

Recently Adopted Accounting Pronouncements

Effective January 1, 2008, RAI adopted SFAS No. 157, "Fair Value Measurements," for financial assets and financial liabilities. SFAS No. 157 does not require any new fair value measurements but provides a definition of fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. SFAS No. 157 also establishes a fair value hierarchy that distinguishes between independent and observable inputs and unobservable inputs based on the best information available. The adoption of SFAS No. 157 on financial assets and financial liabilities did not have a material impact on RAI's consolidated results of operations, cash flows or financial position.

In February 2008, the FASB issued FSP No. 157-2, "Effective Date of FASB Statement No. 157," to allow entities to electively defer the effective date of SFAS No. 157 for nonfinancial assets and liabilities, except for those items recognized or disclosed at fair value on an annual or more frequently recurring basis, until fiscal years

beginning after November 15, 2008. RAI elected to defer SFAS No. 157 for nonfinancial assets and nonfinancial liabilities to be effective as of January 1, 2009. For RAI, the deferral primarily applies to (1) nonfinancial assets and liabilities initially measured at fair value in business combinations; (2) reporting units or nonfinancial assets and liabilities measured at fair value in conjunction with goodwill, trademark and other intangible impairment testing; (3) other nonfinancial assets measured at fair . . .