FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission file number: 1-13277
CNA SURETY CORPORATION
(Exact name of Registrant as specified in its Charter)
Delaware 36-4144905
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
CNA Plaza, Chicago, Illinois 60685
(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 X 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:
42,884,271 shares of Common Stock, $.01 par value as of May 3, 2002.
CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
Page
----
Part I. Financial Information (Unaudited):
Item 1. Condensed Consolidated Financial Statements:
Independent Accountants' Report ................................................... 3
Condensed Consolidated Balance Sheets at March 31, 2002 and
at December 31, 2001 .............................................................. 4
Condensed Consolidated Statements of Income for the Three Months Ended
March 31, 2002 and 2001 ........................................................... 5
Condensed Consolidated Statements of Stockholders' Equity for the Three
Months Ended March 31, 2002 and 2001 .............................................. 6
Condensed Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 2002 and 2001 ........................................................... 7
Notes to Condensed Consolidated Financial Statements at March 31, 2002 ............ 8
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations ............................................................. 13
Part II. Other Information:
Item 1. Legal Proceedings ................................................................. 20
Item 2. Changes in the Rights of the Company's Security Holders ........................... 20
Item 3. Defaults Upon Senior Securities ................................................... 20
Item 4. Submission of Matters to a Vote of Security Holders ............................... 20
Item 5. Other Information ................................................................. 20
Item 6. Exhibits and Reports on Form 8-K .................................................. 20
2
INDEPENDENT ACCOUNTANTS' REPORT
-------------------------------
To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois
We have reviewed the accompanying condensed consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of March 31, 2002, and the related
condensed consolidated statements of income, stockholders' equity and cash flows
for the three-month periods ended March 31, 2002 and 2001. These financial
statements are the responsibility of the Corporation's management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and of making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance
with auditing standards generally accepted in the United States of America, the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to such condensed consolidated financial statements for them to be in
conformity with accounting principles generally accepted in the United States of
America.
We have previously audited, in accordance with auditing standards generally
accepted in the United States of America, the consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of December 31, 2001, and the related
consolidated statements of income, stockholders' equity, and cash flows for the
year then ended (not presented herein); and in our report dated February 11,
2002, we expressed an unqualified opinion on those consolidated financial
statements. In our opinion, the information set forth in the accompanying
condensed consolidated balance sheet as of December 31, 2001 is fairly stated,
in all material respects, in relation to the consolidated balance sheet from
which it has been derived.
Deloitte & Touche LLP
Chicago, Illinois
May 8, 2002
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except per share data)
(Unaudited)
March 31, December 31,
2002 2001
----------------- -----------------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $475,028 and $464,102) ... $ 479,538 $ 471,841
Equity securities, at fair value (cost: $56,748 and $42,614) ..................... 50,651 35,754
Short-term investments, at cost (approximates fair value) ........................ 27,304 53,600
Other investments, at fair value ................................................. 5,261 5,303
Cash ............................................................................. 14,996 13,159
------------ ------------
Total invested assets and cash ............................................... 577,750 579,657
Deferred policy acquisition costs .................................................... 93,125 89,788
Insurance receivables:
Premiums, including $27,219 and $29,829 from affiliates (net of allowance for
doubtful accounts: $2,341 and $2,198) .......................................... 37,738 39,911
Reinsurance, including $55,766 and $58,027 from affiliates ....................... 173,600 176,235
Intangible assets (net of accumulated amortization: $25,523 and $25,523) ........... 143,785 143,785
Property and equipment, at cost (less accumulated
depreciation: $14,913 and $14,138) ................................................. 18,042 17,645
Prepaid reinsurance premiums ......................................................... 9,558 5,838
Other assets ......................................................................... 7,703 8,739
------------ ------------
Total assets ................................................................. $ 1,061,301 $ 1,061,598
============ ============
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses ....................................... $ 312,225 $ 315,811
Unearned premiums ................................................................ 201,271 200,379
------------ ------------
Total reserves ............................................................... 513,496 516,190
Debt ................................................................................. 76,195 76,195
Deferred income taxes, net ........................................................... 20,531 19,969
Payable for securities purchased ..................................................... 7,116 11,406
Current income taxes payable ......................................................... 5,155 1,822
Reinsurance and other payables to affiliates ......................................... 10,223 8,923
Other liabilities .................................................................... 36,683 38,665
------------ ------------
Total liabilities ............................................................ $ 669,399 $ 673,170
------------ ------------
Commitments and contingencies (See Note 5)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,319
shares issued and 42,876 shares outstanding at March 31, 2002 and 44,229
shares issued and 42,780 shares outstanding at December 31, 2001 ................... 443 442
Additional paid-in capital ........................................................... 255,081 254,133
Retained earnings .................................................................... 153,253 149,128
Accumulated other comprehensive income ............................................... (1,374) 278
Treasury stock, at cost .............................................................. (15,501) (15,553)
------------ ------------
Total stockholders' equity ................................................... 391,902 388,428
------------ ------------
Total liabilities and stockholders' equity ................................... $ 1,061,301 $ 1,061,598
============ ============
The accompanying notes are an integral part of these
condensed consolidated financial statements.
4
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Amounts in thousands, except per share data)
(Unaudited)
Three Months Ended
March 31,
--------------------
2002 2001
-------- --------
Revenues:
Net earned premium ................................... $ 67,221 $ 76,749
Net investment income ................................ 7,106 7,735
Net realized investment losses ....................... (278) (29)
-------- --------
Total revenues ..................................... 74,049 84,455
-------- --------
Expenses:
Net losses and loss adjustment expenses .............. 16,647 16,086
Net commissions, brokerage and other underwriting .... 41,552 46,837
Interest expense ..................................... 458 1,588
Amortization of intangible assets .................... -- 1,524
-------- --------
Total expenses ..................................... 58,657 66,035
-------- --------
Income before income taxes ............................. 15,392 18,420
Income taxes ........................................... 4,835 6,476
-------- --------
Net income ............................................. $ 10,557 $ 11,944
======== ========
Earnings per share ..................................... $ 0.25 $ 0.28
======== ========
Earnings per share, assuming dilution .................. $ 0.25 $ 0.28
======== ========
Weighted average shares outstanding .................... 42,845 42,713
======== ========
Weighted average shares outstanding, assuming dilution.. 43,025 42,917
======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Amounts in thousands)
(Unaudited)
Common
Stock Additional
Shares Common Paid-In Comprehensive Retained
Outstanding Stock Capital Income Earnings
----------- ------- ---------- ------------- --------
Balance, December 31, 2000 ............................... 42,702 $ 441 $ 253,497 $135,308
Comprehensive income:
Net income ........................................... -- -- -- $ 11,944 11,944
Other comprehensive income:
Change in unrealized gains on securities
(after incometaxes), net of reclassification
adjustment of $209 ................................. -- -- -- 946 --
---------
Total comprehensive income ....................... $ 12,890
=========
Stock options exercised and other ........................ 23 1 161 --
Dividends paid to stockholders ........................... -- -- -- (3,846)
------- ------- --------- --------
Balance, March 31, 2001 .................................. 42,725 $ 442 $ 253,658 $143,406
======= ======= ========= ========
Balance, December 31, 2001 ............................... 42,780 $ 442 $ 254,133 $149,128
Comprehensive income:
Net income ........................................... -- -- -- $ 10,557 10,557
Other comprehensive income:
Change in unrealized losses on securities
(after income taxes), net of reclassification
adjustment of $90 .................................. -- -- -- (1,652) --
---------
Total comprehensive income ....................... $ 8,905
=========
Issuance of treasury stock to employee stock
purchase program ...................................... 6
Stock options exercised and other ........................ 96 1 942 --
Dividends paid to stockholders ........................... -- -- -- (6,432)
------- ------- --------- --------
Balance, March 31, 2002 .................................. 42,876 $ 443 $ 255,081 $153,253
======= ======= ========= ========
Accumulated
Other Treasury Total
Comprehensive Stock Stockholders'
Income (Loss) (at cost) Equity
------------- --------- -------------
Balance, December 31, 2000 ............................... $ 267 $(15,481) $374,032
Comprehensive income:
Net income ........................................... -- -- 11,944
Other comprehensive income:
Change in unrealized gains on securities
(after income taxes), net of reclassification
adjustment of $209 ................................. 946 -- 946
Total comprehensive income .......................
Stock options exercised and other ........................ -- -- 162
Dividends paid to stockholders ........................... -- -- (3,846)
--------- -------- ---------
Balance, March 31, 2001 .................................. $ 1,213 $(15,481) $ 383,238
========= ========= =========
Balance, December 31, 2001 ............................... $ 278 $(15,553) $388,428
Comprehensive income:
Net income ........................................... -- -- 10,557
Other comprehensive income:
Change in unrealized losses on securities
(after income taxes), net of reclassification
adjustment of $90 .................................. (1,652) -- (1,652)
Total comprehensive income .......................
Issuance of treasury stock to employee stock
purchase program ...................................... 52 58
Stock options exercised and other ........................ -- -- 943
Dividends paid to stockholders ........................... -- -- (6,432)
--------- -------- ---------
Balance, March 31, 2002 .................................. $ (1,374) $(15,501) $ 391,902
========== ========= =========
The accompanying notes are an integral part of these
condensed consolidated financial statements.
6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
(Unaudited)
Three Months Ended
March 31,
--------------------
2002 2001
-------- --------
OPERATING ACTIVITIES:
Net income ...................................................................... $ 10,557 $ 11,944
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization ................................................. 977 2,381
Accretion of bond discount, net ............................................... 195 247
Net realized investment losses ................................................ 278 29
Changes in:
Insurance receivables ......................................................... 4,808 (6,673)
Reserve for unearned premiums ................................................. 892 (3,723)
Reserve for unpaid losses and loss adjustment expenses ........................ (3,586) 7,557
Deferred policy acquisition costs ............................................. (3,337) (590)
Deferred income taxes, net .................................................... 1,433 421
Reinsurance and other payables to affiliates .................................. 1,300 1,120
Prepaid reinsurance premiums .................................................. (3,720) (400)
Other assets and liabilities .................................................. (3,789) (2,289)
-------- --------
Net cash provided by operating activities ................................... 6,008 10,024
-------- --------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases ..................................................................... (63,399) (31,673)
Maturities .................................................................... 30,008 25,533
Sales ......................................................................... 22,121 7,408
Purchases of equity securities .................................................. (14,829) (4,303)
Proceeds from the sale of equity securities ..................................... 557 409
Changes in short-term investments ............................................... 26,304 2,787
Purchases of property and equipment ............................................. (1,491) (1,043)
Changes in receivables/payables for securities sold/purchased ................... (4,290) 13,303
Other, net ...................................................................... (33) (88)
-------- --------
Net cash provided by (used in) investing activities ......................... (5,052) 12,333
-------- --------
FINANCING ACTIVITIES:
Principal payments on long-term debt ............................................ -- (20,000)
Dividends to stockholders ....................................................... -- (3,845)
Employee stock option exercises ................................................. 824 67
Issuance of treasury stock to employee stock purchase plan ...................... 57 --
-------- --------
Net cash provided by (used in) financing activities ......................... 881 (23,778)
-------- --------
Increase (decrease) in cash ....................................................... 1,837 (1,421)
Cash at beginning of period ....................................................... 13,159 5,950
-------- --------
Cash at end of period ............................................................. $ 14,996 $ 4,529
======== ========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest ...................................................................... $ 793 $ 1,561
Income taxes .................................................................. $ -- $ 750
The accompanying notes are an integral part of these condensed
consolidated financial statements.
7
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2002
(Unaudited)
1. Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of CNA Surety
Corporation and all majority-owned subsidiaries.
Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America ("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 2001 Annual Report to Shareholders. Certain financial
information that is normally 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.
Certain reclassifications have been made to the 2001 Financial Statements to
conform with the presentation in the 2002 Condensed Consolidated Financial
Statements.
Accounting Changes
In June 2001, the FASB issued SFAS No. 141 and No. 142 entitled "Business
Combinations" ("SFAS No. 141") and "Goodwill and Other Intangible Assets" ("SFAS
No. 142"), respectively. SFAS No. 141 requires that the purchase method of
accounting be used for all business combinations subsequent to June 30, 2001 and
specifies criteria for recognizing intangible assets acquired in a business
combination. The Company will adopt this standard for any future business
combinations. SFAS No. 142 requires that goodwill and intangible assets with
indefinite useful lives no longer be amortized, but instead be tested for
impairment at least annually. Any impairment loss for the excess of the carrying
amount of an intangible asset over its fair value would be recognized as a
charge to operations. Intangible assets with definite useful lives will continue
to be amortized over their respective estimated useful lives. The Company has
adopted the provisions of Statement No. 142 effective January 1, 2002. In
accordance with the transition guidance provided in SFAS No. 142, the Company
has completed its initial impairment test related to other acquired intangibles
and does not anticipate any asset impairment to be recorded for these
intangibles. The Company plans to complete its goodwill-related impairment tests
by June 30, 2002, with any resulting impairment recorded as a cumulative effect
of a change in accounting principle as of January 1, 2002. The adoption of this
standard eliminated the Company's amortization of goodwill and intangibles as of
December 31, 2001 and therefore, increased the Company's reported net income by
$1.4 million, or 3 cents per share, as compared to the prior year quarter. If
the provisions of this standard were applied to prior periods, net income for
the first three months of 2001 would have been $13.4 million, or $0.31 per
8
share.
In October 2001, the FASB issued SFAS No. 144 entitled "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"). SFAS No. 144
addresses accounting and reporting for the impairment or disposal of long-lived
assets. This statement supersedes FASB Statement No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of."
The provisions of this statement were effective for CNA Surety beginning
January 1, 2002. The initial adoption of this standard had no impact on the
Company's financial position or results of operations.
9
2. Investments
The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety at March 31, 2002 and December 31, 2001, by
investment category, were as follows (dollars in thousands):
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
March 31, 2002 or Cost Gains Losses Value
------------------------------------------------ -------------- ---------- ---------- --------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury ................................ $ 14,822 $ 270 $ (102) $ 14,990
U.S. Agencies ................................ 58,793 1,680 (730) 59,743
Collateralized mortgage obligations .......... 336 4 -- 340
Mortgage pass-through securities ............. 25,946 130 (197) 25,879
Obligations of states and political subdivisions .. 258,916 4,767 (2,809) 260,874
Corporate bonds ................................... 72,802 1,182 (749) 73,235
Non-agency collateralized mortgage obligations .... 12,170 105 (376) 11,899
Other asset-backed securities:
Second mortgages/home equity loans .............. 10,669 303 -- 10,972
Credit card receivables ......................... 10,000 254 -- 10,254
Manufactured housing ............................ 7,204 395 (42) 7,557
Other ........................................... 1,014 91 -- 1,105
Redeemable preferred stock ........................ 2,356 334 -- 2,690
-------- ------- -------- --------
Total fixed income securities ................ 475,028 9,515 (5,005) 479,538
Equity securities ................................ 56,748 546 (6,643) 50,651
-------- ------- -------- --------
Total ........................................ $531,776 $10,061 $(11,648) $530,189
======== ======= ======== ========
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
December 31, 2001 or Cost Gains Losses Value
------------------------------------------------ -------------- ---------- ---------- --------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury ................................ $ 24,751 $ 561 $ (5) $ 25,307
U.S. Agencies ................................ 67,539 2,119 (706) 68,952
Collateralized mortgage obligations .......... 411 4 (1) 414
Mortgage pass-through securities ............. 22,165 231 -- 22,396
Obligations of states and political subdivisions .. 217,757 5,029 (1,987) 220,799
Corporate bonds ................................... 71,029 2,007 (656) 72,380
Non-agency collateralized mortgage obligations .... 12,898 132 (405) 12,625
Other asset-backed securities:
Second mortgages/home equity loans .............. 15,784 537 -- 16,321
Credit card receivables ......................... 10,000 327 -- 10,327
Manufactured housing ............................ 7,314 342 (20) 7,636
Other ........................................... 1,019 108 -- 1,127
Redeemable preferred stock ........................ 13,435 122 -- 13,557
-------- -------- -------- --------
Total fixed income securities ................ 464,102 11,519 (3,780) 471,841
Equity securities ................................. 42,614 2,620 (9,480) 35,754
-------- -------- -------- --------
Total ........................................ $506,716 $ 14,139 $(13,260) $507,595
======== ======== ======== ========
10
3. Reinsurance
The effect of reinsurance on the Company's written and earned premium was as
follows (dollars in thousands):
Three Months Ended March 31,
-----------------------------------------
2002 2001
-----------------------------------------
Written Earned Written Earned
-------- -------- ------- --------
Direct ............................. $ 36,772 $ 31,713 $ 32,657 $ 27,620
Assumed ............................ 45,342 49,541 42,827 51,622
Ceded .............................. (17,721) (14,033) (2,857) (2,493)
-------- -------- -------- --------
$ 64,393 $ 67,221 $ 72,627 $ 76,749
======== ======== ======== ========
Assumed premiums primarily includes all surety business written or renewed,
net of reinsurance, by CCC and CIC, and their affiliates, after the Merger Date
that is reinsured by Western Surety pursuant to intercompany reinsurance and
related agreements.
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 March 31,
------------------------------------
2002 2001
---------------- -----------------
$ Ratio $ Ratio
-------- ----- -------- -----
Gross losses and loss adjustment expenses $ 18,064 22.2% $ 25,062 31.6%
Ceded amounts ............................ (1,417) 10.1 (8,976) 360.0
-------- ---- -------- -----
Net losses and loss adjustment expenses... $ 16,647 24.8% $ 16,086 21.0%
======== ==== ======== =====
The Company's ceded reinsurance program changed significantly in 2002 as
compared to 2001. As a result, ceded written premiums increased in the first
quarter of 2002 as compared to the same quarter in 2001. Ceded written premiums
increased $14.9 million to $17.7 million for the three months ended March 31,
2002. The increase in ceded written premiums included $7.5 million for the
Company's new $40 million excess of $20 million per principal excess of loss
coverage and $8.5 million for the purchase of extended discovery coverage on the
Company's $55 million excess of $5 million per principal excess of loss coverage
that was in place for 2001.
The material differences between the new excess of loss reinsurance program
and the Company's 2001 program are as follows. The annual aggregate coverage
decreases from $115 million in 2001 to $100 million in 2002 with a sub-limit of
$60 million for large commercial accounts. The minimum annual premium for the
2002 excess of loss treaty is $30.0 million compared to $17.2 million of
reinsurance premiums paid in 2001. The 2002 excess of loss treaty provides the
Company with coverage on a per principal basis of 90% of $40 million excess of
$20 million retained by the Company. The higher net retention per principal
together with other changes in reinsurance coverage associated with the 2002
excess of loss reinsurance contract and the extended discovery and related
provisions of the excess of loss reinsurance contract in place for 2001 may
increase the variability of the Company's future results of operations and cash
flows.
11
4. 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 March 31,
-----------------------
2002 2001
---------- ---------
Reserves at beginning of period:
Gross ........................................................ $ 315,811 $ 204,457
Ceded reinsurance ............................................ 166,318 70,159
--------- ---------
Net reserves at beginning of period ........................ 149,493 134,298
--------- ---------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period ............. 16,665 16,380
Increase (decrease) in provision for insured events of prior
periods ...................................................... (18) (294)
--------- ---------
Total net incurred ...................................... 16,647 16,086
--------- ---------
Net payments attributable to:
Current period events ...................................... 1,917 5
Prior period events ........................................ 6,041 15,016
--------- ---------
Total net payments ...................................... 7,958 15,021
--------- ---------
Net reserves at end of period ................................ 158,182 135,363
Ceded reinsurance at end of period ........................... 154,043 76,651
--------- ---------
Gross reserves at end of period ......................... $ 312,225 $ 212,014
========= =========
5. Legal Proceedings
The Company is party to various lawsuits arising in the normal course of
business, some seeking material damages. The Company believes the resolution of
these lawsuits will not have a material adverse effect on its financial
condition or its results of operations.
12
CNA SURETY CORPORATION AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
General
The following is a discussion and analysis of CNA Surety Corporation ("CNA
Surety" or the "Company") and its insurance subsidiaries' operating results,
liquidity and capital resources, and financial condition. This discussion should
be read in conjunction with the Consolidated Financial Statements of CNA Surety
and notes thereto. 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 deferred acquisition costs,
reinsurance and reserves for unpaid losses and loss adjustment expenses. 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. These
areas are highly subjective and require management's most complex judgments
because of the need to make estimates about the effects of matters that are
inherently uncertain. For these reasons, disclosure on these topics is contained
in Item 1. Business of the Company's 2001 Annual Report on Form 10-K as well as
in the Management's Discussion and Analysis of Financial Condition and Results
of Operations and Consolidated Financial Statements and notes thereto within the
2001 Annual Report to Shareholders. Refer to the 2001 Annual Report to
Shareholders Note 1, Significant Accounting Policies, and Notes 7 and 8,
Reinsurance and Reserves for Losses and Loss Adjustment Expenses, respectively,
for further discussion.
Formation of CNA Surety 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") and
Universal Surety of America ("USA"), 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. CNAF owns approximately 64% of the outstanding
common stock of CNA Surety. Loews Corporation owns approximately 89% of the
outstanding common stock of CNAF. 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"). CIC was acquired by CNAF on May 10,
1995. The combined surety operations of CCC and CIC are referred to herein as
CCC Surety Operations.
Pursuant to a reorganization agreement, CCC Surety Operations and Capsure merged
their respective operations at the close of business on September 30, 1997
("Merger Date"). Through reinsurance agreements, CCC and CIC ceded to Western
Surety all of their net unearned premiums and loss and loss adjustment expense
reserves, as of the Merger Date, and will cede to Western Surety all surety
business written or renewed by CCC and CIC for a period of five years
thereafter. Further, CCC and CIC have agreed to assume the obligation for any
adverse development on recorded reserves for CCC Surety Operations as of the
Merger Date, to limit the loss ratio on certain defined business written by CNA
Surety through December 31, 2000 and to provide certain additional excess of
loss reinsurance.
13
Business
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 35,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety and
USA. The insurance subsidiaries write, on a direct basis or as business assumed
from CCC and CIC, small fidelity and non-contract surety bonds, referred to as
commercial bonds; small, medium and large contract bonds; and errors and
omissions ("E&O") liability insurance. Western Surety is a licensed insurer in
all 50 states, the District of Columbia and Puerto Rico. USA is licensed in 44
states and the District of Columbia. Western Surety's affiliated company, Surety
Bonding Company of America ("SBCA"), is licensed in 28 states and the District
of Columbia.
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995
The statements which are not historical facts contained in this Form 10-Q are
forward-looking statements that involve risks and uncertainties, including, but
not limited to, product and policy demand and market response risks, the effect
of economic conditions, the impact of competitive products, policies and
pricing, product and policy development, regulatory changes and conditions,
rating agency policies and practices, development of claims and the effect on
loss reserves, the performance of reinsurance companies under reinsurance
contracts with the Company, investment portfolio developments and reaction to
market conditions, the results of financing efforts, the actual closing of
contemplated transactions and agreements, the effect of the Company's accounting
policies, and other risks detailed in the Company's Securities and Exchange
Commission filings. No assurance can be given that the actual results of
operations and financial condition will conform to the forward-looking
statements contained herein.
Results of Operations
CNA Surety Results for Three Months Ended March 31, 2002 and 2001
The components of income for the Company for the three months ended March
31, 2002 and 2001 are summarized as follows (dollars in thousands):
Three Months
Ended March 31,
------------------------
2002 2001
-------- --------
Total revenues ................................. $ 74,049 $ 84,455
======== ========
Underwriting income ............................ $ 9,022 $ 13,826
Net investment income .......................... 7,106 7,735
Net realized investment losses ................. (278) (29)
Interest expense ............................... 458 1,588
Amortization of intangible assets .............. -- 1,524
-------- --------
Income before income taxes ..................... 15,392 18,420
Income taxes ................................... 4,835 6,476
-------- --------
Net income ..................................... $ 10,557 $ 11,944
======== ========
Net income per share ........................... $ 0.25 $ 0.28
======== ========
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Insurance Underwriting
Underwriting results for the Company for the three months ended March 31,
2002 and 2001 are summarized in the following table (dollars in thousands):
Three Months Ended March 31,
2002 2001
------- -------
Gross written premiums ..................... $82,114 $75,484
======= =======
Net written premiums ....................... $64,393 $72,627
======= =======
Net earned premiums ........................ $67,221 $76,749
Net losses and loss adjustment expenses .... 16,647 16,086
Net commissions, brokerage and other ....... 41,552 46,837
------- -------
Underwriting income ........................ $ 9,022 $13,826
======= =======
Loss ratio ................................. 24.8% 21.0%
Expense ratio .............................. 61.8 61.0
------- -------
Combined ratio ............................. 86.6% 82.0%
======= =======
Premiums Written
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 performance. The Company also writes fidelity bonds which
cover losses arising from employee dishonesty and other insurance products.
Gross written premiums are shown in the table below (dollars in thousands):
Three Months Ended March 31,
2002 2001
------- -------
Contract ................................... $39,380 $38,332
Commercial ................................. 35,088 28,991
Fidelity and other ......................... 7,646 8,161
------- -------
$82,114 $75,484
======= =======
Gross written premiums increased 8.8%, or $6.6 million, for the three
months ended March 31, 2002 over the comparable period in 2001. Commercial
surety accounted for most of this increase with growth of 21.0%, or $6.1
million, in gross written premiums as compared to 2001. In the first quarter of
2002, the Company experienced continued volume growth of small commercial
products along with improving rates on large commercial exposures. Contract
surety increased 2.7%, or $1.0 million, for the three months ended March 31,
2002 reflecting continued strength in public construction spending. Fidelity and
other products decreased 6.3% to $7.6 million for the three months ended March
31, 2002 as compared to the same period in 2001 due primarily to the
discontinuance of the Company's agents' E&O business.
15
Net written premiums are shown in the table below (dollars in thousands):
Three Months Ended March 31,
2002 2001
------- -------
Contract ................................. $31,235 $35,767
Commercial ............................... 25,849 28,699
Fidelity and other ....................... 7,309 8,161
------- -------
$64,393 $72,627
======= =======
For the three months ended March 31, 2002, net written premiums decreased
11.3% to $64.4 million as compared to the same period in 2001, reflecting the
effects of higher reinsurance costs. Ceded written premiums increased $14.9
million to $17.7 million for the three months ended March 31, 2002. Ceded
written premiums in the current quarter include $7.5 million for the Company's
new $40 million excess of $20 million per principal excess of loss coverage and
$8.5 million for the purchase of extended discovery coverage on our $55 million
excess of $5 million per principal excess of loss coverage that was in place for
2001. Net written premiums for contract surety business decreased 12.7% to $31.2
million. Net written premiums for commercial surety decreased 9.9% to $25.8
million for the first three months in 2002. The fidelity and other products
decreased 10.4% to $7.3 million, for the first three months in 2002 as compared
to the same period in 2001.
The material differences between the new excess of loss reinsurance program
and the Company's 2001 program are as follows. The annual aggregate coverage
decreases from $115 million in 2001 to $100 million in 2002 with a sub-limit of
$60 million for large commercial accounts. The minimum annual premium for the
2002 excess of loss treaty is $30.0 million compared to $17.2 million of
reinsurance premiums paid in 2001. The 2002 excess of loss treaty provides the
Company with coverage on a per principal basis of 90% of $40 million excess of
$20 million retained by the Company. The higher net retention per principal
together with other changes in reinsurance coverage associated with the 2002
excess of loss reinsurance contract and the extended discovery and related
provisions of the excess of loss reinsurance contract in place for 2001 may
increase the variability of the Company's future results of operations and cash
flows.
Underwriting Income
Underwriting income decreased 34.8% to $9.0 million for the three months
ended March 31, 2002 compared to $13.8 million for the same period in 2001. This
decrease is primarily due to the impact of increased reinsurance costs on net
earned premium.
Net Loss Ratio
The net loss ratios for the three months ended March 31, 2002 and 2001 were
24.8% and 21.0%, respectively. The 2001 loss ratios included $0.3 million of net
favorable loss reserve development. Excluding the impact of net favorable loss
reserve development, the loss ratios would have been 24.8% and 21.4% for the
period ended March 31, 2002 and March 31, 2001, respectively. The increase in
the adjusted loss ratio in 2002 relates primarily to estimated impact of the
Company's $15 million higher per principal net retention on the Company's net
loss ratio. The Company is using an initial 2002 accident year net loss ratio of
30.0 percent for the medium to large commercial and contract branch business
compared to 22.5 percent when the per principal retention was $5 million. This
business represents about 61% of the Company's gross premiums.
16
Expense Ratio
The expense ratio increased to 61.8% for the three months ended March 31,
2002 compared to 61.0% for the same period in 2001. The increase in the expense
ratio for the three months ended March 31, 2002 primarily reflects the impact of
higher reinsurance costs on net earned premiums. Net earned premiums declined
12.4% and operating expenses decreased at a lower rate of 11.2%, reflecting the
Company's acquisition and operating cost reduction efforts.
Investment Income
For the three months ended March 31, 2002, net investment income was $7.1
million compared to net investment income for the three months ended March 31,
2001 of $7.7 million. The decrease in investment income primarily reflects the
impact of lower investment yields. The annualized pretax yields for the
Company's equity and fixed income portfolio were 5.1% and 5.7% for the three
months ended March 31, 2002 and 2001, respectively. The annualized after-tax
yields for the Company's equity and fixed income portfolio were 3.9% and 4.2%
for the three months ended March 31, 2002 and 2001.
Net realized investment losses were approximately $278,000 for the three
months ended March 31, 2002 compared to approximately $29,000 of net realized
investment losses for the same period in 2001.
Analysis of Other Operations
As of January 1, 2002, the Company adopted SFAS No. 142 which requires that
goodwill and intangible assets with indefinite useful lives no longer be
amortized, but instead be tested for impairment at least annually. The periodic
amortization of goodwill and intangibles ceased as of December 31, 2001.
Amortization expense was $1.5 million for the three months ended March 31, 2001.
The Company plans to complete its goodwill-related impairment tests by June 30,
2002, with any resulting impairment recorded as a cumulative effect of a change
in accounting principle as of January 1, 2002. Any future impairment loss for
the excess of the carrying amount of an intangible asset over its fair value
would be recognized as a charge to operations. Intangible assets primarily
represent goodwill and identified intangibles arising from the acquisition of
Capsure.
Interest expense for the three months ended March 31, 2002 decreased $1.1
million, or 71.2%, as compared to the first quarter in 2001, primarily due to
lower outstanding debt levels and lower interest rates. Average debt outstanding
was $76.2 million for the first quarter of 2002 compared to $100.9 million in
the first quarter of 2001. The weighted average interest rate for the three
months ended March 31, 2001 was 2.2% compared to 6.1% for the same period in
2001.
Income Taxes
Income tax expense was $4.8 million and $6.5 million and the effective
income tax rates were 31.4% and 35.2% for the three months ended March 31, 2002
and 2001, respectively. This decrease in the estimated effective tax rate in
first quarter 2002 primarily relates to the adoption of SFAS No. 142 which ended
the periodic amortization the Company's goodwill and intangibles.
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
17
sales and maturities of investments. CNA Surety also may generate funds from
additional borrowings under the credit facility described below. The primary
cash flow uses are payments for claims, operating expenses, federal income
taxes, debt service for the credit facility, as well as dividends to CNA Surety
stockholders. 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. At March 31, 2002, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $474.0 million of fixed income
securities, $50.7 million of equity securities, $2.4 million of short-term
investments, $5.3 million of other investments and $10.1 million of cash. At
December 31, 2001, the carrying value of the Company's insurance subsidiaries'
invested assets was comprised of $466.6 million of fixed income securities,
$35.8 million of equity securities, $38.9 million of short-term investments,
$5.3 million of other investments and $0.8 million of cash.
Cash flow at the parent company level is derived principally from dividend
and tax sharing payments from its insurance subsidiaries. The principal
obligations at the parent company level are to service debt, pay operating
expenses, including income taxes, and pay dividends to stockholders. At March
31, 2002, the parent company's invested assets consisted of $5.5 million of
fixed income securities, $24.9 million of short-term investments and $4.9
million of cash. At December 31, 2001, the parent company's invested assets
consisted of $5.2 million of fixed income securities, $14.7 million of
short-term investments and $2.4 million of cash. As of March 31, 2002 and
December 31, 2001, parent company short-term investments and cash included $4.5
million and $13.8 million, respectively, of restricted cash 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 $6.0 million for the three months ended March 31, 2002 and $10.0 million for
the comparable period in 2001. The decrease in net cash flow provided by
operating activities primarily relates to an increase in prepaid reinsurance
premiums, primarily a payment of $8.5 million to purchase extended discovery
coverage on the Company's $55 million excess of $5 million per principal excess
of loss coverage that was in place for 2001.
CNA Surety's bank borrowings are under a five-year unsecured revolving
credit facility (the "Credit Facility") that provides for borrowings of up to
$130 million. As of March 31, 2001, the Company has unused capacity under the
revolver of approximately $55 million.
The interest rate on borrowings under the Credit Facility may be fixed, at
CNA Surety's option, for a period of one, two, three, or six months and is based
on, among other rates, the London Interbank Offered Rate ("LIBOR"), plus the
applicable margin. The margin, including the facility fee, was 0.30% at March
31, 2002 and can vary based on CNA Surety's leverage ratio (debt to total
capitalization) from 0.25% to 0.40%. As of March 31, 2002, the weighted average
interest rate was 2.1% on the $75 million of outstanding borrowings. As of
December 31, 2001, the weighted average interest rate was 2.5% on the $75.0
million of outstanding borrowings.
The Credit Facility contains, among other conditions, limitations on CNA
Surety with respect to the incurrence of additional indebtedness and requires
the maintenance of certain financial ratios. As of March 31, 2002, the Company
was in compliance with all restrictions and covenants contained in the Credit
Facility agreement. The Credit Facility provides for the payment of all
outstanding principal
18
balances by September 30, 2002 with no required principal payments prior to such
time. Principal prepayments, if any, and interest payments are expected to be
funded primarily through dividends from CNA Surety's insurance subsidiaries.
In 1999 CNA Surety acquired certain assets of Clark Bonding Company, Inc.,
a Charlotte, North Carolina, insurance agency and brokerage doing business as
The Bond Exchange for $5.9 million. As part of this acquisition, the Company
incurred an additional $1.9 million of debt in the form of a promissory note.
The promissory note matures on July 27, 2004 and has an interest rate of 5.0%.
The balance of this promissory note at March 31, 2002 was $1.2 million.
As an insurance holding company, CNA Surety is dependent upon dividends and
other permitted payments from its insurance subsidiaries to pay operating
expenses, meet debt service requirements, as well as to pay cash dividends. The
payment of dividends by the insurance subsidiaries is subject to varying degrees
of supervision by the insurance regulatory authorities in South Dakota and
Texas. In South Dakota, where Western Surety and SBCA are domiciled, insurance
companies may only pay dividends from earned surplus excluding surplus arising
from unrealized capital gains or revaluation of assets. In Texas, where USA is
domiciled, an insurance company may only declare or pay dividends to
stockholders from the insurer's earned surplus. 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 appropriate insurance department 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 2002 is based on
statutory surplus and income at and for the year ended December 31, 2001.
Without prior regulatory approval in 2002, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $51.5 million in the aggregate. CNA Surety
received $12.0 million and $20.0 million in dividends from its insurance
subsidiaries during the first three months of 2002 and 2001, respectively.
In accordance with the provisions of intercompany tax sharing agreements
between CNA Surety and its subsidiaries, the tax of each subsidiary shall be
determined based upon each subsidiary's separate return liability. Intercompany
tax payments are made at such times as estimated tax payments would be required
by the Internal Revenue Service ("IRS"). CNA Surety did not receive any tax
sharing payments from its subsidiaries for the three months ended March 31, 2002
and received $0.3 million for the same period in 2001.
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.
19
CNA SURETY CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings - None.
ITEM 2. Changes in the Rights of the Company's Security Holders - None.
ITEM 3. Defaults Upon Senior Securities - None.
ITEM 4. Submission of Matters to a Vote of Security Holders - None.
ITEM 5. Other Information - None.
ITEM 6. Exhibits and Reports on Form 8-K:
(a) Exhibits: - None.
(b) Reports on Form 8-K:
February 15, 2002; CNA Surety Corporation Press Release issued on
February 11, 2002.
20
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 S. Heneghan
------------------------------------------
John S. Heneghan
Vice President and Chief Financial Officer
Date: May 13, 2002
21