Edgar Filing: CNA SURETY CORP

Large accelerated filer o

Accelerated filer þ

Non-accelerated filer o

Smaller Reporting Company o

(Do not check if a smaller reporting company)

e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 1-13277

CNA SURETY CORPORATION

(Exact name of Registrant as specified in its Charter)


DELAWARE		36-4144905
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

333 S. WABASH AVE., CHICAGO, ILLINOIS		60604
(Address of principal executive offices)		(Zip Code)

(312) 822-5000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. o Yes o No

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

44,267,471 shares of Common Stock, $.01 par value as of October 22, 2009.

CNA SURETY CORPORATION AND SUBSIDIARIES

INDEX


	Page
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (Unaudited):
Condensed Consolidated Balance Sheets at September 30, 2009 and at December 31, 2008		3
Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2009 and 2008		4
Condensed Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2009 and 2008		5
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2009 and 2008		6
Notes to Condensed Consolidated Financial Statements		7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		26
Item 3. Quantitative and Qualitative Disclosures About Market Risk		45
Item 4. Controls and Procedures		46
PART II. OTHER INFORMATION
Item 1. Legal Proceedings		46
Item 1A. Risk Factors		46
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		46
Item 3. Defaults Upon Senior Securities		47
Item 4. Submission of Matters to a Vote of Security Holders		47
Item 5. Other Information		47
Item 6. Exhibits		47
EX-31.1
EX-31.2
EX-32.1
EX-32.2

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)


	September 30,			December 31,
	2009			2008
	(Amounts in thousands, except per
	share data)
Assets
Invested assets:
Fixed income securities, at fair value (amortized cost: $1,164,709 and $1,041,816)	$	1,229,282		$	1,034,646
Equity securities, at fair value (cost: $1,379 and $1,231)		1,553			1,231
Short-term investments, at cost (approximates fair value)		70,472			80,606

Total invested assets		1,301,307			1,116,483
Cash		7,890			9,596
Deferred policy acquisition costs		105,081			102,092
Insurance receivables:
Premiums, including $9,657 and $14,303 from affiliates, (net of allowance for doubtful accounts: $1,336 and $1,307)		43,556			36,948
Reinsurance, including $768 and $46,122 from affiliates		48,530			91,452
Deposit with affiliated ceding company		27,368			29,693
Goodwill and other intangible assets (net of accumulated amortization: $25,523 and $25,523)		138,785			138,785
Property and equipment, at cost (less accumulated depreciation and amortization: $37,433 and $33,506)		18,592			24,378
Prepaid reinsurance premiums (including $0 and $105 from affiliates)		266			420
Accrued investment income		14,383			13,464
Other assets		3,205			2,208

Total assets	$	1,708,963		$	1,565,519


Liabilities
Reserves:
Unpaid losses and loss adjustment expenses	$	428,286		$	428,724
Unearned premiums		262,616			258,824

Total reserves		690,902			687,548
Long-term debt		30,930			30,892
Deferred income taxes, net		34,282			9,647
Reinsurance and other payables to affiliates		90			1,680
Accrued expenses		14,305			20,056
Liability for postretirement benefits		10,443			9,283
Payable for securities purchased		—			8,398
Federal income tax payable		1,621			1,581
Other liabilities		41,628			29,139

Total liabilities		824,201			798,224
Commitments and contingencies (See Notes 3, 5, & 8)

Stockholders’ Equity
Common stock, par value $.01 per share, 100,000 shares authorized; 45,634 shares issued and 44,267 shares outstanding at September 30, 2009 and 45,544 shares issued and 44,168 shares outstanding at December 31, 2008		456			455
Additional paid-in capital		278,849			276,255
Retained earnings		578,199			509,644
Accumulated other comprehensive income (loss)		41,929			(4,286	)
Treasury stock, 1,367 and 1,376 shares, at cost		(14,671	)		(14,773	)

Total stockholders’ equity		884,762			767,295

Total liabilities and stockholders’ equity	$	1,708,963		$	1,565,519

The accompanying notes are an integral part of these condensed consolidated financial statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2009		2008			2009			2008
	(Amount in thousands, except per share data)
Revenues:
Net earned premium	$	109,703	$	109,696		$	316,549		$	320,814
Net investment income		12,536		11,781			37,359			35,292
Net realized investment gains (losses):
Other-than-temporary impairment losses		—		(178	)		(1,870	)		(178	)
Portion of other-than-temporary impairment losses recognized in other comprehensive income (before taxes)		—		—			1,708			—

Net impairment losses recognized in earnings		—		(178	)		(162	)		(178	)
Net realized investment gains (losses), excluding impairment losses on available-for-sale securities		1,056		1			1,105			(29	)

Total net realized investment gains (losses)		1,056		(177	)		943			(207	)

Total revenues		123,295		121,300			354,851			355,899

Expenses:
Net losses and loss adjustment expenses		24,429		8,745			84,992			62,103
Net commissions, brokerage and other underwriting expenses		62,169		61,694			172,364			174,806
Interest expense		319		508			1,096			1,659

Total expenses		86,917		70,947			258,452			238,568

Income before income taxes		36,378		50,353			96,399			117,331
Income tax expense		10,854		16,020			27,844			36,046

Net income	$	25,524	$	34,333		$	68,555		$	81,285

Earnings per common share	$	0.58	$	0.78		$	1.55		$	1.84

Earnings per common share, assuming dilution	$	0.57	$	0.78		$	1.54		$	1.84

Weighted average shares outstanding		44,263		44,138			44,240			44,139

Weighted average shares outstanding, assuming dilution		44,411		44,264			44,397			44,258

The accompanying notes are an integral part of these condensed consolidated financial statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)


	Common											Accumulated
	Stock				Additional							Other			Treasury			Total
	Shares		Common		Paid-in		Comprehensive			Retained		Comprehensive			Stock			Stockholders’
	Outstanding		Stock		Capital		Income			Earnings		Income (Loss)			At Cost			Equity
Balance, January 1, 2008		44,121	$	455	$	274,069				$	399,241	$	8,800		$	(14,860	)	$	667,705

Comprehensive income:
Net income		—	$	—	$	—	$	81,285			81,285		—			—		$	81,285
Other comprehensive income:
Change in unrealized gains (losses) on securities, after income tax benefit of $15,779 (net of reclassification adjustment of $8, after income tax expense of $5)		—		—		—		(29,304	)		—		(29,304	)		—			(29,304	)
Adjustment to recognize re-measurement of accumulated postretirement benefit obligations, after income tax expense of $778		—		—		—		828			—		828			—			828
Net change related to postretirement benefits, after income tax benefit of $42		—		—		—		(79	)		—		(79	)		—			(79	)

Total comprehensive income		—		—		—	$	52,730			—		—			—			—

Stock-based compensation		—		—		1,327					—		—			—			1,327
Stock options exercised and other		38		—		382					—		—			87			469

Balance, September 30, 2008		44,159	$	455	$	275,778				$	480,526	$	(19,755	)	$	(14,773	)	$	722,231

Balance, January 1, 2009		44,168	$	455	$	276,255				$	509,644	$	(4,286	)	$	(14,773	)	$	767,295

Comprehensive income:
Net income		—		—		—	$	68,555			68,555		—			—			68,555
Other comprehensive income:
Change in unrealized gains (losses) on securities, after income tax expense of $25,317 (net of reclassification adjustment of ($2,550), after income tax benefit of $1,373)		—		—		—		47,016			—		47,016			—			47,016
Other-than-temporary impairment losses not recognized in the Condensed Consolidated Statements of Income, after income tax benefit of $146		—		—		—		(270	)		—		(270	)		—			(270	)
Adjustment to recognize re-measurement of accumulated postretirement benefit obligations, after income tax benefit of $150		—		—		—		(438	)		—		(438	)		—			(438	)
Net change related to postretirement benefits, after income tax benefit of $28		—		—		—		(93	)		—		(93	)		—			(93	)

Total comprehensive income		—		—		—	$	114,770			—		—			—			—

Stock-based compensation		—		—		1,453					—		—			—			1,453
Stock options exercised and other		99		1		1,141					—		—			102			1,244

Balance, September 30, 2009		44,267	$	456	$	278,849				$	578,199	$	41,929		$	(14,671	)	$	884,762

The accompanying notes are an integral part of these condensed consolidated financial statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)


	Nine Months Ended
	September 30,
	2009			2008
	(Amounts in thousands)
Cash Flows from Operating Activities:
Net income	$	68,555		$	81,285
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for doubtful accounts		543			(38	)
Depreciation and amortization		4,516			4,238
Amortization of bond premium, net		3,534			2,007
Loss on disposal or impairment of property and equipment		4,921			1,130
Net realized investment (gains) losses		(943	)		207
Stock-based compensation		1,453			1,327
Changes in:
Insurance receivables		35,771			23,965
Reserve for unearned premiums		3,792			12,621
Reserve for unpaid losses and loss adjustment expenses		(438	)		(48,281	)
Deposit with affiliated ceding company		2,325			3,792
Deferred policy acquisition costs		(2,989	)		(2,681	)
Deferred income taxes, net		(449	)		(202	)
Reinsurance and other payables to affiliates		(1,590	)		(183	)
Prepaid reinsurance premiums		154			191
Accrued expenses		(5,751	)		(1,301	)
Other assets and liabilities		(3,702	)		7,167

Net cash provided by operating activities		109,702			85,244


Cash Flows from Investing Activities:
Fixed income securities:
Purchases		(260,383	)		(99,751	)
Maturities		84,747			25,602
Sales		50,115			24,402
Purchases of equity securities		(715	)		(370	)
Proceeds from the sale of equity securities		528			460
Changes in short-term investments		10,209			(32,830	)
Purchases of property and equipment, net		(3,612	)		(4,882	)
Changes in receivables/payables for securities sold/purchased		(8,398	)		—
Other, net		—			200

Net cash (used in) investing activities		(127,509	)		(87,169	)


Cash Flows from Financing Activities:
Employee stock option exercises and other		1,244			469
Investment custody account bank overdraft		14,857			—

Net cash provided by financing activities		16,101			469


Decrease in cash		(1,706	)		(1,456	)
Cash at beginning of period		9,596			10,230

Cash at end of period	$	7,890		$	8,774


Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest	$	1,126		$	1,665
Income taxes	$	28,059		$	27,741

The accompanying notes are an integral part of these condensed consolidated financial statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)

1. Significant Accounting Policies

Formation of CNA Surety Corporation and Merger

In December 1996, CNA Financial Corporation (“CNAF”) and Capsure Holdings Corp. (“Capsure”) agreed to merge (the “Merger”) the surety business of CNAF with Capsure’s insurance subsidiaries, Western Surety Company (“Western Surety”), Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“Universal Surety”), into CNA Surety Corporation (“CNA Surety” or the “Company”). CNAF, through its operating subsidiaries, writes multiple lines of property and casualty insurance, including surety business that is reinsured by Western Surety. The principal operating subsidiaries of CNAF that wrote the surety line of business for their own account prior to the Merger were Continental Casualty Company and its property and casualty affiliates (collectively, “CCC”) and The Continental Insurance Company and its property and casualty affiliates (collectively, “CIC”). Through its insurance subsidiaries, CNAF owns approximately 62% of the outstanding common stock of CNA Surety. Loews Corporation (“Loews”) owns approximately 90% of the outstanding common stock of CNAF.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of CNA Surety and all majority-owned subsidiaries.

Estimates

The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Basis of Presentation

These unaudited Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company’s 2008 Form 10-K. Certain financial information that is included in annual financial statements prepared in accordance with GAAP is not required for interim reporting and has been condensed or omitted. The accompanying unaudited Condensed Consolidated Financial Statements reflect, in the opinion of management, all adjustments necessary for a fair presentation of the interim financial statements. All such adjustments are of a normal and recurring nature. The financial results for interim periods may not be indicative of financial results for a full year.

Earnings Per Share

Basic earnings per common share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per common share is computed based on the weighted average number of shares outstanding plus the dilutive effect of common stock equivalents which is computed using the treasury stock method.

The computation of earnings per common share is as follows (amounts in thousands, except for per share data):


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2009		2008		2009		2008
Net income	$	25,524	$	34,333	$	68,555	$	81,285

Shares:
Weighted average shares outstanding		44,254		44,132		44,168		44,121
Weighted average shares of options exercised and additional stock issuance		9		6		72		18

Total weighted average shares outstanding		44,263		44,138		44,240		44,139
Effect of dilutive options		148		126		157		119

Total weighted average shares outstanding, assuming dilution		44,411		44,264		44,397		44,258

Earnings per share	$	0.58	$	0.78	$	1.55	$	1.84

Earnings per share, assuming dilution	$	0.57	$	0.78	$	1.54	$	1.84

No adjustments were made to reported net income in the computation of earnings per share. Options to purchase shares of common stock of 0.8 million and 0.6 million were excluded from the calculation of diluted earnings per share for both the three months and nine months ended September 30, 2009 and September 30, 2008, respectively, because the exercise price of these options was greater than the average market price of CNA Surety’s common stock during the respective periods.

Subsequent Events

The Company has evaluated subsequent events since the date of these condensed consolidated financial statements through the issuance date of October 30, 2009.

Adopted Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board (“FASB”) issued guidance related to noncontrolling interests in consolidated financial statements. This guidance establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary and clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. This noncontrolling interest guidance requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest and requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest. The guidance also establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation and clarifies that all of those transactions are equity transactions if the parent retains its controlling financial interest in the subsidiary. Finally, the guidance requires expanded disclosures in the consolidated financial statements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners of a subsidiary. The guidance was effective for the Company on January 1, 2009. The adoption had no impact on the Company’s financial condition or results of operations.

In February 2008, the FASB issued guidance which delays the effective date for disclosures related to nonrecurring fair value measurements of nonfinancial assets and nonfinancial liabilities until fiscal years beginning after November 15, 2008. The Company adopted this guidance on January 1, 2009. The adoption had no impact on the Company’s financial condition or results of operations.

In March 2008, the FASB issued guidance which requires enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for and how derivative instruments and related hedge items affect an entity’s financial position, financial performance and cash flows. This derivative guidance also requires the disclosure of the fair values of derivative instruments and their gains and losses in a tabular format and requires cross-referencing within the footnotes of important information about derivative instruments. The Company adopted this guidance on January 1, 2009. The adoption had no impact on the Company’s required disclosures.

In September 2008, the FASB issued guidance which requires disclosures by sellers of credit derivatives and requires additional disclosure about the current status of the risk of a guarantee. This guidance was effective for the Company on January 1, 2009. The adoption had no impact on the Company’s required disclosures.

In December 2008, the FASB issued guidance which requires employers to make additional disclosures regarding postretirement benefit plan assets and to provide information regarding the following: how investment allocation decisions are made, including the factors that are pertinent to an understanding of investment policies and procedures; the major categories of plan assets; the inputs and valuation techniques used to measure the fair value of plan assets; the effect of fair value measurements using significant unobservable inputs (Level 3) on changes in plan assets for the period; and significant concentrations of risk within plan assets. The disclosures are required for fiscal years ending after December 15, 2009 and were effective for the Company on January 1, 2009. The adoption had no impact on the Company’s disclosures as the Company’s postretirement benefit plans have no plan assets.

In April 2009, the FASB issued guidance which requires entities to assess whether certain factors exist that indicate that the volume and level of market activity for an asset or liability have decreased or that transactions are not orderly. If, after evaluating those factors, the evidence indicates there has been a significant decrease in the volume and level of activity in relation to normal market activity, observed transactional values or quoted prices may not be determinative of fair value and adjustment to the observed transactional values or quoted prices may be necessary to estimate fair value. This guidance was effective for interim and annual periods ending after June 15, 2009. The adoption had no impact on the Company’s financial condition or results of operations.

In April 2009, the FASB issued guidance which amends the criteria for the recognition of other-than-temporary impairments (“OTTI”) for debt securities and requires that credit losses be recognized in earnings and losses resulting from factors other than credit of the issuer be recognized in other comprehensive income. Prior to adoption, all OTTI were recorded in earnings in the period of recognition. This guidance also expands and increases the frequency of existing disclosures. This guidance was effective for interim and annual periods ending after June 15, 2009, and required a cumulative effect adjustment of initial application as an adjustment to the opening balance of retained earnings with a corresponding adjustment to accumulated other comprehensive income. The adoption had no cumulative effect adjustment to the opening balance of retained earnings or accumulated other comprehensive income as the Company determined that previously recorded OTTI on fixed income securities were credit-related and would have been recognized through earnings as required. The Company records OTTI losses in accordance with this guidance.

In April 2009, the FASB issued guidance requiring disclosures about fair value of financial instruments in interim as well as annual financial statements. This guidance was effective for interim and fiscal periods ending after June 15, 2009. The adoption had no impact on the Company’s financial condition or results of operations. The Company has complied with the interim disclosure requirements in Note 4, Fair Value of Financial Instruments.

In May 2009, the FASB issued guidance on the recognition and disclosure of events that occur after the balance sheet date, but before financial statements are issued or are available to be issued. This guidance was effective for interim and annual periods ending after June 15, 2009 and requires the disclosure of the date through which an entity has evaluated subsequent events and whether that date represents the date the financial statements were issued or were available to be issued. This guidance does not change previous guidance regarding the recognition or disclosure of subsequent events, other than the additional requirement regarding the date through which subsequent events have been considered. The Company has disclosed the date through which subsequent events are evaluated.

In June 2009, the FASB announced that the FASB Accounting Standards Codification (the “Codification”) will become the source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities. The Codification supersedes all then-existing accounting and reporting standards that are not standards of the Securities and Exchange Commission (“SEC”). All other non-grandfathered non-SEC accounting literature not included in the Codification will become non-authoritative. This guidance is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The adoption did not have an impact on the Company’s financial condition or results of operations.

Pending Accounting Pronouncements

In June 2009, the FASB issued guidance which removes the concept of a qualifying special-purpose entity and eliminates it from exceptions under the guidance for consolidation of variable interest entities. It also modifies the de-recognition conditions related to legal isolation and effective control and adds additional disclosure requirements for transfers of financial assets. This guidance is effective for annual reporting periods beginning after November 15, 2009. The adoption is not expected to have a material impact on the Company’s financial condition or results of operations.

information regarding an enterprise’s involvement in a variable interest entity. This guidance is effective for annual reporting periods beginning after November 15, 2009. The adoption is not expected to have a material impact on the Company’s financial condition or results of operations.

In August 2009, the FASB issued guidance which proposes the following clarifying guidance for determining the fair value of a liability. If a quoted price in an active market for the identical liability is available, it represents a Level 1 measurement. If a quoted price in an active market for the identical liability is not available, an entity may utilize the following approaches: (a) the quoted price of the identical liability when traded as an asset in an active market; (b) the quoted price of the identical liability when traded as an asset in markets that are not active; (c) the quoted price for similar liabilities or similar liabilities traded as assets in markets that are not active; (d) another valuation technique that is consistent with the generally accepted fair value principles (income approach or market approach). The Company does not report any of its financial liabilities at fair value. This guidance is effective for financial statements issued for annual periods beginning after August 2009. The adoption is not expected to have an impact on the Company’s financial condition or results of operations.

2. Investments

Major categories of net investment income were as follows (dollars in thousands):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Investment income:
Fixed income securities	$	12,763		$	11,407		$	37,790		$	34,211
Equity securities		8			13			27			38
Short-term investments		26			367			110			1,097
Other		14			57			48			81

Total investment income on available-for-sale securities		12,811			11,844			37,975			35,427
Investment income on deposit with affiliated ceding company		35			224			307			761
Investment expenses		(310	)		(287	)		(923	)		(896	)

Net investment income	$	12,536		$	11,781		$	37,359		$	35,292

Net realized investment gains and losses and the net change in unrealized gains and losses of available-for-sale securities were as follows (dollars in thousands):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Net realized investment gains (losses):
Fixed income securities:
Gross realized investment gains	$	1,448		$	—		$	1,491		$	—
Gross realized investment losses:
Other-than-temporary impairment losses		—			—			(116	)		—
Realized losses from sales		(392	)		—			(392	)		(19	)

Total gross realized investment losses		(392	)		—			(508	)		(19	)

Net realized investment gains (losses) on fixed income securities		1,056			—			983			(19	)

Equity securities:
Gross realized investment gains		—			1			27			11
Gross realized investment losses:
Other-than-temporary impairment losses		—			(178	)		(46	)		(178	)
Realized losses from sales		—			—			(20	)		(20	)

Total gross realized investment losses		—			(177	)		(66	)		(198	)

Net realized investment gains (losses) on equity securities		—			(177	)		(39	)		(187	)

Other		—			—			(1	)		(1	)

Net realized investment gains (losses)	$	1,056		$	(177	)	$	943		$	(207	)

Net change in unrealized gains (losses):
Fixed income securities	$	46,768		$	(27,674	)	$	71,743		$	(44,977	)
Equity securities		93			19			174			(106	)

Total net change in unrealized gains (losses)	$	46,861		$	(27,655	)	$	71,917		$	(45,083	)

Net realized gains (losses) and change in unrealized gains (losses)	$	47,917		$	(27,832	)	$	72,860		$	(45,290	)

Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements or other similar factors. As a result, the Company considers all of its fixed income securities (bonds) and equity securities as available-for-sale, and as such, they are carried at fair value.

The amortized cost of fixed income securities is determined based on cost and the cumulative effect of amortization of premiums and accretion of discounts using the interest method. Such amortization and accretion are included in net investment income in the Condensed Consolidated Statements of Income. For mortgage-backed and asset-backed securities, the Company considers estimates of future prepayments in the calculation of the effective yield used to apply the interest method. If a difference arises between the anticipated prepayments and the actual prepayments, the Company recalculates the effective yield based on actual prepayments and the currently anticipated future prepayments. The amortized costs of such securities are adjusted to the amount that would have resulted had the recalculated effective yields been applied since the acquisition of the securities with a corresponding charge or credit to net investment income in the Condensed Consolidated Statements of Income. Prepayment estimates are based on the structural elements of specific securities, interest rates and generally recognized prepayment speed indices.

The estimated fair value, gross unrealized gains, gross unrealized losses, other-than temporary impairments and amortized cost of fixed income securities and the fair value, gross unrealized gains, gross unrealized losses and cost of equity securities held by CNA Surety at September 30, 2009, by investment category, were as follows (dollars in thousands):


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated		Unrealized
September 30, 2009	or Cost		Gains		12 Months			12 Months			Fair Value		OTTI Losses^(a)
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	17,377	$	1,115	$	—		$	—		$	18,492	$	—
U.S. Agencies		24,303		429		—			—			24,732		—
Collateralized mortgage obligations — residential		31,626		1,810		—			—			33,436		—
Mortgage pass-through securities — residential		56,785		2,572		—			—			59,357		—
Obligations of states and political subdivisions		700,001		48,091		—			(2,271	)		745,821		—
Corporate bonds		292,550		13,219		(128	)		(633	)		305,008		—
Collateralized mortgage obligations — commercial		10,025		—		—			(425	)		9,600		—
Other asset-backed securities:
Second mortgages/home equity loans — residential		5,931		—		—			(611	)		5,320		(1,502	)
Consumer credit receivables		16,386		670		—			—			17,056		—
Other		9,725		735		—			—			10,460		—

Total fixed income securities		1,164,709		68,641		(128	)		(3,940	)		1,229,282	$	(1,502	)

Equity securities		1,379		174		—			—			1,553

Total	$	1,166,088	$	68,815	$	(128	)	$	(3,940	)	$	1,230,835


^(a)		The unrealized loss position of this security has improved to $0.4 million at September 30, 2009.

The estimated fair value, gross unrealized gains, gross unrealized losses and amortized cost of fixed income securities and the fair value, gross unrealized gains, gross unrealized losses and cost of equity securities held by CNA Surety at December 31, 2008, by investment category, were as follows (dollars in thousands):


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated
December 31, 2008	or Cost		Gains		12 Months			12 Months			Fair Value
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	33,140	$	3,519	$	—		$	—		$	36,659
U.S. Agencies		36,476		1,116		—			—			37,592
Collateralized mortgage obligations — residential		35,671		984		—			—			36,655
Mortgage pass-through securities — residential		72,203		1,489		—			—			73,692
Obligations of states and political subdivisions		697,305		19,730		(6,929	)		(13,943	)		696,163
Corporate bonds		96,048		1,711		(2,430	)		(1,853	)		93,476
Collateralized mortgage obligations — commercial		35,025		—		(2,040	)		(3,607	)		29,378
Other asset-backed securities:
Second mortgages/home equity loans — residential		7,956		—		(779	)		(2,180	)		4,997
Consumer credit receivables		17,239		—		(1,708	)		—			15,531
Other		10,753		23		(273	)		—			10,503

Total fixed income securities		1,041,816		28,572		(14,159	)		(21,583	)		1,034,646
Equity securities		1,231		—		—			—			1,231

Total	$	1,043,047	$	28,572	$	(14,159	)	$	(21,583	)	$	1,035,877

A security is in an unrealized loss position, or impaired, if the fair value of the security is less than its amortized cost or cost, which includes adjustments for accretion, amortization and previously recorded other-than-temporary impairment losses. When a security is impaired, the impairment is evaluated to determine whether it is temporary or other-than-temporary.

A significant judgment in the valuation of investments is the determination of when an other-than-temporary decline in value has occurred. The Company follows a consistent and systematic process for identifying securities that sustain other-than-temporary declines in value. The Company has established a watch list that is reviewed by the Chief Financial Officer and one other executive officer on at least a quarterly basis. The watch list includes individual securities that fall below certain thresholds or that exhibit evidence of impairment indicators including, but not limited to, a significant adverse change in the financial condition and near-term prospects of the investment or a significant adverse change in legal factors, the business climate or credit ratings.

When a security is placed on the watch list, it is monitored for further market value changes and additional news related to the issuer’s financial condition. The focus is on objective evidence that may influence the evaluation of impairment factors. The decision to record an other-than-temporary impairment loss incorporates both quantitative criteria and qualitative information.

In determining whether an equity security is other-than-temporarily impaired, the Company considers a number of factors including, but not limited to: (a) the length of time and the extent to which the market value has been less than book value, (b) the financial condition and near-term prospects of the issuer, (c) the intent and ability of the Company to retain its investment for a period of time sufficient to allow for any anticipated recovery in value and (d) general market conditions and industry or sector specific factors. Currently, the Company’s equity portfolio is comprised solely of mutual funds related to the Company’s deferred compensation plan, which is an unfunded, nonqualified deferred compensation plan for a select group of management or highly compensated employees. Due to the nature of the plan, the Company does not assert the ability to hold these securities until their recovery in value. As such, if any of these securities are in an unrealized loss position, they are considered to be other-than-temporarily impaired.

For equity securities for which an other-than-temporary impairment loss has been identified, the security is written down to fair value and the resulting losses are recognized in realized gains/losses in the Condensed Consolidated Statements of Income.

and near-term prospects of the issuer, (b) credit ratings of the securities, (c) whether the debtor is current on interest and principal payments, (d) the length of time and the extent to which the market value has been less than book value and (e) general market conditions and industry or sector specific factors.

In addition to these factors, the Company considers the results of discounted cash flow modeling using assumptions representative of current market conditions as well as those specific to the Company’s particular security holdings. For asset-backed and mortgage-backed securities, the focus of this analysis is on assessing the sufficiency and quality of underlying collateral and timing of cash flows. Significant assumptions considered by the Company in its cash flow projections include delinquency rates, probable risk of default, over collateralization and credit support from lower level tranches. If the discounted expected cash flows for a security equal or exceed the amortized cost of that security, no credit loss exists and the security is deemed to be temporarily impaired.

Fixed income securities in an unrealized loss position for which management believes a credit loss exists are considered to be other-than-temporarily impaired. For these fixed income securities, the Company bifurcates OTTI losses into a credit component and a non-credit component. The credit component, which represents the difference between the discounted expected cash flows and the fixed income security’s amortized cost, is recognized in earnings. The non-credit component is recognized in other comprehensive income and represents the difference between fair value and the discounted cash flows that the Company expects to collect.

Based on the Company’s September 30, 2009 evaluation of this quantitative criteria and qualitative information, the Company did not record any OTTI losses in the three months ended September 30, 2009.

In the three months ended June 30, 2009, the Company recorded OTTI losses of $1.8 million on one asset-backed fixed income security which included a credit loss component. This security was rated below investment grade by S&P and collateralized by sub-prime home loans. The credit component of the loss, $0.1 million, was recognized in earnings with $1.7 million (49.3% of the security’s amortized cost at that time) of the loss recognized in other comprehensive income.

The OTTI of fixed income securities for which only the amount related to credit losses was recognized in net realized gains (losses) on the Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2009 are as follows (in thousands of dollars):


	Three Months Ended		Nine Months Ended
	September 30, 2009		September 30, 2009
Beginning balance	$	116	$	—
Credit losses for which an OTTI loss was not previously recognized		—		116
Credit losses for which an OTTI loss was previously recognized		—		—

Ending balance	$	116	$	116

During the three months ended March 31, 2009, the Company recorded other-than-temporary impairment losses of less than $0.1 million on the equity securities that are related to the Company’s nonqualified deferred compensation plan.

During the three months ended September 30, 2008, the Company recorded other-than-temporary impairment losses of $0.2 million on these equity securities. Other-than-temporary impairment losses for the nine months ended September 30, 2008 were also $0.2 million as no other-than-temporary impairments were recorded in the six months ended June 30, 2008.

The amortized cost and estimated fair value of fixed income securities, by contractual maturity, at September 30, 2009 and December 31, 2008 are shown below. Actual maturities may differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (dollars in thousands):


	September 30, 2009				December 31, 2008
	Amortized		Estimated Fair		Amortized		Estimated Fair
	Cost		Value		Cost		Value
Fixed income securities:
Due within one year	$	7,525	$	7,592	$	4,535	$	4,590
Due after one year but within five years		305,493		320,562		216,232		222,344
Due after five years but within ten years		428,560		459,319		345,285		355,171
Due after ten years		292,653		306,580		296,917		281,785

		1,034,231		1,094,053		862,969		863,890

Mortgage pass-through securities, collateralized mortgage obligations and asset-backed securities		130,478		135,229		178,847		170,756

	$	1,164,709	$	1,229,282	$	1,041,816	$	1,034,646

The following table provides the composition of fixed income securities with an unrealized loss at September 30, 2009 in relation to the total of all fixed income securities in an unrealized loss position by contractual maturities:


	% of
	Estimated			% of
	Fair			Unrealized
Contractual Maturity	Value			Loss
Due after one year through five years		9	%		16	%
Due after five years through ten years		41			4
Due after ten years		35			54
Asset-backed securities		15			26

Total		100	%		100	%

The following table summarizes for fixed income securities in an unrealized loss position at September 30, 2009 and December 31, 2008, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position (dollars in thousands):


	September 30, 2009				December 31, 2008
			Gross				Gross
	Estimated		Unrealized		Estimated		Unrealized
Unrealized Loss Aging	Fair Value		Loss		Fair Value		Loss
Fixed income securities:
Investment grade^(a):
0-6 months	$	31,910	$	84	$	109,973	$	3,095
7-12 months		4,937		44		121,419		11,064
13-24 months		11,630		261		81,395		12,010
Greater than 24 months		36,917		2,099		33,450		9,573

Total investment grade		85,394		2,488		346,237		35,742
Non-investment grade:
Greater than 24 months		17,700		1,580		—		—

Total	$	103,094	$	4,068	$	346,237	$	35,742


^(a)		Investment grade is determined by using the Standard & Poor’s (“S&P”) rating. If a security is not rated by S&P, the Moody’s Investor Services (“Moody’s”) rating is used. As of September 30, 2009 and December 31, 2008, all of the Company’s fixed income securities were rated by S&P or Moody’s.

At September 30, 2009, the Company holds 271 fixed income securities in an unrealized gain position with a total estimated fair value of $1,126.2 million and an aggregate gross unrealized gain of $68.6 million.

The following table summarizes securities in a gross unrealized loss position by investment category and by credit rating. The table also discloses the corresponding count of securities in an unrealized loss position and estimated fair value by category (in thousands of dollars):


	Gross Unrealized Losses												Estimated
September 30, 2009	AAA		AA		A		BBB		Total		Count		Fair Value
Fixed income securities:
Investment grade^(a):
U.S. Treasury securities and obligations of U. S. Government and agencies:
Collateralized mortgage obligations — residential	$	—	$	—	$	—	$	—	$	—		1	$	1
Obligations of states and political subdivisions		389		100		618		—		1,107		5		29,887
Corporate bonds		6		14		111		630		761		10		43,225
Collateralized mortgage obligations — commercial		425		—		—		—		425		2		9,600
Other asset-backed securities:
Second mortgages/home equity loans — residential		195		—		—		—		195		1		2,681

Total investment grade		1,015		114		729		630		2,488		19		85,394
Non-investment grade:
Obligations of states and political subdivisions		—		—		—		—		1,164		2		15,061
Other asset-backed securities:
Second mortgages/home equity loans — residential		—		—		—		—		416		1		2,639

Total non-investment grade		—		—		—		—		1,580		3		17,700

Total	$	1,015	$	114	$	729	$	630	$	4,068		22	$	103,094


^(a)		Securities are categorized using the S&P rating. If a security is not rated by S&P, the Moody’s rating is used. At September 30, 2009, all of the Company’s fixed income securities were rated by S&P or Moody’s.

As of September 30, 2009, the Company’s fixed income securities included one U.S. Government agency collateralized mortgage obligation backed by residential mortgages in a nominal unrealized loss position. The Company has no current intent to sell this security, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. The Company does not believe this unrealized loss is indicative of a credit loss and, as such, has not recorded an OTTI loss on this security at September 30, 2009.

The unrealized losses on the Company’s investments in obligations of states and political subdivisions are due to overall market conditions, changes in credit spreads, and to a lesser extent, changes in interest rates. At September 30, 2009, only one of the five investment grade securities was in an unrealized loss position exceeding 5% of the security’s amortized cost. This security, issued by a governmental utility authority, had an unrealized loss of $0.6 million which was 9.9% of the security’s amortized cost. The unrealized loss position of this security has improved from 23.6% of amortized cost at June 30, 2009 and 43.6% of amortized cost at March 31, 2009. Similarly, changing market conditions resulted in a $12.6 million improvement in the unrealized losses on the Company’s investments in obligations of states and political subdivisions compared to March 31, 2009 and an $8.6 million improvement compared to June 30, 2009. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. The Company does not believe the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded an OTTI loss on these securities at September 30, 2009.

During the three months ended September 30, 2009, the Company’s investments in two other obligations of states and political subdivisions, issued by governmental utility authorities, were downgraded below investment grade due to the downgrade of the mono-line bond insurer guaranteeing a portion of these securities. Despite the downgrades, improving market conditions during the second and third quarters resulted in a $4.0 million improvement in the unrealized loss on these securities compared to March 31, 2009 and a $2.2 million improvement compared to the unrealized loss on these securities at June 30, 2009. At September 30, 2009, one of these securities had an unrealized loss of $0.3 million, or 5.0% of its amortized cost, and the other had an unrealized loss of $0.9 million, or 8.3% of its amortized cost. Based on the underlying fundamentals of these securities, the Company continues to believe that all interest and principal will be paid according to their contractual terms. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. As such, the Company has not recorded an OTTI loss on these securities at September 30, 2009.

At September 30, 2009, only one of the Company’s corporate bond investments was in an unrealized loss position that exceeded 5% of its amortized cost. This unrealized loss, 20.9% ($0.6 million) of the security’s amortized cost, was on a security issued by a large student loan provider. The unrealized loss position of this security was 19.6% of amortized cost at June 30, 2009. However, the

unrealized loss position was 47.2% of amortized cost, or $1.4 million, at March 31, 2009. Further, the overall unrealized loss position on the Company’s corporate bond holdings improved $6.0 million compared to March 31, 2009 and $1.3 million compared to June 30, 2009. The unrealized losses on the Company’s corporate bond investments are primarily attributable to deterioration and volatility in the broader credit markets throughout 2008, and continuing in to 2009, that resulted in widening of credit spreads over risk-free rates. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. The Company does not believe the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded any OTTI losses on these securities at September 30, 2009.

The Company holds only two collateralized commercial mortgage-backed securities. At September 30, 2009, one of these securities had an unrealized loss of $0.1 million, or 2.0% of its amortized cost, and the other had an unrealized loss of $0.3 million, or 6.5% of its amortized cost. The overall unrealized loss position of these securities has continued to improve from $2.5 million at March 31, 2009 and $1.5 million at June 30, 2009. The Company believes that these securities will recover in value based on the current performance of the underlying collateral, the senior or super-senior position of each of the holdings and the amount of credit support available to these holdings. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. The Company does not believe these unrealized losses are indicative of credit losses and, as such, has not recorded any OTTI losses on these securities at September 30, 2009.

At September 30, 2009 the Company’s exposure to sub-prime home loans is limited to two asset-backed securities collateralized by sub-prime home loans originated prior to 2005. Both of these securities are in an unrealized loss position. One of these securities has an estimated fair value of $2.7 million and is in an unrealized loss position of $0.2 million, or 6.8% of its amortized cost, at September 30, 2009. The other security, which is rated below investment grade, was determined to be other-than-temporarily impaired at June 30, 2009. The Company recorded OTTI losses of $0.1 million in earnings in addition to recording an unrealized loss of $1.7 million in other comprehensive income. As previously discussed, the Company did not record any additional credit-related loss on this security during the three months ended September 30, 2009 and the unrealized loss position has improved to $0.4 million, or 13.6% of its adjusted amortized cost. The Company believes the unrealized losses on these securities are primarily attributable to broader economic conditions and liquidity concerns and are not indicative of the quality of the underlying collateral. The Company continues to receive repayments on these securities, including $1.9 million, or 24% of the par value outstanding at December 31, 2008, in the first nine months of 2009. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost and, as such, has not recorded any additional OTTI losses at September 30, 2009.

Based on the current facts and circumstances discussed above for the Company’s securities in an unrealized loss position, the Company has determined that no additional OTTI losses related to the securities in an unrealized loss position are required to be recorded at September 30, 2009.

Invested assets are exposed to various risks, such as interest rate, market and credit risks. Due to the level of risk associated with certain of these invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may significantly affect the amounts reported in the Condensed Consolidated Balance Sheets and Condensed Consolidated Statements of Income.

3. Reinsurance

The effect of reinsurance on the Company’s written and earned premium was as follows (dollars in thousands):


	Three Months Ended September 30,
	2009						2008
	Written			Earned			Written			Earned
Direct	$	90,472		$	91,994		$	94,407		$	94,163
Assumed		22,930			24,813			25,955			27,267
Ceded		(7,041	)		(7,104	)		(11,557	)		(11,734	)

	$	106,361		$	109,703		$	108,805		$	109,696


	Nine Months Ended September 30,
	2009						2008
	Written			Earned			Written			Earned
Direct	$	271,619		$	262,628		$	280,784		$	267,087
Assumed		69,742			74,941			80,515			81,591
Ceded		(20,866	)		(21,020	)		(27,673	)		(27,864	)

	$	320,495		$	316,549		$	333,626		$	320,814

Assumed premiums primarily includes surety business written or renewed, net of reinsurance, by CCC and CIC after September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write certain business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of the business assumed from these affiliates.

Assumed premium also includes surety business written by another affiliate, First Insurance Company of Hawaii, Ltd. and its subsidiaries First Indemnity Insurance of Hawaii, Inc., First Fire and Casualty Insurance of Hawaii, Inc. and First Security Insurance of Hawaii, Inc. (collectively, “FICOH”). Through its insurance subsidiaries, CNAF owns approximately 50% of the outstanding common stock of First Insurance Company of Hawaii, Ltd. Under the terms of this excess of loss agreement that covers certain contract business, FICOH retains losses of $2 million per principal and Western Surety assumes 80% of $5 million per principal in excess of $2 million subject to an aggregate annual limit of $8 million. Premiums assumed by Western Surety under this agreement were less than $0.1 million for both the three months ended September 30, 2009 and 2008, respectively, and $0.1 million for both the nine months ended September 30, 2009 and 2008, respectively.

The effect of reinsurance on the Company’s provision for loss and loss adjustment expenses and the corresponding ratio to earned premium was as follows (dollars in thousands):


	Three Months Ended September 30,
	2009						2008
	$			Ratio			$		Ratio
Gross losses and loss adjustment expenses	$	28,062			24.0	%	$	21		0.2	%
Ceded amounts		(3,633	)		51.6	%		8,724		(74.3	)%

Net losses and loss adjustment expenses	$	24,429			22.3	%	$	8,745		8.0	%


	Nine Months Ended September 30,
	2009						2008
	$			Ratio			$			Ratio
Gross losses and loss adjustment expenses	$	92,115			27.3	%	$	70,559			20.2	%
Ceded amounts		(7,123	)		33.9	%		(8,456	)		30.4	%

Net losses and loss adjustment expenses	$	84,992			26.8	%	$	62,103			19.4	%

The unusual relationship in the gross and ceded amounts shown above for the three months ended September 30, 2008 resulted from adjustments made based on actuarial reviews performed during the three months ended September 30, 2008. The Company reduced gross reserves related to prior accident years by approximately $33.3 million reflecting changes in estimates of incurred-but-not-reported reserves. The corresponding change in ceded reserves was such that net reserves related to prior accident years were reduced by $24.9 million for the three months ended September 30, 2008.

The Company’s reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company’s retention on a per principal basis. The Company’s reinsurance coverage is provided by third party reinsurers and related parties. Due to the terms and conditions of these excess of loss treaties, reinsurers may cover some principals in one year but then exclude these same principals in subsequent years. As a result, the Company may have exposures to these principals that have limited or no reinsurance coverage.

2009 Third Party Reinsurance

Effective January 1, 2009, CNA Surety entered into a new excess of loss treaty (“2009 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2008 Excess of Loss Treaty discussed below. Under the 2009 Excess of Loss Treaty, the Company’s net retention per principal is $15 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provides aggregate coverage of $185 million and includes an optional extended discovery period, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer), which will provide coverage for losses discovered beyond 2009 on bonds that were in force during 2009. The contract also includes a provision for additional premiums of up to $13.8 million based on losses ceded under the contract. The base annual premium for the 2009 Excess of Loss Treaty is $28.0 million. Only the large national contractor discussed below remains excluded from the 2009 Excess of Loss Treaty.

2008 Third Party Reinsurance

Effective January 1, 2008, CNA Surety entered into an excess of loss treaty (“2008 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the excess of loss treaty effective in 2007. Under the 2008 Excess of Loss Treaty, the Company’s net retention per principal remained at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provided aggregate coverage of $185 million and included an optional extended discovery period, which was not exercised. The contract also included a provision for additional premiums of up to $26.1 million based on losses ceded under the contract. The actual ceded premiums for the 2008 Excess of Loss Treaty were $30.4 million. Only the large national contractor discussed below was excluded from the 2008 Excess of Loss Treaty. There were no additional premiums or loss recoveries under the 2008 Excess of Loss Treaty as no losses were discovered to this treaty in 2008.

Related Party Reinsurance

Reinsurance agreements together with the Services and Indemnity Agreement that are described below provide for the transfer of the surety business written by CCC and CIC to Western Surety. All of these agreements originally were entered into on September 30, 1997 (the “Merger Date”): (i) the Surety Quota Share Treaty (the “Quota Share Treaty”); (ii) the Aggregate Stop Loss Reinsurance Contract (the “Stop Loss Contract”); and (iii) the Surety Excess of Loss Reinsurance Contract (the “Excess of Loss Contract”). All of these contracts have expired. Some have been renewed on different terms as described below.

The Services and Indemnity Agreement provides the Company’s insurance subsidiaries with the authority to perform various administrative, management, underwriting and claim functions in order to conduct the business of CCC and CIC and to be reimbursed by CCC for services rendered. In consideration for providing the foregoing services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. This agreement was renewed with the same terms on January 1, 2009 and expires on December 31, 2009 and is annually renewable thereafter. Effective June 30, 2009, the Company and CCC agreed to an addendum to this agreement that is discussed below.

Through the Quota Share Treaty, CCC and CIC transfer to Western Surety surety business written or renewed by CCC and CIC after the Merger Date. The Quota Share Treaty was renewed on January 1, 2009 and expires on December 31, 2009 and is annually renewable thereafter. CCC and CIC transfer the related liabilities of such business and pay to Western Surety an amount in cash equal to CCC’s and CIC’s net written premiums written on all such business, minus a quarterly ceding commission to be retained by CCC and CIC equal to $50,000 plus 25% of net written premiums written on all such business. For 2008, this resulted in an override commission on their actual direct acquisition costs of 5.9% to CCC and CIC.

Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and loss adjustment expense reserves transferred to Western Surety as of the Merger Date by agreeing to pay Western Surety, within 30 days following the end of each calendar quarter, the amount of any adverse development on such reserves, as re-estimated as of the end of such calendar quarter. There was no adverse reserve development for the period from the Merger Date through September 30, 2009.

Through the Stop Loss Contract, the Company’s insurance subsidiaries were protected from adverse loss development on certain business underwritten after the Merger Date. The Stop Loss Contract between the insurance subsidiaries and CCC limited the insurance subsidiaries’ prospective net loss ratios with respect to certain accounts and lines of insured business for three full accident years following the Merger Date. In the event the insurance subsidiaries’ accident year net loss ratio exceeds 24% in any of the accident years 1997 through 2000 on certain insured accounts (the “Loss Ratio Cap”), the Stop Loss Contract requires CCC at the end of each calendar quarter following the Merger Date, to pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which the Company’s actual accident year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. In consideration for the coverage provided by the Stop Loss Contract, the insurance subsidiaries paid to CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. Through September 30, 2009, losses incurred under the Stop Loss Contract were $49.7 million. Through December 31, 2008, losses incurred under the Stop Loss Contract were $48.9 million. The increase is primarily due to unfavorable development of a large commercial claim that was settled for less than what had been carried as an expected recovery. As a result of this unfavorable development, the Company recorded a receivable of $0.8 million from CCC at September 30, 2009. As a result of favorable development on claims subject to the Stop Loss Contract during the fourth quarter of 2008, the Company paid CCC $0.7 million in 2009 under the Stop Loss Contract. At September 30, 2009 and December 31, 2008 these losses incurred are net of $1.6 million and $2.1 million, respectively, related to expected indemnity recoveries.

The Company and CCC previously participated in a $40 million excess of $60 million reinsurance contract effective from January 1, 2005 to December 31, 2005 providing coverage exclusively for the one large national contractor excluded from the Company’s third party reinsurance. The premium for this contract was $3.0 million plus an additional premium of $6.0 million if a loss was ceded under this contract. In the second quarter of 2005, this contract was amended to provide unlimited coverage in excess of the $60 million retention, to increase the premium to $7.0 million and to eliminate the additional premium provision. This treaty provides coverage for the life of bonds either in force or written during the term of the treaty which was from January 1, 2005 to December 31, 2005. The Company and CCC agreed by addendum to extend this contract for twelve months beginning on January 1, 2006, 2007, 2008 and 2009. Additional premiums for these periods were $0.8 million, $0.5 million, $0.2 million and less than $0.1 million, respectively, and were based on the level of actual premiums written on bonds for the large national contractor.

On June 30, 2009, the Company and CCC agreed by addendum to terminate the reinsurance contract discussed in the preceding paragraph under which the Company had ceded losses and loss adjustment expenses of $50.0 million through both June 30, 2009 and December 31, 2008. Unpaid ceded losses under this contract on June 30, 2009, prior to the termination becoming effective, were $50.0 million compared to $46.8 million at December 31, 2008. As a result of indemnification recoveries during the first quarter of 2009, $3.2 million was returned to CCC. In addition to the termination of this contract, the Company and CCC agreed to commute the Quota Share Treaty as regards premium and losses for the large national contractor. The impact of this commutation was a decrease of gross loss reserves of $51.8 million. Further, the Services and Indemnity Agreement was amended by addendum to specifically extend the Company’s authority to conduct administrative, management, underwriting and claim functions as respects business of the large national contractor until CCC’s bonds have expired and claims have been settled or closed.

Under the terms of the agreements effecting this commutation, the Company paid CCC $1.8 million. This settlement reflects the difference between the Company’s $60.0 million retention under the reinsurance contract and $58.2 million paid by the Company for losses of the large national contractor through June 30, 2009. These transactions had no net impact on the results of operations for the nine months ended September 30, 2009.

As of September 30, 2009, CNA Surety had an insurance receivable balance from CCC and CIC of $10.5 million, including $0.8 million of reinsurance recoverables and $9.7 million of premiums receivable, respectively. At December 31, 2008, the Company’s insurance receivable balance from CCC and CIC was $60.4 million, including $46.1 million of reinsurance recoverables and $14.3 million of premiums receivable, respectively. CNA Surety had no reinsurance payables to CCC and CIC as of September 30, 2009. CNA Surety had reinsurance payables to CCC and CIC of $1.2 million as of December 31, 2008.

The Company’s Condensed Consolidated Balance Sheets also include a “Deposit with affiliated ceding company” of $27.4 million and $29.7 million at September 30, 2009 and December 31, 2008, respectively. In 2005, pursuant to an agreement with the claimant on a bond regarding certain aspects of the claim resolution, the Company deposited $32.7 million with an affiliate to enable the affiliate to establish a trust to fund future payments under the bond. The bond was written by the affiliate and assumed by one of the Company’s insurance subsidiaries pursuant to the Quota Share Treaty. The Company is entitled to the interest income earned by the trust. Prior to the establishment of the trust, the Company had fully reserved its obligation under the bond and the claim remains fully reserved.

4. Fair Value of Financial Instruments

Fair value is 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. The Company uses the following fair value hierarchy in selecting inputs, with the highest priority given to Level 1, as these are the most transparent or reliable:

	•		Level 1 — Quoted prices for identical instruments in active markets.

	•		Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable in active markets.

	•		Level 3 — Valuations derived from valuation techniques in which one or more significant inputs are unobservable.

The Company utilizes a pricing service for the valuation of the majority of securities held. This pricing service is an independent, third party vendor recognized to be an industry leader with access to market information who obtains or computes fair market values from quoted market prices, pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models. For valuations obtained from the pricing service, the Company performs due diligence to understand how the valuation was calculated or derived, focusing on the valuation technique used and the nature of the inputs.

The following section describes the valuation methodologies used to measure different financial instruments at fair value, including an indication of the level in the fair value hierarchy in which the instrument is generally classified.

Fixed Income Securities

Securities valued using Level 1 inputs include highly liquid government bonds for which quoted market prices are available. Securities using Level 2 inputs are valued using pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models utilizing observable inputs. Most fixed income securities are valued using Level 2 inputs. Level 2 includes corporate bonds, municipal bonds, asset-backed securities and mortgage pass-through securities.

Equity Securities

Level 1 includes publicly traded securities valued using quoted market prices.

Short-Term Investments

The valuation of securities that are actively traded or have quoted prices are classified as Level 1. These securities include money market funds and U.S. Treasury bills. Level 2 includes commercial paper, for which all significant inputs are observable.

Assets measured at fair value on a recurring basis as of September 30, 2009 and December 31, 2008 are summarized below (amounts in thousands):


	September 30, 2009
	Fair Value Measurements Using
							Assets at Fair
	Level 1		Level 2		Level 3		Value
Assets:
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	18,492	$	—	$	—	$	18,492
U.S. Agencies		—		24,732		—		24,732
Collateralized mortgage obligations — residential		—		33,436		—		33,436
Mortgage pass-through securities — residential		—		59,357		—		59,357
Obligations of states and political subdivisions		—		745,821		—		745,821
Corporate bonds		—		305,008		—		305,008
Collateralized mortgage obligations — commercial		—		9,600		—		9,600
Other asset-backed securities:
Second mortgages/home equity loans — residential		—		5,320		—		5,320
Consumer credit receivables		—		17,056		—		17,056
Other		—		10,460		—		10,460

Total fixed income securities		18,492		1,210,790		—		1,229,282
Equity securities at fair value		1,553		—		—		1,553
Short-term investments at fair value ^(a)		22,524		47,948		—		70,472

Total assets	$	42,569	$	1,258,738	$	—	$	1,301,307


^(a)		Includes commercial paper and money market funds.


	December 31, 2008
	Fair Value Measurements Using
							Assets at Fair
	Level 1		Level 2		Level 3		Value
Assets:
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	36,659	$	—	$	—	$	36,659
U.S. Agencies		—		37,592		—		37,592
Collateralized mortgage obligations — residential		—		36,655		—		36,655
Mortgage pass-through securities — residential		—		73,692		—		73,692
Obligations of states and political subdivisions		—		696,163		—		696,163
Corporate bonds		—		93,476		—		93,476
Collateralized mortgage obligations — commercial		—		29,378		—		29,378
Other asset-backed securities:
Second mortgages/home equity loans — residential		—		4,997		—		4,997
Consumer credit receivables		—		15,531		—		15,531
Other		—		10,503		—		10,503

Total fixed income securities		36,659		997,987		—		1,034,646
Equity securities at fair value		1,231		—		—		1,231
Short-term investments at fair value ^(a)		30,616		49,990		—		80,606

Total assets	$	68,506	$	1,047,977	$	—	$	1,116,483


^(a)		Includes commercial paper and money market funds.

5. Reserves for Losses and Loss Adjustment Expenses

Activity in the reserves for unpaid losses and loss adjustment expenses was as follows (dollars in thousands):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Reserves at beginning of period:
Gross	$	419,812		$	495,041		$	428,724		$	472,842
Ceded reinsurance		40,796			152,296			83,691			150,496

Net reserves at beginning of period		379,016			342,745			345,033			322,346

Net incurred loss and loss adjustment expenses:
Provision for insured events of current year		32,291			33,685			92,907			87,104
Decrease in provision for insured events of prior years		(7,862	)		(24,940	)		(7,915	)		(25,001	)

Total net incurred		24,429			8,745			84,992			62,103

Net payments attributable to:
Current year events		6,717			3,456			10,323			5,996
Prior year events		11,843			5,854			34,817			36,273

Total net payments		18,560			9,310			45,140			42,269

Net reserves at end of period		384,885			342,180			384,885			342,180
Ceded reinsurance at end of period		43,401			82,381			43,401			82,381

Gross reserves at end of period	$	428,286		$	424,561		$	428,286		$	424,561

Prior to 2009 the Company’s periodic actuarial analyses of loss reserves included a comprehensive review performed in the third quarter based on data as of June 30 and an update of the comprehensive review performed in January based on data as of December 31. The Company has changed the timing of the comprehensive review to occur in the fourth quarter using data as of September 30. This timing was changed to include an additional three months of actual loss data in this review. In between these analyses, management monitors claim activity against benchmarks of expected claim activity prepared in connection with the comprehensive review and records adjustments as necessary. The Company has experienced favorable claim activity through the first nine months of 2009 and management believes that this experience is sufficiently credible to indicate that adjustments to reserves are appropriate, particularly for more mature accident years. The decrease in the provision for insured events of prior years for the three and nine months ended September 30, 2009, reflect adjustments of the reserves for accident years 2004 and prior as a result of specific indemnity recoveries and reductions in case reserves, and for accident year 2006 as a result of claim activity that was substantially below expectations.

In comparison, the conclusion of the actuarial analysis conducted during the third quarter of 2008 with data as of June 30, 2008 resulted in lower actuarial point estimates, or reserve indications. These lower estimates resulted from positive claim frequency trends which resulted in improvements for accident years 2001 through 2006. As a result, management recorded favorable prior year loss development of $24.9 million on a net basis during the three months ended September 30, 2008.

6. Debt

In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities, issued by CNA Surety Capital Trust I (the “Issuer Trust”), bear interest at the London Interbank Offered Rate (“LIBOR”) plus 337.5 basis points with a 30-year term. Beginning in May 2009, these securities may be redeemed, in whole or in part, at par value at any scheduled quarterly interest payment date. As of September 30, 2009, none of these preferred securities have been redeemed.

The Company’s investment of $0.9 million in the Issuer Trust is carried at cost in “Other assets” in the Company’s Condensed Consolidated Balance Sheets. The sole asset of the Issuer Trust consists of a $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. Due to the underlying characteristics of this debt, the carrying value of the debenture approximates its estimated fair value.

The Company has also guaranteed the dividend payments and redemption of the preferred securities issued by the Issuer Trust. The maximum amount of undiscounted future payments the Company could make under the guarantee is approximately $58.2 million, consisting of annual dividend payments of approximately $1.1 million until maturity and the redemption value of the preferred securities of $30.0 million. Because payment under the guarantee would only be required if the Company does not fulfill its obligations under the debentures held by the Issuer Trust, the Company has not recorded any additional liabilities related to this guarantee.

The junior subordinated debenture bears interest at a rate of LIBOR plus 337.5 basis points and matures in April 2034. As of September 30, 2009 and 2008, the interest rate on the junior subordinated debenture was 3.815% and 6.179%, respectively.

On June 30, 2008, the Company’s credit facility matured. The term of borrowings under this facility (the “2005 Credit Facility”) was fixed, at the Company’s option, for a period of one, two, three or six months. The interest rate was based on, among other rates, LIBOR plus the applicable margin. The margin, including a utilization fee, varied based on the Company’s leverage ratio (debt to total capitalization) from 0.80% to 1.00%. There was no outstanding balance under the 2005 Credit Facility during the six months ended June 30, 2008. As such, the Company incurred only the facility fee of 0.300% through the first six months of 2008.

The 2005 Credit Facility was entered into on July 27, 2005, when the Company refinanced $30.0 million in outstanding borrowings under its previous credit facility. The 2005 Credit Facility provided an aggregate of up to $50.0 million in borrowings under a revolving credit facility. In September 2006, the Company reduced the available aggregate revolving credit facility to $25.0 million in borrowings. The 2005 Credit Facility also contained certain conditions and limitations on the Company. The Company was in compliance with all covenants as of and for the three and six months ended June 30, 2008 when the 2005 Credit Facility matured.

7. Employee Benefits

Western Surety sponsors two postretirement benefit plans covering certain employees. One plan provides medical benefits and the other plan provides sick leave termination payments. The medical benefit plan provides coverage for employees, and their eligible dependents, hired by Western Surety before November 1, 1991 and who retire at age 55 or later with at least 15 years of service. Only employees hired by Western Surety prior to 1988 are eligible for the sick leave plan. Further, benefits for the sick leave plan are based on unused accrued sick leave as of December 31, 2003, the date the accruals were frozen. The postretirement medical benefit plan is contributory and the sick leave plan is non-contributory. Western Surety uses a December 31 measurement date for both of its postretirement benefit plans. There were no plan assets for either of the postretirement benefit plans.

The plans’ combined net periodic postretirement benefit cost included the following components (amounts in thousands):


	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
Net periodic benefit cost:
Service cost	$	65		$	26		$	171		$	144
Interest cost		160			74			429			364
Amortization of prior service cost (benefit)		(40	)		(68	)		(121	)		(121	)
Net amortization of actuarial (gain) loss		—			(12	)		—			—

Net periodic benefit cost	$	185		$	20		$	479		$	387

The Company uses a roll-forward technique to develop its year-end measurement of the accumulated postretirement benefit obligation and subsequently performs a valuation as of January 1 of the following year using updated data. This valuation was completed during the third quarter of 2009. As a result, in the third quarter of 2009, the liability for postretirement benefits and the 2009 net periodic benefit costs have been adjusted. The postretirement benefit liability increased by $0.6 million. Net periodic benefit costs also increased by less than $0.1 million for the three months ended September 30, 2009 due to this remeasurement. These increases were driven by higher claims costs for the medical benefit plan.

In the third quarter of 2008, the liability for postretirement benefits and the 2008 net periodic benefit were also adjusted due to this remeasurement. The postretirement benefit liability decreased by $1.6 million and net periodic benefit costs decreased $0.2 million for the three months ended September 30, 2008. These decreases were driven by lower expected per capita claims costs for the medical benefit plan related to changes in the plan provider.

The Company expects to contribute $0.2 million to the postretirement benefit plans to pay benefits in 2009. As of September 30, 2009, less than $0.1 million of contributions have been made to the postretirement benefit plans.

8. Commitments and Contingencies

The Company is party to various lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations.

9. Income Taxes

The Company is subject to taxation in the United States and various state jurisdictions. On July 22, 2009, the Internal Revenue Service notified the Company that the ongoing examination of the Company’s tax return for the year 2006 had been completed and no changes were made to the Company’s reported income taxes. However, the Company’s tax year 2006, as well as tax years 2007 and 2008, remain open as to the applicable statute of limitations and are subject to examination by the Internal Revenue Service.

The Company has not recognized any liabilities for uncertain income taxes as of September 30, 2009 or December 31, 2008, respectively. Also, the Company does not anticipate any material change in the total amount of unrecognized tax benefits to occur within the next twelve months.

10. Stockholders Equity

The compensation expense recorded for the Company’s stock-based compensation plan was $0.4 million for both the three months ended September 30, 2009 and 2008, respectively, and $1.4 million and $1.3 million for the nine months ended September 30, 2009 and 2008, respectively. The total income tax benefit recognized in the Condensed Consolidated Statements of Income for stock-based compensation arrangements was $0.2 million for both the three months ended September 30, 2009 and 2008, respectively. The total income tax benefit recognized in the Condensed Consolidated Statements of Income for stock-based compensation was $0.5 million for both the nine months ended September 30, 2009 and 2008, respectively. The amount of cash received from the exercise of stock options was $0.1 million and $0.2 million for the three months ended September 30, 2009 and 2008, respectively. For the nine months ended September 30, 2009 and 2008, the amount of cash received was $1.2 million and $0.4 million, respectively.

Equity Compensation Plans

The Company reserved shares of its common stock for issuance to directors, officers, employees and certain advisors of the Company through incentive stock options, nonqualified stock options, restricted stock, bonus shares or stock appreciation rights (“SARs”) to be granted under the CNA Surety 2006 Long-Term Equity Compensation Plan (the “2006 Plan”), approved by shareholders on April 25, 2006. The aggregate number of shares initially available for which options may be granted under the 2006 Plan was 3,000,000. Option exercises under the 2006 Plan are settled in newly issued common shares.

The 2006 Plan is administered by a committee (the “Committee”) of the Board of Directors, consisting of two or more directors of the Company. Subject to the provisions set forth in the 2006 Plan, all of the members of the Committee shall be independent members of the Board of Directors. The Committee determines the option exercise prices. Exercise prices may not be less than the fair market value of the Company’s common stock on the date of grant for incentive stock options and may not be less than the par value of the Company’s common stock for nonqualified stock options.

The 2006 Plan provides for the granting of incentive stock options as defined under Section 409A of the Internal Revenue Code of 1986, as amended. All nonqualified stock options and incentive stock options granted under the 2006 Plan expire ten years after the date of grant and vest ratably over the four-year period following the date of grant.

On February 6, 2009, 217,960 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $8.95 for these options. The fair value of these options was estimated at the grant date using a Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 1.95%; dividend yield of 0.0%; expected option life of 5.3 years and volatility of 51.8%. The Company estimated the expected option life of the 2009 grant based on its analysis of past exercise patterns for similar options. As of September 30, 2009, the number of shares available for granting of options under the 2006 Plan was 2,247,180.

On February 8, 2008, 259,380 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $6.32 for these options. The fair value of these options was estimated at the grant date using a Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 2.7%; dividend yield of 0.0%; expected option life of 5.3 years and volatility of 38.3%. The Company estimated the expected option life of the 2008 grant based on its analysis of past exercise patterns for similar options. As of September 30, 2008, the number of shares available for granting of options under the 2006 Plan was 2,434,905.

A summary of option activity for the nine months ended September 30, 2009 and 2008 is presented below:


				Weighted
				Average
	Shares			Exercise
	Subject			Price Per
	To Option			Share
Outstanding options at January 1, 2008		1,054,588		$	14.53
Options granted		259,380		$	16.35
Options forfeited		(22,210	)	$	16.99
Options expired		(6,125	)	$	12.71
Options exercised		(29,800	)	$	11.53

Outstanding options at September 30, 2008		1,255,833		$	14.94

Outstanding options at January 1, 2009		1,221,118		$	14.93
Options granted		217,960		$	18.85
Options forfeited		(10,900	)	$	17.63
Options expired		(13,270	)	$	14.34
Options exercised		(89,905	)	$	11.51

Outstanding options at September 30, 2009		1,325,003		$	15.79

A summary of the status of the Company’s non-vested options as of September 30, 2009 and 2008 and changes during the nine months then ended is presented below:


				Weighted
	Shares			Average
	Subject			Grant Date
	To Option			Fair Value
Non-vested options at January 1, 2008		554,557		$	7.23
Options granted		259,380		$	6.32
Options vested		(80,785	)	$	8.94
Options forfeited		(22,210	)	$	6.95

Non-vested options at September 30, 2008		710,942		$	6.71

Non-vested options at January 1, 2009		545,095		$	7.29
Options granted		217,960		$	8.95
Options vested		(136,849	)	$	7.82
Options forfeited		(10,900	)	$	7.43

Non-vested options at September 30, 2009		615,306		$	7.76

A summary of the options vested or expected to vest and options exercisable as of September 30, 2009 is presented below:

Options Vested or Expected to Vest

Weighted

Weighted Average

Average

Aggregate

Remaining

Number

Exercise Price

Intrinsic Value

Contractual Life

September 30, 2009

1,250,036

15.62

2,483,307

6.7 years

Options Exercisable

Weighted

Weighted Average

Average

Aggregate

Remaining

Number

Exercise Price

Intrinsic Value

Contractual Life

September 30, 2009

709,697

13.97

2,259,472

5.6 years

The total intrinsic value of options exercised was less than $0.1 million for the three months ended September 30, 2009. For the three months ended September 30, 2008, the total intrinsic value of options exercised was $0.1 million. The total intrinsic value of options exercised was $0.5 million and $0.2 million for the nine months ended September 30, 2009 and 2008, respectively. The tax benefits recognized by the Company for these exercises were $0.1 million and less than $0.1 million for the three months ended September 30, 2009 and 2008, respectively. The tax benefits recognized by the company for these exercises were $0.2 million and less than $0.1 million for the nine months ended September 30, 2009 and 2008, respectively.

As of September 30, 2009, there was $1.7 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements granted under the Company’s equity compensation plans. That cost is expected to be recognized as follows: 2009 — $0.4 million; 2010 — $0.8 million; 2011 — $0.4 million; and 2012 — $0.1 million.

CNA SURETY CORPORATION AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

The following is a discussion and analysis of CNA Surety Corporation and its subsidiaries’ (collectively, “CNA Surety” or the “Company”) operating results, liquidity and capital resources, and financial condition. This discussion should be read in conjunction with the Condensed Consolidated Financial Statements in Item 1 of Part 1 of this Quarterly Report on Form 10-Q and the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

Critical Accounting Policies

Management believes the most significant accounting policies and related disclosures for purposes of understanding the Company’s results of operations and financial condition pertain to reserves for unpaid losses and loss adjustment expenses and reinsurance, investments, goodwill and other intangible assets, recognition of premium revenue and the related unearned premium liability and deferred policy acquisition costs. The Company’s accounting policies related to reserves for unpaid losses and loss adjustment expenses and related estimates of reinsurance recoverables are particularly critical to an assessment of the Company’s financial results. Given the nature of the surety business, the determination of these balances is inherently a highly subjective exercise, which requires management to analyze, weigh, and balance numerous macroeconomic, customer specific, and claim specific factors and trends, most of which, in themselves, are inherently uncertain and difficult to predict.

Reserves for Unpaid Losses and Loss Adjustment Expenses and Reinsurance

CNA Surety accrues liabilities for unpaid losses and loss adjustment expenses (“LAE”) under its surety and property and casualty insurance contracts based upon estimates of the ultimate amounts payable under the contracts related to losses occurring on or before the balance sheet date.

Reported claims are in various stages of the settlement process. Due to the nature of surety, which is the relationship among three parties whereby the surety guarantees the performance of the principal to a third party (the obligee), the investigation of claims and the establishment of case estimates on claim files can be a complex process that can occur over a period of time depending on the type of bond(s) and the facts and circumstances involving the particular bond(s), the claim(s) and the principal. Case reserves are typically established after a claim is filed and an investigation and analysis has been conducted as to the validity of the claim, the principal’s response to the claim and the principal’s financial viability. To the extent it is determined that there are no bona fide defenses to the claim and the principal is unwilling or financially unable to resolve the claim, a case estimate is established on the claim file for the amount the Company estimates it will have to pay to honor its obligations under the provisions of the bond(s).

While the Company intends to establish initial case reserve estimates that are sufficient to cover the ultimate anticipated loss on a claim file, some estimates need to be adjusted during the life cycle of the claim file as matters continue to develop. Factors that can necessitate case estimate increases or decreases are the complexity of the bond(s) and/or underlying contract(s), if additional and/or unexpected claims are filed, if the financial condition of the principal or obligee changes or as claims develop and more information is discovered that was unknown and/or unexpected at the time the initial case reserve estimate was established. Ultimately, claims are resolved through payment and/or a determination that, based on the information available, a case reserve is no longer required.

As of any balance sheet date, not all claims have been reported and some claims may not be reported for many years. As a result, the liability for unpaid losses includes significant estimates for incurred-but-not-reported (“IBNR”) claims. The IBNR reserves also include provisions for losses in excess of the current case reserve for previously reported claims and for claims that may be reopened. The IBNR reserves also include offsets for anticipated indemnity recoveries.

The following table shows the estimated liability as of September 30, 2009 for unpaid claims applicable to reported claims and to IBNR for each sub-line of business (dollars in thousands):


	Gross Case Loss		Gross IBNR Loss		Total Gross
	and LAE Reserves		and LAE Reserves		Reserves
Contract	$	43,287	$	260,977	$	304,264
Commercial		51,814		57,498		109,312
Fidelity and other		3,600		11,110		14,710

Total	$	98,701	$	329,585	$	428,286

Periodic actuarial analyses of the Company’s loss reserves are performed. These analyses have typically included a comprehensive review performed in the third quarter based on data as of June 30 and an update of the comprehensive review performed in January based on data as of December 31. The Company has changed the timing of the comprehensive review to occur in the fourth quarter using data as of September 30. In between these analyses, management monitors claim activity against benchmarks of expected claim activity prepared in connection with the comprehensive review and records adjustments as necessary.

The actuarial analyses are based upon multiple projection methodologies that involve detailed statistical analysis of past claim reporting, settlement activity, and indemnification activity, as well as claim frequency and severity data when sufficient information exists to lend statistical credibility to the analysis. The analysis may be based upon internal loss experience or industry experience. Methodologies may vary depending on the type of claim being estimated. While methodologies may vary, each employs significant judgments and assumptions.

Each of the projection methodologies employed rely to varying degrees on the basic assumption that the Company’s historical claim experience is indicative of the Company’s future claim development. The amount of weight given to any individual projection method is based on an assessment of the volatility of the historical data and development patterns, an understanding of the changes in the overall surety industry over time and the resultant potential impact of these changes on the Company’s prospective claims development, an understanding of the changes to the Company’s processes and procedures within its underwriting, claims handling and data systems functions, among other things. The decision as to how much weight to give to any particular projection methodology is ultimately a matter of experience and professional judgment.

Surety results, especially for contract and certain commercial products like insurance program bonds, workers compensation insurance bonds and reclamation bonds, tend to be impacted by fewer, but more severe, losses. With this type of loss experience, it is more difficult to estimate the required reserves, particularly for the most current accident years which may have few reported claims. Therefore, assumptions related to the frequency and magnitude of severe loss are key in estimating surety loss reserves.

The indicated reserve, or actuarial point estimate, was developed by reviewing the Company’s claims experience by accident year for several individual sub-lines of business. Within each sub-line, the selection of the point estimate was made after consideration of the appropriateness of the various projection methodologies in light of the sub-line’s loss characteristics and historical data. In general, for the older, more mature, accident years the historical development method (i.e., link ratio method) was relied upon more heavily. For the more recent years, the indicated reserves were more heavily based on the Bornhuetter-Ferguson and loss ratio methods since these are not as reliant on the Company’s large (i.e., leveraged) development factors and thus are believed to represent a more stable set of methods from which to select indicated reserves for the more recent years.

The actuarial analysis is the primary tool that management utilizes in determining its best estimate of loss reserves. However, the carried reserve may differ from the actuarial point estimate as a result of management’s consideration of the impact of factors such as the following, especially as they relate to the current accident year:

	—		Current claim activity, including the frequency and severity of current claims;

	—		Changes in underwriting standards and business mix such as the Company’s efforts to reduce exposures to large commercial bonds;

	—		Changes in the claims handling process;

	—		Potential changes in the Company’s reinsurance program; and

	—		Current economic conditions, especially corporate default rates and the condition of the construction economy.

Management believes that the impact of the factors listed above, and others, may not be fully quantifiable through actuarial analysis. Accordingly, management may apply its judgment of the impact of these factors, and others, to its selection of the recorded loss reserves.

Receivables recorded with respect to insurance losses ceded to reinsurers under reinsurance contracts are estimated in a manner similar to liabilities for insurance losses and, therefore, are also subject to uncertainty. In addition to the factors cited above, estimates of reinsurance recoveries may prove uncollectible if the reinsurer is unable to perform under the contract. Reinsurance contracts do not relieve the ceding company of its obligations to indemnify its own policyholders.

Casualty insurance loss reserves are subject to a significant amount of uncertainty. Given the nature of surety losses with its low frequency, high severity characteristics, this is particularly true for surety loss reserves. As a result, the range of reasonable loss reserve estimates may be broader than that associated with traditional property/casualty insurance products. While the loss reserve estimates represent the best professional judgments, arrived at after careful actuarial analysis of the available data, it is important to note that variation from the estimates is not only possible but, in fact, probable. The sources of this inherent variability are numerous — future economic conditions, court decisions, legislative actions, and individual large claim impacts, for example.

Due to the inherent uncertainties in the process of establishing the liabilities for unpaid losses and loss adjustment expenses, the actual ultimate claims amounts will differ from the currently recorded amounts. This difference could have a material effect on reported earnings and financial condition. Future effects from changes in these estimates will be recorded in the period such changes are determined to be needed.

Investments

Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company considers all of its fixed income securities (bonds) and equity securities as available-for-sale. These securities are reported at fair value, with unrealized gains and losses, net of deferred income taxes, reported in stockholders’ equity as a separate component of accumulated other comprehensive income.

Fixed income securities in an unrealized loss position that the Company intends to sell, or it more likely than not will be required to sell before recovery of amortized cost, are considered to be other-than-temporarily impaired. These securities are written down to fair value and the resulting losses are recognized in realized gains/losses in the Condensed Consolidated Statements of Income. Fixed income securities in an unrealized loss position for which management believes a credit loss exists are considered to be other-than-temporarily impaired. For those securities, the Company bifurcates the impairment into a credit component and a non-credit component. The credit component, which represents the difference between discounted cash flows and the fixed income security’s amortized cost, is recognized in earnings and the non-credit component is recognized in other comprehensive income. Cash flows from purchases, sales and maturities of fixed income and equity securities are reported gross in the investing activities section of the Condensed Consolidated Statements of Cash Flows.

The amortized cost of fixed income securities is determined based on cost and the cumulative effect of amortization of premiums and accretion of discounts using the interest method. Such amortization and accretion are included in investment income. For mortgage-backed and asset-backed securities, the Company considers estimates of future prepayments in the calculation of the effective yield used to apply the interest method. If a difference arises between the anticipated prepayments and the actual prepayments, the Company recalculates the effective yield based on actual prepayments and the currently anticipated future prepayments. The amortized costs of such securities are adjusted to the amount that would have resulted had the recalculated effective yields been applied since the acquisition of the securities with a corresponding charge or credit to investment income. Prepayment estimates are based on the structural elements of specific securities, interest rates and generally recognized prepayment speed indices.

Short-term investments, that generally include U.S. Treasury bills, corporate notes, money market funds and investment grade commercial paper equivalents, are carried at amortized cost, which approximates fair value.

Invested assets are exposed to various risks, such as interest rate risk, market risk and credit risk. Due to the level of risk associated with invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may materially affect the amounts reported in the Condensed Consolidated Balance Sheets and Condensed Consolidated Statements of Income.

Intangible Assets

CNA Surety’s Condensed Consolidated Balance Sheets as of September 30, 2009 and December 31, 2008 include goodwill and intangible assets of approximately $138.8 million. This amount primarily represents goodwill and identified intangibles with indefinite useful lives arising from the acquisition of Capsure Holdings Corp. (“Capsure”).

A significant amount of judgment is required in performing intangible assets impairment tests. Such tests include periodically determining or reviewing the estimated fair value of CNA Surety’s reporting units. Under the relevant standard, fair value refers to the

amount for which the entire reporting unit may be bought or sold. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. The Company uses a valuation technique based on discounted cash flows. Significant inputs to the Company’s discounted cash flow model include estimated capital requirements to support the business, expected cash flows from underwriting activity, required capital investment to support growth and the selected discount rates. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of intangible assets. The excess of the recorded amount of intangible assets over the implied value of intangible assets is recorded as an impairment loss.

Insurance Premiums

Insurance premiums are recognized as revenue ratably over the term of the related policies in proportion to the insurance protection provided. Contract bonds provide coverage for the length of the bonded project and not a fixed time period. As such, the Company uses estimates of the contract length as the basis for recognizing premium revenue on these bonds. Premium revenues are net of amounts ceded to reinsurers. Unearned premiums represent the portion of premiums written, before ceded reinsurance which is shown as an asset, applicable to the unexpired terms of policies in force determined on a pro rata basis.

Deferred Policy Acquisitions Costs

Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses which vary with, and are primarily related to, the production of business, net of reinsurance commissions, are deferred and amortized as a charge to income as the related premiums are earned. The Company periodically tests that deferred policy acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred policy acquisition costs, a charge to net income is taken and the deferred policy acquisition cost balance is reduced to the amount determined to be recoverable. Anticipated investment income is considered in the determination of the recoverability of deferred policy acquisition costs.

Results of Operations

Financial Measures

The Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) discusses certain accounting principles generally accepted in the United States of America (“GAAP”) and non-GAAP financial measures in order to provide information used by management to monitor the Company’s operating performance. Management utilizes various financial measures to monitor the Company’s insurance operations and investment portfolio. Underwriting results, which are derived from certain income statement amounts, are considered a non-GAAP financial measure and are used by management to monitor performance of the Company’s insurance operations.

Underwriting results are computed as net earned premiums less net loss and loss adjustment expenses and net commissions, brokerage and other underwriting expenses. Management uses underwriting results to monitor its insurance operations’ results without the impact of certain factors, including net investment income, net realized investment gains (losses) and interest expense. Management excludes these factors in order to analyze the direct relationship between net earned premiums and the related net loss and loss adjustment expenses along with net commissions, brokerage and other underwriting expenses.

Operating ratios are calculated using insurance results and are widely used by the insurance industry and regulators such as state departments of insurance and the National Association of Insurance Commissioners for financial regulation and as a basis of comparison among companies. The ratios discussed in the Company’s MD&A are calculated using GAAP financial results and include the net loss and loss adjustment expense ratio (“loss ratio”) as well as the net commissions, brokerage and other underwriting expense ratio (“expense ratio”) and combined ratio. The loss ratio is the percentage of net incurred losses and loss adjustment expenses to net earned premiums. The expense ratio is the percentage of net commissions, brokerage and other underwriting expenses, including the amortization of deferred acquisition costs, to net earned premiums. The combined ratio is the sum of the loss and expense ratios.

While management uses various GAAP and non-GAAP financial measures to monitor various aspects of the Company’s performance, net income is the most directly comparable GAAP measure and represents a more comprehensive measure of operating

performance. Management believes that its process of evaluating performance through the use of these non-GAAP financial measures provides a basis for enhanced understanding of the operating performance and the impact to net income as a whole. Management also believes that investors may find these widely used financial measures described above useful in interpreting the underlying trends and performance, as well as to provide visibility into the significant components of net income.

Comparison of CNA Surety Actual Results for the Three and Nine Months Ended September 30, 2009 and 2008

Analysis of Net Income

Net income for the three months ended September 30, 2009 was $25.5 million, or $0.57 per diluted share, compared to $34.3 million, or $0.78 per diluted share, for the same period in 2008. The decrease in net income reflects the impact of higher net favorable loss reserve development in the 2008 period, partially offset by higher investment income and higher net realized investment gains in the 2009 period.

Net income for the nine months ended September 30, 2009 was $68.6 million, or $1.54 per diluted share, compared to $81.3 million, or $1.84 per diluted share, in 2008. The decrease in net income reflects lower earned premium and the impact of a higher loss ratio, partially offset by higher net investment income and higher net realized investment gains. The 2008 period also benefitted from higher levels of favorable loss reserve development in prior accident years.

The components of net income are discussed in the following sections.

Results of Insurance Operations

Underwriting components for the Company for the three and nine months ended September 30, 2009 and 2008 are summarized in the following table (dollars in thousands):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Gross written premiums	$	113,402		$	120,362		$	341,361		$	361,299

Net written premiums	$	106,361		$	108,805		$	320,495		$	333,626

Net earned premiums	$	109,703		$	109,696		$	316,549		$	320,814

Net losses and loss adjustment expenses	$	24,429		$	8,745		$	84,992		$	62,103

Net commissions, brokerage and other underwriting expenses	$	62,169		$	61,694		$	172,364		$	174,806

Loss ratio		22.3	%		8.0	%		26.8	%		19.4	%
Expense ratio		56.7			56.2			54.5			54.5

Combined ratio		79.0	%		64.2	%		81.3	%		73.9	%

Premiums Written/Earned

CNA Surety primarily markets contract and commercial surety bonds. Contract surety bonds generally secure a contractor’s performance and/or payment obligation with respect to a construction project. Contract surety bonds are generally required by federal, state and local governments for public works projects. The most common types include bid, performance and payment bonds. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. The commercial surety market includes numerous types of bonds categorized as court judicial, court fiduciary, public official, license and permit and many miscellaneous bonds that include guarantees of financial performance. The Company also writes fidelity bonds that cover losses arising from employee dishonesty and other insurance products that are generally companion products to certain surety bonds. For example, the Company writes surety bonds for notaries and also offers related errors and omissions (“E&O”) insurance coverage.

Through one of its insurance subsidiaries, Western Surety Company (“Western Surety”), the Company assumes significant amounts of premiums primarily from affiliates. This includes surety business written or renewed, net of reinsurance, by Continental Casualty Company (“CCC”) and The Continental Insurance Company (“CIC”), and their affiliates, after September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write certain business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of this assumed business.

Gross written premium, which is the aggregate of direct written premiums and assumed written premiums, for the three months and nine months ended September 30, 2009 and 2008 is shown in the table below (dollars in thousands) for each sub-line of business:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2009		2008		2009		2008
Contract	$	71,817	$	78,418	$	215,301	$	233,766
Commercial		34,163		34,331		102,579		103,192
Fidelity and other		7,422		7,613		23,481		24,341

	$	113,402	$	120,362	$	341,361	$	361,299

For the quarter ended September 30, 2009, gross written premiums decreased 5.8 percent to $113.4 million compared to $120.4 million for the quarter ended September 30, 2008. Contract surety gross written premiums decreased 8.4 percent to $71.8 million due to lower demand resulting from fewer new construction projects. Commercial surety written premiums decreased slightly to $34.2 million due to continued adverse economic conditions.

For the nine months ended September 30, 2009, gross written premiums decreased 5.5 percent to $341.4 million compared to $361.3 million for the nine-month period ended September 30, 2008. Gross written premiums for contract surety decreased 7.9 percent to $215.3 million due to lower demand resulting from fewer new construction projects. Commercial surety decreased 0.6 percent to $102.6 million in the first nine months of 2009, reflecting adverse economic conditions.

The Company’s insurance subsidiaries purchase reinsurance from other insurance companies and affiliates. Reinsurance arrangements are used to limit maximum loss, provide greater diversification of risk and minimize exposure on larger risks. The cost of this reinsurance is recorded as ceded written premium. Ceded written premium decreased $4.5 million and $6.8 million for the three and nine-month periods ended September 30, 2009, respectively, compared to the same periods in 2008. The Company’s decision to increase the per principal retention from $10.0 million to $15.0 million resulted in lower ceded premiums on the 2009 core reinsurance program. Further, as a result of additional losses ceded under the 2007 third party excess of loss treaty, the Company recorded additional ceded premiums of $0.5 million and $4.2 million for the three and nine months ended September 30, 2009 and 2008, respectively.

Net written premiums, which is gross written premiums less ceded written premiums, for the three months and nine months ended September 30, 2009 and 2008 are shown in the table below (dollars in thousands) for each sub-line of business:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2009		2008		2009		2008
Contract	$	65,674	$	67,692	$	196,826	$	208,490
Commercial		33,265		33,500		100,188		100,795
Fidelity and other		7,422		7,613		23,481		24,341

	$	106,361	$	108,805	$	320,495	$	333,626

For the quarter ended September 30, 2009, net written premiums decreased 2.2 percent to $106.4 million compared to $108.8 million for the quarter ended September 30, 2008 reflecting the decrease in gross written premium, partially offset by lower ceded premium.

Net written premiums for the nine months ended September 30, 2009 decreased 3.9 percent to $320.5 million compared to $333.6 million for the nine months ended September 30, 2008 reflecting the decrease in gross written premium, partially offset by lower ceded premium.

Net written premiums are recognized as revenue over the policy term as net earned premiums. Net earned premiums for the three months and nine months ended September 30, 2009 and 2008 are shown in the table below (dollars in thousands) for each sub-line of business:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2009		2008		2009		2008
Contract	$	68,815	$	68,274	$	195,314	$	198,772
Commercial		33,208		33,493		98,246		98,487
Fidelity and other		7,680		7,929		22,989		23,555

	$	109,703	$	109,696	$	316,549	$	320,814

For the quarter ended September 30, 2009, net earned premiums were flat as compared to the third quarter of 2008. For the nine months ended September 30, 2009, net earned premiums decreased 1.3 percent to $316.5 million, due to the decrease in net written premiums described above.

Net Loss Ratio

The net loss ratio was 22.3% for the three months ended September 30, 2009 compared with 8.0% for the same period in 2008. The net loss ratio was 26.8% for the nine months ended September 30, 2009 compared with 19.4% for the same period last year. These loss ratios include re-estimates of prior accident year reserves, known as reserve development. The dollar amount and percentage point effect of these reserve reductions were $7.9 million, or 7.1 percentage points, and $24.9 million, or 22.7 percentage points, for the three months ended September 30, 2009 and 2008, respectively. The dollar amount of these revisions were reductions of $7.9 million, or 2.6 percentage points, and $25.0 million, or 7.8 percentage points, for the nine months ended September 30, 2009 and 2008, respectively.

Management monitors claim activity against benchmarks of expected claim activity prepared in connection with the comprehensive actuarial review. As previously discussed, prior to 2009 the Company’s periodic actuarial analyses of loss reserves included a comprehensive review performed in the third quarter based on data as of June 30 and an update of the comprehensive review performed in January based on data as of December 31. The Company has changed the timing of the comprehensive review to occur in the fourth quarter using data as of September 30. This timing was changed to include an additional three months of actual loss data in this review. The Company has experienced favorable claim activity through the first nine months of 2009 and management believes that this experience is sufficiently credible to indicate that adjustments to reserves are appropriate, particularly for more mature accident years. The reserve reductions for the three and nine months ended September 30, 2009, reflect adjustments of the reserves for accident years 2004 and prior as a result of specific indemnity recoveries and reductions in case reserves, and for accident year 2006 as a result of claim activity that was substantially below expectations.

Expense Ratio

The expense ratio was 56.7% and 54.5% for the three months and nine months ended September 30, 2009 as compared with 56.2% and 54.5% for the same periods in 2008, respectively. Expenses for the quarter ended September 30, 2009 included impairments of capitalized software development costs related to in-development projects that the Company decided to terminate. These impairments totaled $4.9 million, which added 4.5 and 1.6 percentage points to the expense ratio for the three and nine months ended September 30, 2009, respectively. The expense ratios for the three months and nine months ended September 30, 2008 included the impact on net earned premium of the additional ceded premiums discussed above and the impact of increased accruals for incentive compensation based on strong results for the nine months ended September 30, 2008.

Investment Income and Realized Investment Gains/Losses

Net investment income for the quarter ended September 30, 2009 was $12.5 million compared to $11.8 million during the third quarter of 2008 due to an increase in invested assets, partially offset by lower yields, particularly on short-term investments. The annualized pre-tax yields were 4.1% and 4.3% for the three months ended September 30, 2009 and 2008, respectively. The annualized after-tax yields were 3.4% and 3.5% for the three months ended September 30, 2009 and 2008, respectively.

Net investment income for the nine months ended September 30, 2009 was $37.4 million compared to $35.3 million for the same period in 2008. The increase reflects the impact of higher overall invested assets. The annualized pre-tax yields were 4.2% and 4.4% for the nine months ended September 30, 2009 and 2008, respectively. The annualized after-tax yields were 3.5% and 3.7% for the nine months ended September 30, 2009 and 2008, respectively. The decrease in annualized yields was primarily due to a decline in short-term yields.

The following summarizes net realized investment gains (losses) activity (dollars in thousands):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Net realized investment gains (losses):
Fixed income securities:
Gross realized investment gains	$	1,448		$	—		$	1,491		$	—
Gross realized investment losses:
Other-than-temporary impairment losses		—			—			(116	)		—
Realized losses from sales		(392	)		—			(392	)		(19	)

Total gross realized investment losses		(392	)		—			(508	)		(19	)

Net realized investment gains (losses) on fixed income securities		1,056			—			983			(19	)

Equity securities:
Gross realized investment gains		—			1			27			11
Gross realized investment losses:
Other-than-temporary impairment losses		—			(178	)		(46	)		(178	)
Realized losses from sales		—			—			(20	)		(20	)

Total gross realized investment losses		—			(178	)		(66	)		(198	)

Net realized investment gains (losses) on equity securities		—			(177	)		(39	)		(187	)

Other		—			—			(1	)		(1	)

Net realized investment gains (losses)	$	1,056		$	(177	)	$	943		$	(207	)

The Company’s investment portfolio is generally managed to maximize after-tax investment return, while minimizing credit risk with investments concentrated in high quality fixed income securities. CNA Surety’s portfolio is managed to provide diversification by limiting exposures to any one industry, issue or issuer, and to provide liquidity by investing in the public securities markets. The portfolio is structured to support CNA Surety’s insurance underwriting operations and to consider the expected duration of liabilities and short-term cash needs. In achieving these goals, assets may be sold to take advantage of market conditions or other investment opportunities or regulatory, credit and tax considerations. These activities will produce realized gains and losses.

Interest Expense

The benchmark interest rate for the Company’s variable interest rate debt is the London Interbank Offered Rate (“LIBOR”). Due to lower three-month LIBOR rates, interest expense decreased by 37.2 percent and 33.9 percent for the three and nine months ended September 30, 2009, respectively, as compared with the same periods in 2008. Weighted average debt outstanding was $30.9 million for each of these periods. The weighted average interest rate for the three months ended September 30, 2009 was 4.0% as compared with 6.1% for the same period in 2008. The weighted average interest rate for the nine months ended September 30, 2009 was 4.5% as compared with 6.6% for the same period in 2008.

Income Taxes

The Company’s income tax expense was $10.9 million and $27.8 million for the three and nine months ended September 30, 2009, respectively. The Company’s income tax expense was $16.0 million and $36.0 million for the three and nine months ended September 30, 2008, respectively. The effective income tax rates for the three and nine months ended September 30, 2009 were 29.8% and 28.9%, respectively. The effective income tax rates for the three and nine months ended September 30, 2008 were 31.8% and 30.7%, respectively. The Company’s effective tax rate differs from the statutory tax rate due primarily to tax-exempt investment income. Tax-exempt investment income was $6.1 million and $19.2 million for the three and nine months ended September 30, 2009, respectively. Tax-exempt investment income was $6.1 million and $17.5 million for the three and nine months ended September 30, 2008, respectively.

Exposure Management

The Company’s business is subject to certain risks and uncertainties associated with the current economic environment and corporate credit conditions. In response to these risks and uncertainties, the Company has enacted various exposure management initiatives. With respect to risks on large commercial accounts, the Company generally limits its exposure to $25.0 million per account, but will selectively accept higher exposures.

With respect to contract surety, the Company’s portfolio is predominantly comprised of contractors with bonded backlog of less than $30.0 million. Bonded backlog is an estimate of the Company’s exposure in the event of default before indemnification. The Company does have accounts with bonded backlogs greater than $30.0 million.

The Company manages its exposure to any one contract credit and aggressively looks for co-surety, shared accounts and other means to support or reduce larger exposures. Reinsurance and indemnification rights, including rights to contract proceeds on construction projects in the event of default, exist that substantially reduce CNA Surety’s exposure to loss.

Excess of Loss Reinsurance

2009 Third Party Reinsurance

2008 Third Party Reinsurance

Related Party Reinsurance

renewable thereafter. CCC and CIC transfer the related liabilities of such business and pay to Western Surety an amount in cash equal to CCC’s and CIC’s net written premiums written on all such business, minus a quarterly ceding commission to be retained by CCC and CIC equal to $50,000 plus 25% of net written premiums written on all such business. For 2008, this resulted in an override commission on their actual direct acquisition costs of 5.9% to CCC and CIC.

million of premiums receivable, respectively. CNA Surety had no reinsurance payables to CCC and CIC as of September 30, 2009. CNA Surety had reinsurance payables to CCC and CIC of $1.2 million as of December 31, 2008.

Liquidity and Capital Resources

It is anticipated that the liquidity requirements of CNA Surety will be met primarily by funds generated from operations. The principal sources of operating cash flows are premiums, investment income and recoveries under reinsurance contracts. The primary cash flow uses are payments for claims, operating expenses, federal income taxes and debt service. In general, surety operations generate premium collections from customers in advance of cash outlays for claims. Premiums are invested until such time as funds are required to pay claims and claims adjusting expenses.

The Company believes that total invested assets, including cash and short-term investments, are sufficient in the aggregate and have suitably scheduled maturities to satisfy all policy claims and other operating liabilities, including dividend and income tax sharing payments of its insurance subsidiaries. If cash requirements unexpectedly exceed cash inflows, the Company may raise additional cash by liquidating fixed income securities ahead of their scheduled maturity. Depending on the interest rate environment at that time, the Company could generate realized gains or losses that would increase or decrease net income for the period. The extent of these gains or losses would depend on a number of factors such as the prevailing interest rates and credit spreads, the duration of the assets sold and the marketability of the assets. The need to liquidate fixed income securities would be expected to cause a reduction in future investment income.

At September 30, 2009, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $1,229.3 million of fixed income securities, $66.9 million of short-term investments and $3.6 million of cash. At December 31, 2008, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $1,034.6 million of fixed income securities, $72.1 million of short-term investments and $4.1 million of cash.

Cash flow at the parent company level is derived principally from dividend and tax sharing payments from its insurance subsidiaries, and to a lesser extent, investment income. The principal obligations at the parent company level are to service debt and pay operating expenses, including income taxes. At September 30, 2009, the parent company’s invested assets consisted of $1.6 million of equity securities, $3.6 million of short-term investments and $3.2 million of cash. At December 31, 2008, the parent company’s invested assets consisted of $1.2 million of equity securities, $8.5 million of short-term investments and $4.6 million of cash. At September 30, 2009 and December 31, 2008, parent company short-term investments and cash included $5.9 million and $11.5 million, respectively, of restricted cash primarily related to premium receipt collections ultimately due to the Company’s insurance subsidiaries.

The Company’s consolidated net cash flow provided by operating activities was $109.7 million for the nine months ended September 30, 2009 compared to net cash flow provided by operating activities of $85.2 million for the comparable period in 2008. The increase in net cash flow provided by operating activities primarily relates to the absence of the payment of $49.0 million on July 1, 2008 in settlement of a large claim and collection of $25.4 million of recoveries associated with that claim during the third quarter of 2008.

The Company’s consolidated net cash flow provided by operating activities was $44.5 million for the three months ended September 30, 2009 compared to net cash flow provided by operating activities of $31.0 million for the comparable period in 2008. The increase in net cash flow provided by operating activities primarily relates to the absence of the payment and reinsurance recoveries associated with the large claim discussed above. Without the impact of that claim settlement, loss and loss adjustment expense payments were higher in the third quarter of 2009 compared to the same period in 2008.

The Company’s consolidated net cash flow provided by financing activities for the nine months ended September 30, 2009 included the effect of a $14.9 million overdraft of a short-term investment account associated with the Company’s investment custody account which occurred due to the timing of settlement of purchases of long-term fixed income securities and the related sale of a

short-term U.S. Government discount note. Since the Company records investment transactions on the trade date basis, the result was a negative balance in this account, which was reported in Other Liabilities on the Company’s Condensed Consolidated Balance Sheet as of September 30, 2009. The short-term account overdraft was cleared on October 1, 2009 when the sale of the discount note was initiated and settled.

In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities, issued by CNA Surety Capital Trust I (the “Issuer Trust”), bear interest at LIBOR plus 337.5 basis points with a 30-year term. Beginning in May 2009, these securities may be redeemed, in whole or in part, at par value at any scheduled quarterly interest payment date. As of September 30, 2009, none of these preferred securities have been redeemed.

On June 30, 2008, the Company’s credit facility matured. There was no outstanding balance under this facility (the “2005 Credit Facility”) during 2008. The term of borrowings under the 2005 Credit Facility was fixed, at the Company’s option, for a period of one, two, three or six months. The interest rate was based on, among other rates, LIBOR plus the applicable margin. The margin, including a utilization fee, varied based on the Company’s leverage ratio (debt to total capitalization) from 0.80% to 1.00%. There was no outstanding balance under the 2005 Credit Facility during the six months ended June 30, 2008. As such, the Company incurred only the facility fee of 0.300% through the first six months of 2008.

The Company does not have any material off-balance sheet arrangements as defined by Item 303 of Regulation S-K under the Exchange Acts of 1933 and 1934.

A summary of the Company’s commitments as of September 30, 2009 is presented in the following table (in millions):


Contractual Obligations as of September 30, 2009	2009		2010		2011		2012		2013		Thereafter		Total
Debt ^(a)	$	0.3	$	1.2	$	1.2	$	1.2	$	1.2	$	54.9	$	60.0
Operating leases		0.6		2.0		1.9		0.9		––		––		5.4
Loss and loss adjustment expense reserves		31.0		135.7		100.0		54.2		34.2		73.2		428.3
Other long-term liabilities ^(b)		0.2		1.2		1.0		0.6		0.4		9.9		13.3

Total	$	32.1	$	140.1	$	104.1	$	56.9	$	35.8	$	138.0	$	507.0


^(a)		Reflects expected principal and interest payments.

^(b)		Reflects unfunded postretirement benefit plans and long-term incentive plan payments to certain executives.

As an insurance holding company, CNA Surety is dependent upon dividends and other permitted payments from its insurance subsidiaries to pay operating expenses and meet debt service requirements, as well as to potentially pay cash dividends. The payment

of dividends by the insurance subsidiaries is subject to varying degrees of supervision by the insurance regulatory authorities in the insurance subsidiaries’ states of domicile. Western Surety, Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“Universal Surety”) are domiciled in South Dakota. In South Dakota, insurance companies may only pay dividends from earned surplus excluding surplus arising from unrealized capital gains or revaluation of assets. The insurance subsidiaries may pay dividends without obtaining prior regulatory approval only if such dividend or distribution (together with dividends or distributions made within the preceding 12-month period) is less than, as of the end of the immediately preceding year, the greater of (i) 10% of the insurer’s surplus to policyholders or (ii) statutory net income. In South Dakota, net income includes net realized capital gains in an amount not to exceed 20% of net unrealized capital gains. All dividends must be reported to the South Dakota Division of Insurance prior to payment.

The dividends that may be paid without prior regulatory approval are determined by formulas established by the applicable insurance regulations, as described above. The formulas that determine dividend capacity in the current year are dependent on, among other items, the prior year’s ending statutory surplus and statutory net income. Dividend capacity for 2009 is based on statutory surplus and income at and for the year ended December 31, 2008. Without prior regulatory approval in 2009, Western Surety may pay dividends of $108.5 million to CNA Surety. CNA Surety received dividends of $2.0 million from its insurance subsidiaries during the first nine months of 2009. CNA Surety received no dividends from its non-insurance subsidiaries during the first nine months of 2009. CNA Surety received $3.0 million in dividends from its insurance subsidiaries and no dividends from its non-insurance subsidiaries during the first nine months of 2008.

Combined statutory surplus totaled $626.9 million at September 30, 2009, resulting in an annualized net written premium to statutory surplus ratio of to 0.7 to 1. Insurance regulations restrict Western Surety’s maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2009 Excess of Loss Treaty, the Company’s net retention on new bonds would generally be $15 million plus a 5% co-participation in the $90 million layer of excess reinsurance above the Company’s retention. Based on statutory surplus as of September 30, 2009, this regulation would limit Western Surety’s largest gross risk to $148.2 million. This surplus requirement may limit the amount of future dividends Western Surety could otherwise pay to CNA Surety.

In accordance with the provisions of intercompany tax sharing agreements between CNA Surety and its subsidiaries, the income tax of each subsidiary shall be determined based upon each subsidiary’s separate return liability. Intercompany tax payments are made at such times when estimated tax payments would be required by the Internal Revenue Service. CNA Surety received tax sharing payments of $29.3 million and $30.1 million from its subsidiaries for the nine months ended September 30, 2009 and September 30, 2008, respectively.

Western Surety and Surety Bonding each qualify as an acceptable surety for federal and other public works project bonds pursuant to U.S. Department of Treasury regulations. U.S. Treasury underwriting limitations, the maximum net retention on a single federal surety bond, are based on an insurer’s statutory surplus. Effective July 1, 2008 through June 30, 2009, the underwriting limitations of Western Surety and Surety Bonding were $43.5 million and $0.7 million, respectively. Effective July 1, 2009 through June 30, 2010, the underwriting limitations of Western Surety and Surety Bonding are $54.7 million and $0.7 million, respectively. Through the Quota Share Treaty previously discussed, CNA Surety has access to CCC and its affiliates’ U.S. Department of Treasury underwriting limitations. Effective July 1, 2008 through June 30, 2009, the underwriting limitations of CCC and its affiliates utilized under the Quota Share Treaty totaled $783.7 million. Effective July 1, 2009 through June 30, 2010, the underwriting limitations of CCC and its affiliates utilized under the Quota Share Treaty total $732.3 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business.

CNA Surety management believes that the Company has sufficient available resources, including capital protection against large losses provided by the Company’s excess of loss reinsurance arrangements, to meet its present capital needs.

Insurance Regulation and Supervision

CNA Surety’s insurance subsidiaries are subject to regulation and supervision by the various insurance regulatory authorities of the states in which they conduct business. Such supervision includes periodic financial and market conduct examinations. These examinations are generally performed by the domiciliary state insurance regulatory authorities; however, they may be performed by any jurisdiction in which the insurer transacts business. During 2008, the South Dakota Division of Insurance began preliminary work on its financial examination of Western Surety, Surety Bonding and Universal Surety as of and for the period January 1, 2004 through December 31, 2008. The information systems portion of the examination was completed in March 2009 and the Company’s responses to the comments and recommendations provided were comprehensive and will be summarized in the final report. Based on the ongoing financial portion of the examination, the Company has also received certain preliminary comments and recommendations,

none of which have had a material impact on the statutory results of operations and financial condition of its insurance subsidiaries. The Company has responded to these as appropriate and does not expect any further results of the ongoing examination to have a material impact on the results of operations or financial condition of its insurance subsidiaries.

Financial Condition

Investment Portfolio

The estimated fair value, gross unrealized gains, gross unrealized losses, other-than temporary impairments (“OTTI”) and amortized cost of fixed income securities and the fair value, gross unrealized gains, gross unrealized losses and cost of equity securities held by CNA Surety at September 30, 2009, by investment category, were as follows (dollars in thousands):


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated		Unrealized
September 30, 2009	or Cost		Gains		12 Months			12 Months			Fair Value		OTTI Losses^(a)
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	17,377	$	1,115	$	—		$	—		$	18,492	$	—
U.S. Agencies		24,303		429		—			––			24,732		––
Collateralized mortgage obligations — residential		31,626		1,810		—			––			33,436		––
Mortgage pass-through securities — residential		56,785		2,572		—			––			59,357		––
Obligations of states and political subdivisions		700,001		48,091		—			(2,271	)		745,821		––
Corporate bonds		292,550		13,219		(128	)		(633	)		305,008		––
Collateralized mortgage obligations — commercial		10,025		—		—			(425	)		9,600		––
Other asset-backed securities:
Second mortgages/home equity loans — residential		5,931		—		—			(611	)		5,320		(1,502	)
Consumer credit receivables		16,386		670		—			––			17,056		––
Other		9,725		735		––			––			10,460		––

Total fixed income securities		1,164,709		68,641		(128	)		(3,940	)		1,229,282	$	(1,502	)

Equity securities		1,379		174		—			—			1,553

Total	$	1,166,088	$	68,815	$	(128	)	$	(3,940	)	$	1,230,835


^(a)		The unrealized loss position of this security has improved to $0.4 million at September 30, 2009.


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated
December 31, 2008	or Cost		Gains		12 Months			12 Months			Fair Value
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	33,140	$	3,519	$	—		$	—		$	36,659
U.S. Agencies		36,476		1,116		—			––			37,592
Collateralized mortgage obligations — residential		35,671		984		—			––			36,655
Mortgage pass-through securities — residential		72,203		1,489		—			––			73,692
Obligations of states and political subdivisions		697,305		19,730		(6,929	)		(13,943	)		696,163
Corporate bonds		96,048		1,711		(2,430	)		(1,853	)		93,476
Collateralized mortgage obligations — commercial		35,025		—		(2,040	)		(3,607	)		29,378
Other asset-backed securities:
Second mortgages/home equity loans — residential		7,956		—		(779	)		(2,180	)		4,997
Consumer credit receivables		17,239		—		(1,708	)		––			15,531
Other		10,753		23		(273	)		––			10,503

Total fixed income securities		1,041,816		28,572		(14,159	)		(21,583	)		1,034,646
Equity securities		1,231		—		—			—			1,231

Total	$	1,043,047	$	28,572	$	(14,159	)	$	(21,583	)	$	1,035,877


	% of
	Estimated			% of
	Fair			Unrealized
Contractual Maturity	Value			Loss
Due after one year through five years		9	%		16	%
Due after five years through ten years		41			4
Due after ten years		35			54
Asset-backed securities		15			26

Total		100	%		100	%

The following table summarizes for fixed income securities in an unrealized loss position at September 30, 2009 and December 31, 2008 the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position (dollars in thousands):


	September 30, 2009				December 31, 2008
			Gross				Gross
	Estimated		Unrealized		Estimated		Unrealized
Unrealized Loss Aging	Fair Value		Loss		Fair Value		Loss
Fixed income securities:
Investment grade^(a):
0-6 months	$	31,910	$	84	$	109,973	$	3,095
7-12 months		4,937		44		121,419		11,064
13-24 months		11,630		261		81,395		12,010
Greater than 24 months		36,917		2,099		33,450		9,573

Total investment grade		85,394		2,488		346,237		35,742
Non-investment grade:
Greater than 24 months		17,700		1,580		—		—

Total	$	103,094	$	4,068	$	346,237	$	35,742


^(a)		Investment grade is determined by using the Standard & Poor’s (“S&P”) rating. If a security is not rated by S&P, the Moody’s Investor Services (“Moody’s”) rating is used. As of September 30, 2009 and December 31, 2008, all of the Company’s fixed income securities were rated by S&P or Moody’s.

Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company considers all of its fixed income securities (bonds) and equity securities as available-for-sale, and as such, they are carried at fair value.

A security is in an unrealized loss position, or impaired, if the fair value of the security is less than its amortized cost adjusted for accretion, amortization and previously recorded OTTI losses. When a security is impaired, the impairment is evaluated to determine whether it is temporary or other-than-temporary.

financial condition and near-term prospects of the issuer, (c) the intent and ability of the Company to retain its investment for a period of time sufficient to allow for any anticipated recovery in value and (d) general market conditions and industry or sector specific factors. Currently, the Company’s equity portfolio is comprised solely of mutual funds related to the Company’s deferred compensation plan, which is an unfunded, nonqualified deferred compensation plan for a select group of management or highly compensated employees. Due to the nature of the plan, the Company does not assert the ability to hold these securities until their recovery in value. As such, if any of these securities are in an unrealized loss position, they are considered to be other-than-temporarily impaired.

The remaining fixed income securities in an unrealized loss position are evaluated to determine if a credit loss exists. To determine if a credit loss exists, the Company considers a number of factors including, but not limited to: (a) the financial condition and near-term prospects of the issuer, (b) credit ratings of the securities, (c) whether the debtor is current on interest and principal payments, (d) the length of time and the extent to which the market value has been less than book value and (e) general market conditions and industry or sector specific factors.

In addition to these factors, the Company considers the results of discounted cash flow modeling using assumptions representative of current market conditions as well as those specific to the Company’s particular security holdings. For asset-backed and mortgage-backed securities, the focus of this analysis is on assessing the sufficiency and quality of underlying collateral and timing of cash flows. If the discounted expected cash flows for a security equal or exceed the amortized cost of that security, no credit loss exists and the security is deemed to be temporarily impaired.


	Gross Unrealized Losses												Estimated
September 30, 2009	AAA		AA		A		BBB		Total		Count		Fair Value
Fixed income securities:
Investment grade^(a):
U.S. Treasury securities and obligations of U. S. Government and agencies:
Collateralized mortgage obligations — residential	$	—	$	—	$	—	$	—	$	—		1	$	1
Obligations of states and political subdivisions		389		100		618		––		1,107		5		29,887
Corporate bonds		6		14		111		630		761		10		43,225
Collateralized mortgage obligations — commercial		425		––		––		––		425		2		9,600
Other asset-backed securities:
Second mortgages/home equity loans — residential		195		––		––		––		195		1		2,681

Total investment grade		1,015		114		729		630		2,488		19		85,394
Non-investment grade:
Obligations of states and political subdivisions		––		––		––		––		1,164		2		15,061
Other asset-backed securities:
Second mortgages/home equity loans — residential		––		––		––		––		416		1		2,639

Total non-investment grade		––		––		––		––		1,580		3		17,700

Total	$	1,015	$	114	$	729	$	630	$	4,068		22	$	103,094


^(a)		Securities are categorized using the S&P rating. If a security is not rated by S&P, the Moody’s rating is used. At September 30, 2009, all of the Company’s fixed income securities were rated by S&P or Moody’s.

The Company holds three non-investment grade securities in an unrealized loss position at September 30, 2009. Two of these, obligations of states and political subdivisions issued by governmental utility authorities, were downgraded below investment grade during the third quarter 2009 due to the downgrade of the mono-line bond insurer guaranteeing a portion of these securities. Despite the downgrade, the unrealized loss on these securities improved from $0.9 million, or 16.7% of amortized cost, and $2.5 million, or 22.6% of amortized cost at June 30, 2009 to $0.3 million, or 5.0% of amortized cost and $0.9 million, or 8.3% of amortized cost, respectively, at September 30, 2009. Based on the underlying fundamentals of these securities, the Company continues to believe that all interest and principal will be paid according to their contractual terms. The Company does not believe the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded an OTTI loss for these securities at September 30, 2009.

The other security rated below investment grade and in an unrealized loss position is an asset-backed security collateralized by sub-prime home loans originated prior to 2005. This security was determined to be other-than-temporarily impaired at June 30, 2009. The Company recorded OTTI losses of $0.1 million in earnings in addition to recording an unrealized loss of $1.7 million in other comprehensive income. The Company did not record any additional credit-related loss on this security during the third quarter and the unrealized loss position has improved to $0.4 million, or 13.6% of its adjusted amortized cost. The Company holds one other asset-backed security collateralized by sub-prime home loans originated prior to 2005. This security has an estimated fair value of $2.7 million and is in an unrealized loss position of $0.2 million, or 6.8% of its amortized cost, at September 30, 2009. The Company believes the unrealized losses on these securities with sub-prime exposure are primarily attributable to broader economic conditions and liquidity concerns and are not indicative of the quality of the underlying collateral. In the first nine months of 2009, the Company received repayments on these securities of $1.9 million, or 24% of the par value outstanding at December 31, 2008.

Of the 19 investment grade securities in an unrealized loss position, one was in a loss position that exceeded 20% of the security’s amortized cost. This security, issued by a large student loan provider, which has an unrealized loss of 20.9% of amortized cost, was also the largest unrealized loss in dollars ($0.6 million). Three other securities were in an unrealized loss position that exceeded 5% of each security’s amortized cost. Gross unrealized losses on the Company’s fixed income portfolio have continued to improve from $35.7 million at December 31, 2008, $31.8 million at March 31, 2009 and $19.0 million at June 30, 2009. The Company believes that the unrealized losses are primarily due to credit spread widening, and to a lesser extent, market illiquidity and certain asset classes being out of favor with investors.

The Company holds two commercial collateralized mortgage-backed securities. At September 30, 2009, one of these securities had an unrealized loss of $0.1 million, or 2.0% of its amortized cost, and the other had an unrealized loss of $0.3 million, or 6.5% of its amortized cost. The overall unrealized loss position of these securities has continued to improve from $2.5 million at March 31, 2009 and $1.5 million at June 30, 2009. The Company believes that these securities will recover in value based on the current performance of the underlying collateral, the senior or super-senior position of each of the holdings and the amount of credit support available to our holdings.

As of September 30, 2009, $412.7 million of the Company’s investments were guaranteed by one of three major mono-line bond insurers. This includes $405.0 million of bonds of states and political obligations, or about 54% of the Company’s investments in this category of security. Investments in obligations of states and political subdivisions represent approximately 61% of the Company’s invested assets. The ratings on these securities reflect the higher of the underlying rating of the issuer or the insurer’s rating. Of the $405.0 million of bonds that were insured, only $97.9 million of these securities reflect credit rating enhancement due to the guarantee. The underlying ratings of the enhanced securities are $55.2 million AA, $42.2 million A and $0.5 million BBB. The underlying ratings of all municipal holdings remain very strong and carry an average rating of AA. The Company views bond insurance as credit enhancement and not credit substitution and a credit review is performed on each issuer of bonds purchased. Based on the strong underlying credit quality of its insured bonds of states and political subdivisions, the Company believes that any impact of potential ratings downgrades or other difficulties of the mono-line bond insurers would not have a significant impact on the Company’s financial position or results of operations.

The Company has no current intent to sell any of the securities in an unrealized loss position, nor is it more likely than not that it will be required to sell these securities prior to recovery of amortized cost. The Company believes that all of the securities in an unrealized loss position will recover in value and that none of these unrealized losses were indicative of credit losses. Based on the current facts and circumstances of the Company’s particular security holdings, the Company has determined that no additional OTTI losses related to the securities in an unrealized loss position are required to be recorded.

Impact of Pending Accounting Standards

In June 2009, the FASB issued guidance which removes the concept of a qualifying special-purpose entity and eliminates it from exceptions under the guidance for consolidation of variable interest entities. This guidance also modifies the de-recognition conditions related to legal isolation and effective control and adds additional disclosure requirements for transfers of financial assets. This guidance is effective for annual reporting periods beginning after November 15, 2009. The adoption is not expected to have a material impact on the Company’s financial condition or results of operations.

In June 2009, the FASB issued guidance which amends existing consolidation guidance applicable for variable interest entities as well as requirements for determination of the primary beneficiary of a variable interest entity, requires an ongoing assessment of whether an entity is the primary beneficiary and requires enhanced disclosures that will provide users of financial statements information regarding an enterprise’s involvement in a variable interest entity. This guidance is effective for annual reporting periods beginning after November 15, 2009. The adoption is not expected to have a material impact on the Company’s financial condition or results of operations.

In August 2009, the FASB issued guidance which proposes the following clarifications guidance for determining the fair value of a liability. If a quoted price in an active market for the identical liability is available, it represents a Level 1 measurement. If a quoted price in an active market for the identical liability is not available, an entity may utilize the following approaches: (a) the quoted price of the identical liability when traded as an asset in an active market; (b) the quoted price of the identical liability when traded as an asset in markets that are not active; (c) the quoted price for similar liabilities or similar liabilities traded as assets in markets that are not active; (d) another valuation technique that is consistent with the generally accepted fair value principles (income approach or market approach). The Company does not carry any of its financial liabilities at fair value. This guidance is effective for financial statements issued for annual periods beginning after August 2009. The adoption is not expected to have an impact on the Company’s financial condition or results of operations.

FORWARD-LOOKING STATEMENTS

This report includes a number of statements, which relate to anticipated future events (forward-looking statements) rather than actual present conditions or historical events. Forward-looking statements generally include words such as “believes,” “expects,” “intends,” “anticipates,” “estimates” and similar expressions. Forward-looking statements in this report include expected developments in the Company’s insurance business, including losses and loss reserves; the impact of routine ongoing insurance reserve reviews being conducted by the Company; the routine state regulatory examinations of the Company’s primary insurance company subsidiaries, and the Company’s responses to the results of those reviews and examinations; the Company’s expectations concerning its revenues, earnings, expenses and investment activities; expected cost savings and other results from the Company’s expense reduction and restructuring activities; and the Company’s proposed actions in response to trends in its business.

Forward-looking statements, by their nature, are subject to a variety of inherent risks and uncertainties that could cause actual results to differ materially from the results projected. Many of these risks and uncertainties cannot be controlled by the Company.

Some examples of these risks and uncertainties are:

	•		general economic and business conditions;

	•		changes in financial markets such as fluctuations in interest rates, long-term periods of low interest rates, credit conditions and currency, commodity and stock prices;

	•		the ability of the Company’s contract principals to fulfill their bonded obligations;

	•		the effects of corporate bankruptcies on surety bond claims, as well as on capital markets;

	•		changes in foreign or domestic political, social and economic conditions;

	•		regulatory initiatives and compliance with governmental regulations, judicial decisions, including interpretation of policy provisions, decisions regarding coverage, trends in litigation and the outcome of any litigation involving the Company, and rulings and changes in tax laws and regulations;

	•		regulatory limitations, impositions and restrictions upon the Company, including the effects of assessments and other surcharges for guaranty funds and other mandatory pooling arrangements;

	•		the impact of competitive products, policies and pricing and the competitive environment in which the Company operates, including changes in the Company’s books of business;

	•		product and policy availability and demand and market responses, including the level of ability to obtain rate increases and decline or non-renew underpriced accounts, to achieve premium targets and profitability and to realize growth and retention estimates;

	•		development of claims and the impact on loss reserves, including changes in claim settlement practices;

	•		the performance of reinsurance companies under reinsurance contracts with the Company;

	•		results of financing efforts, including the Company’s ability to access capital markets;

	•		changes in the Company’s composition of operating segments;

	•		the sufficiency of the Company’s loss reserves and the possibility of future increases in reserves;

	•		the risks and uncertainties associated with the Company’s loss reserves; and,

	•		the possibility of further changes in the Company’s ratings by ratings agencies, including the inability to access certain markets or distribution channels and the required collateralization of future payment obligations as a result of such changes, and changes in rating agency policies and practices.

Any forward-looking statements made in this report are made by the Company as of the date of this report. The Company does not have any obligation to update or revise any forward-looking statement contained in this report, even if the Company’s expectations or any related events, conditions or circumstances change.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

CNA Surety’s investment portfolio is subject to economic losses due to adverse changes in the fair value of its financial instruments, or market risk. Interest rate risk represents the largest market risk factor affecting the Company’s consolidated financial condition due to its significant level of investments in fixed income securities. Increases and decreases in prevailing interest rates generally translate into decreases and increases in the fair value of the Company’s fixed income portfolio. The fair value of these interest rate sensitive instruments may also be affected by the credit-worthiness of the issuer, prepayment options, relative value of alternative investments, the liquidity of the instrument, income tax considerations and general market conditions. The Company manages its exposure to interest rate risk primarily through an asset/liability matching strategy. The Company’s exposure to interest rate risk is mitigated by the relative short-term nature of its insurance and other liabilities. The targeted effective duration of the Company’s investment portfolio is approximately 5 years, consistent with the expected duration of its insurance and other liabilities.

The tables below summarize the estimated effects of certain hypothetical increases and decreases in interest rates. It is assumed that the changes occur immediately and uniformly across each investment category. The hypothetical changes in market interest rates selected at September 30, 2009 reflect the Company’s expectations of the reasonably possible scenarios over a one-year period. The hypothetical fair values are based upon the same prepayment assumptions that were utilized in computing fair values as of September 30, 2009. At December 31, 2008, the hypothetical changes in market interest rates reflected the Company’s expectations of the reasonably possible best or worst case scenarios over a one year period. Significant variations in market interest rates could produce changes in the timing of repayments due to prepayment options available. The fair value of such instruments could be affected and therefore actual results might differ from those reflected in the following tables.


						Hypothetical
				Estimated Fair		Percentage
			Hypothetical	Value After		Increase
	Fair Value at		Change in	Hypothetical		(Decrease) in
	September 30,		Interest Rate	Change in		Stockholders’
	2009		(bp=basis points)	Interest Rate		Equity
	(Dollars in thousands)
U.S. Government and government agencies and authorities	$	136,017	200 bp increase	$	128,504		(0.6	)%
			150 bp increase		130,735		(0.4	)
			100 bp increase		132,828		(0.2	)
			50 bp increase		134,628		(0.1	)

States, municipalities and political subdivisions		745,821	200 bp increase		656,703		(6.5	)
			150 bp increase		677,733		(5.0	)
			100 bp increase		699,591		(3.4	)
			50 bp increase		722,285		(1.7	)

Corporate bonds		305,008	200 bp increase		274,816		(2.2	)
			150 bp increase		281,956		(1.7	)
			100 bp increase		289,360		(1.1	)
			50 bp increase		297,040		(0.6	)

Mortgage-backed and asset-backed		42,436	200 bp increase		40,203		(0.2	)
			150 bp increase		40,743		(0.1	)
			100 bp increase		41,295		(0.1	)
			50 bp increase		41,859		––

Total fixed income securities available-for-sale	$	1,229,282	200 bp increase		1,100,226		(9.5	)
			150 bp increase		1,131,167		(7.2	)
			100 bp increase		1,163,074		(4.9	)
			50 bp increase		1,195,812		(2.5	)


						Hypothetical
				Estimated Fair		Percentage
			Hypothetical	Value After		Increase
	Fair Value at		Change in	Hypothetical		(Decrease) in
	December 31,		Interest Rate	Change in		Stockholders’
	2008		(bp=basis points)	Interest Rate		Equity
	(Dollars in thousands)
U.S. Government and government agencies and authorities	$	184,598	200 bp increase	$	172,966		(1.0	)%
			100 bp increase		179,485		(0.4	)
			100 bp decrease		187,485		0.2
			200 bp decrease		189,197		0.4

States, municipalities and political subdivisions		696,163	200 bp increase		613,030		(7.0	)
			100 bp increase		652,614		(3.7	)
			100 bp decrease		743,635		4.0
			200 bp decrease		786,829		7.7

Corporate bonds		93,476	200 bp increase		84,743		(0.7	)
			100 bp increase		88,962		(0.4	)
			100 bp decrease		98,115		0.4
			200 bp decrease		101,424		0.7

Mortgage-backed and asset-backed		60,409	200 bp increase		56,769		(0.3	)
			100 bp increase		58,563		(0.2	)
			100 bp decrease		62,039		0.1
			200 bp decrease		62,557		0.2

Total fixed income securities available-for-sale	$	1,034,646	200 bp increase		927,508		(9.1	)
			100 bp increase		979,624		(4.7	)
			100 bp decrease		1,091,274		4.8
			200 bp decrease		1,140,007		8.9

ITEM 4. CONTROLS AND PROCEDURES

The Company maintains a system of disclosure controls and procedures which are designed to ensure that information required to be disclosed by the Company in reports that it files or submits to the Securities and Exchange Commission under the Securities and Exchange Act of 1934, including this report, is recorded, processed, summarized and reported on a timely basis. These disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed under the Exchange Act is accumulated and communicated to the Company’s management on a timely basis to allow decisions regarding required disclosure.

The Company’s principal executive officer and its principal financial officer undertook an evaluation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a — 15(e) and 15d — 15(e)) as of the end of the period covered by this report and concluded that the Company’s controls and procedures were effective.

There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS — Information on the Company’s legal proceedings is set forth in Note 8 of the Condensed Consolidated Financial Statements included under Part 1, Item 1.

ITEM 1A. RISK FACTORS — Information on the Company’s risk factors is set forth in Item 1A “Risk Factors” in the Company’s Annual Report on Form 10-K for the year-ended December 31, 2008.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS — None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES — None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS — None.

ITEM 5. OTHER INFORMATION — Reports on Form 8-K:

July 31, 2009; CNA Surety Corporation Earnings Press Release issued on July 31, 2009.

ITEM 6. EXHIBITS


	Exhibit Number
Certification of Chief Executive Officer pursuant to Rule 13a–14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		31(1	)

Certification of Chief Financial Officer pursuant to Rule 13a–14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		31(2	)

Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002		32(1	)*

Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002		32(2	)*


*		Exhibits 32(1) and 32(2) are being furnished and shall not be deemed “filed” for the purpose of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of that Section. These Exhibits shall not be incorporated by reference into any registration statement or other document pursuant to the Securities Act of 1933, as amended.

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.


CNA SURETY CORPORATION (Registrant)

/s/ John F. Welch John F. Welch
President and Chief Executive Officer

/s/ John F. Corcoran John F. Corcoran
Senior Vice President and Chief Financial Officer

Date: October 30, 2009

EXHIBIT INDEX


31(1)		Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 — Chief Executive Officer.

31(2)		Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 — Chief Financial Officer.

32(1)		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 — Chief Executive Officer.

32(2)		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 — Chief Financial Officer.