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 SEPTEMBER 30, 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 of incorporation or organization) (I.R.S. Employer Identification No.)
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:
42,947,482 shares of Common Stock, $.01 par value as of November 1, 2002.
CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
Page
----
Part I. Financial Information:
Item 1. Condensed Consolidated Financial Statements:
Independent Accountants' Report............................................................... 3
Condensed Consolidated Balance Sheets at September 30, 2002 (Unaudited) and
at December 31, 2001........................................................................... 4
Condensed Consolidated Statements of Income for the Three and Nine Months
Ended September 30, 2002 and 2001 (Unaudited).................................................. 5
Condensed Consolidated Statements of Stockholders' Equity for the Nine
Months Ended September 30, 2002 and 2001 (Unaudited)........................................... 6
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2002 and 2001 (Unaudited)........................................................ 7
Notes to Condensed Consolidated Financial Statements
at September 30, 2002 (Unaudited) ............................................................. 8
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................................................... 17
Item 4 Controls and Procedures........................................................................ 30
Part II. Other Information:
Item 1. Legal Proceedings.............................................................................. 31
Item 2. Changes in the Rights of the Company's Security Holders........................................ 31
Item 3. Defaults Upon Senior Securities................................................................ 31
Item 4. Submission of Matters to a Vote of Security Holders............................................ 31
Item 5. Other Information.............................................................................. 31
Item 6. Exhibits and Reports on Form 8-K .............................................................. 31
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 September 30, 2002, and the related
condensed consolidated statements of income for the three-month and nine-month
periods ended September 30, 2002 and 2001 and the related condensed consolidated
statements of stockholders' equity and of cash flows for the nine-month periods
ended September 30, 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
November 4, 2002
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(Unaudited)
September 30, December 31,
2002 2001
---------------- ----------------
ASSETS Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $474,767 and $464,102) ......... $ 516,193 $ 471,841
Equity securities, at fair value (cost: $59,535 and $42,614) ........................... 45,446 35,754
Short-term investments, at cost (approximates fair value) .............................. 60,795 53,600
Other investments, at fair value ....................................................... 6,961 5,303
Cash ................................................................................... 14,418 13,159
---------------- ----------------
Total invested assets and cash ...................................................... 643,813 579,657
Deferred policy acquisition costs ........................................................ 97,133 89,788
Insurance receivables:
Premiums, including $28,012 and $29,829 from affiliates (net of allowance for
doubtful accounts: $1,865 and $2,614) .................................................. 39,399 39,911
Reinsurance, including $47,949 and $58,027 from affiliates ............................. 166,393 176,235
Intangible assets (net of accumulated amortization: $25,523 and $25,523) ............... 143,785 143,785
Property and equipment, at cost (less accumulated
depreciation: $15,390 and $14,138) ..................................................... 17,198 17,645
Prepaid reinsurance premiums ............................................................. 10,516 5,838
Receivable for securities sold ........................................................... 23 --
Other assets ............................................................................. 8,273 8,739
---------------- ----------------
Total assets ...................................................................... $ 1,126,533 $ 1,061,598
================ ================
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses ............................................. $ 337,934 $ 315,811
Unearned premiums ...................................................................... 220,071 200,379
---------------- ----------------
Total reserves ...................................................................... 558,005 516,190
Debt ..................................................................................... 65,816 76,195
Deferred income taxes, net ............................................................... 32,272 19,969
Payable for securities purchased ......................................................... -- 11,406
Current income taxes payable ............................................................. 2,011 1,822
Reinsurance and other payables to affiliates ............................................. 10,977 8,923
Other liabilities ........................................................................ 43,368 38,665
---------------- ----------------
Total liabilities ................................................................... $ 712,449 $ 673,170
---------------- ----------------
Commitments and contingencies (See Note 5)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,386 shares
issued and 42,947 shares outstanding at September 30, 2002 and 44,229 shares
issued and 42,780 shares outstanding at December 31, 2001 .............................. 444 442
Additional paid-in capital ............................................................. 255,765 254,133
Retained earnings ...................................................................... 155,895 149,128
Accumulated other comprehensive income ................................................. 17,426 278
Treasury stock, at cost ................................................................ (15,446) (15,553)
---------------- ----------------
Total stockholders' equity ........................................................ 414,084 388,428
---------------- ----------------
Total liabilities and stockholders' equity ........................................ $ 1,126,533 $ 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 Nine Months Ended
September 30, September 30,
-------------------------- -------------------------
2002 2001 2002 2001
----------- ----------- ----------- -----------
Revenues:
Net earned premium ..................................... $ 79,196 $ 81,931 $ 222,159 $ 237,530
Net investment income .................................. 7,031 7,088 21,258 22,303
Net realized investment gains (losses) ................. (698) 367 625 530
----------- ----------- ----------- -----------
Total revenues ...................................... 85,529 89,386 244,042 260,363
----------- ----------- ----------- -----------
Expenses:
Net losses and loss adjustment expenses ................ 35,380 17,068 71,633 49,967
Net commissions, brokerage and other underwriting ...... 46,027 51,748 133,173 146,769
Interest expense ....................................... 407 803 1,310 3,348
Amortization of intangible assets ...................... -- 1,525 -- 4,573
----------- ----------- ----------- -----------
Total expenses ...................................... 81,814 71,144 206,116 204,657
----------- ----------- ----------- -----------
Income before income taxes ............................... 3,715 18,242 37,926 55,706
Income taxes ............................................. 1,098 6,228 11,850 19,405
----------- ----------- ----------- -----------
Net income ............................................... $ 2,617 $ 12,014 $ 26,076 $ 36,301
=========== =========== =========== ===========
Earnings per share ....................................... $ 0.06 $ 0.28 $ 0.61 $ 0.85
=========== =========== =========== ===========
Earnings per share, assuming dilution .................... $ 0.06 $ 0.28 $ 0.61 $ 0.85
=========== =========== =========== ===========
Weighted average shares outstanding ...................... 42,945 42,758 42,896 42,736
=========== =========== =========== ===========
Weighted average shares outstanding, assuming dilution ... 43,094 42,945 43,048 42,939
=========== =========== =========== ===========
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................................................. -- -- -- $ 36,301 36,301
Other comprehensive income:
Change in unrealized gains on securities (after income ....
taxes), net of reclassification adjustment of $(130)......... -- -- -- 2,876 --
---------
Total comprehensive income.............................. $ 39,177
=========
Purchase of treasury stock................................... (10) -- -- --
Employee Stock Purchase Program issuance from treasury stock. 5 -- -- --
Stock options exercised and other............................ 56 1 401 --
Dividends paid to stockholders............................... -- -- -- (16,671)
------- ------- --------- --------
Balance, September 30, 2001.................................. 42,753 $ 442 $ 253,898 $154,938
======= ======= ========= ========
Balance, December 31, 2001................................... 42,780 $ 442 $ 254,133 $149,128
Comprehensive income:
Net income................................................. -- -- -- $ 26,076 26,076
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net -- -- -- 17,148 --
---------
of reclassification adjustment of $1,190...................
Total comprehensive income.............................. $ 43,224
=========
Issuance of treasury stock to employee stock purchase program 10 --
15
Stock options exercised and other............................ 157 2 1,617 --
Dividends paid to stockholders............................... -- -- -- (19,309)
------- ------- --------- --------
Balance, September 30, 2002 42,947 $ 444 $ 255,765 $155,895
======= ======= ========= ========
Accumulated
Other Treasury Total
Comprehensive Stock Stockholders'
Income (at cost) Equity
------------- --------- ---------------
Balance, December 31, 2000................................... $ 267 $(15,481) $374,032
Comprehensive income:
Net income................................................. -- -- 36,301
Other comprehensive income:
Change in unrealized gains on securities (after income ....
taxes), net of reclassification adjustment of $(130)......... 2,876 -- 2,876
Total comprehensive income..............................
Purchase of treasury stock................................... -- (125) (125)
Employee Stock Purchase Program issuance from treasury stock. -- 53 53
Stock options exercised and other............................ -- -- 402
Dividends paid to stockholders............................... -- -- (16,671)
--------- -------- ---------
Balance, September 30, 2001.................................. $ 3,143 $(15,553) $ 396,868
========= ========= =========
Balance, December 31, 2001................................... $ 278 $(15,553) $ 388,428
Comprehensive income:
Net income................................................. -- -- 26,076
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net 17,148 -- 17,148
of reclassification adjustment of $1,190...................
Total comprehensive income..............................
Issuance of treasury stock to employee stock purchase program 107 122
Stock options exercised and other............................ -- -- 1,619
Dividends paid to stockholders............................... -- -- (19,309)
--------- -------- ---------
Balance, September 30, 2002 $ 17,426 $(15,446) $ 414,084
========= ========= =========
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)
Nine Months Ended
September 30,
--------------------------------------
2002 2001
----------------- -----------------
OPERATING ACTIVITIES:
Net income..................................................................... $ 26,076 $ 36,301
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization............................................... 2,861 7,159
Accretion of bond discount, net............................................. 647 556
Net realized investment (gains)............................................. (625) (530)
Changes in:
Insurance receivables....................................................... 10,354 (25,119)
Reserve for unearned premiums............................................... 19,692 1,342
Reserve for unpaid losses and loss adjustment expenses...................... 22,123 14,968
Deferred policy acquisition costs........................................... (7,345) (1,962)
Deferred income taxes, net.................................................. 3,027 1,102
Reinsurance and other payables to affiliates................................ 2,054 (2,748)
Prepaid reinsurance premiums................................................ (4,678) (1,363)
Other assets and liabilities, net........................................... (573) 6,312
----------- ----------
Net cash provided by operating activities................................. 73,613 36,018
---------- ----------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases................................................................... (137,937) (94,242)
Maturities.................................................................. 105,938 56,265
Sales....................................................................... 24,305 44,236
Purchases of equity securities................................................. (22,572) (5,457)
Proceeds from the sale of equity securities.................................... 2,649 1,436
Changes in short-term investments.............................................. (7,187) 635
Purchases of property and equipment............................................ (2,675) (3,943)
Changes in receivables/payables for securities sold/purchased, net............. (11,429) 10,316
Other, net..................................................................... (1,733) (23)
----------- -----------
Net cash provided by (used in) investing activities....................... (50,641) 9,223
----------- ----------
FINANCING ACTIVITIES:
Principal payments on long-term debt........................................... (75,379) (25,361)
Proceeds from long-term debt................................................... 65,000 --
Dividends to stockholders...................................................... (12,868) (16,671)
Issuance of treasury stock to employee stock purchase plan..................... 122 --
Purchase of treasury stock..................................................... -- (125)
Employee stock option exercises................................................ 1,412 314
---------- ----------
Net cash used in financing activities..................................... (21,713) (41,843)
----------- -----------
Increase in cash................................................................. 1,259 3,398
Cash at beginning of period...................................................... 13,159 5,950
---------- ----------
Cash at end of period............................................................ $ 14,418 $ 9,348
========== ==========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest.................................................................... $ 1,726 $ 3,344
Income taxes................................................................ $ 8,000 12,650
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
SEPTEMBER 30, 2002
(UNAUDITED)
1. SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The condensed 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 the 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 Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("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.
Although all of the Company's products are sold through the same
independent insurance agent and broker distribution network, the Company's
underwriting and management reporting are organized by the two broad types of
surety products or operating segments - contract surety and commercial surety,
which also includes fidelity bonds and other insurance products for these
purposes. These two operating segments are comprised of five components: large
commercial, small commercial, large contract, small contract and international
contract and commercial. The small, large and international components of
8
commercial have been aggregated into one operating segment (reporting unit) and
the small, large and international components of contract have been aggregated
into one operating segment (reporting unit) because of their similar economic
characteristics.
The goodwill test for impairment consists of a two-step process that begins
with an estimation of the fair value of the entity's reporting units. The first
step of the test is a screen for potential impairment and the second step
measures the amount of impairment, if any. SFAS No. 142 required an entity to
complete the first step of the transitional goodwill impairment test within six
months of adopting the Statement. In accordance with SFAS No. 142, the Company
identified two reporting units that constitute components of its business that
include goodwill.
The Company completed the first step of the transitional goodwill
impairment test as of June 30, 2002 and has determined that the fair value of
each reporting unit exceeded the reporting unit's carrying amount, and as such
no impairment was taken.
In accordance with the transition guidance provided in SFAS No. 142, the
Company has classified its intangible assets as intangibles with indefinite
lives and has completed its initial impairment test. No asset impairment was
indicated for these indefinite lived intangibles.
In determining whether there is an impairment of goodwill or other
intangible assets, the Company calculated its estimated fair value using the
present value of estimated expected future cash flows. The resulting estimated
fair value was then compared to the net book value, including goodwill. If the
net book value exceeded the estimated fair value, the Company would have
measured the amount of impairment loss by comparing the implied estimated fair
value of goodwill with the carrying amount of that goodwill. To the extent that
the carrying amount of the goodwill exceeds its implied fair value, a goodwill
impairment loss would be recognized. This impairment test will be performed
annually and whenever facts and circumstances indicate that there is a possible
impairment of goodwill. The Company believes the methodology it uses in testing
impairment of goodwill provides a reasonable basis in determining whether an
impairment charge should be taken.
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 third quarter and nine-month net income by $1.4 million, or 3
cents per share, and $4.3 million, or 10 cents per share, respectively, as
compared to the prior year. If the provisions of this standard were applied to
prior periods, net income for the three- and nine-month periods ended September
30, 2001 would have been $13.4 million, or $0.31 per share and $40.6 million, or
$0.95 per 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 September 30, 2002 and December 31, 2001, by
investment category, were as follows (dollars in thousands):
Gross Gross
Amortized Cost or Unrealized Unrealized Estimated Fair
September 30, 2002 Cost Gains Losses Value
------------------ ---------------- ------------ ---------- --------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury............................. $ 6,741 $ 593 $ -- $ 7,334
U.S. Agencies............................. 33,463 3,519 -- 36,982
Collateralized mortgage obligations....... 212 4 (1) 215
Mortgage pass-through securities.......... 24,914 1,081 -- 25,995
Obligations of states and political subdivisions 303,018 27,469 -- 330,487
Corporate bonds................................ 67,510 6,451 (421) 73,540
Non-agency collateralized mortgage obligations 11,281 595 (42) 11,834
Other asset-backed securities:
Second mortgages/home equity loans........... 5,271 275 -- 5,546
Credit card receivables...................... 12,000 630 -- 12,630
Other........................................ 8,001 820 -- 8,821
Redeemable preferred stock..................... 2,356 453 -- 2,809
---------- ---------- ---------- ----------
Total fixed income securities............. 474,767 41,890 (464) 516,193
Equity securities.............................. 59,535 2,236 (16,325) 45,446
---------- ---------- ---------- ----------
Total..................................... $ 534,302 $ 44,126 $ (16,789) $ 561,639
========== ========== =========== ==========
Gross Gross
Amortized Cost or Unrealized Unrealized Estimated Fair
December 31, 2001 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
Other........................................ 8,333 450 (20) 8,763
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
========== ========== =========== ==========
The Company's objectives with respect to the management of the fixed
maturity and equity portfolios is to maximize return on the fixed maturity
portfolio, and to match equity index returns for the equity portfolio, relative
to underlying liabilities and respective liquidity and capital needs. In
achieving these goals, assets may be sold to take advantage of market conditions
or other investment opportunities or credit and tax considerations. This
activity will produce realized gains and losses.
CNA Surety classifies its fixed maturity securities and its equity
securities as available-for-sale, and as such, they are carried at fair value.
The amortized cost of fixed maturity securities is adjusted for amortization of
premiums and accretion of discounts to maturity, which is included in net
investment income. Changes in fair value are reported as a component of other
comprehensive income.
Invested assets are exposed to various risks, such as interest rate, market
and credit. 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 Consolidated Balance Sheets and Consolidated
Statements of Income.
10
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,
-------------------------------------------------------
2002 2001
------------------------- --------------------------
Written Earned Written Earned
----------- ----------- ----------- ------------
Direct........................................................ $ 38,024 $ 35,891 $ 32,342 $ 31,281
Assumed ...................................................... 59,005 52,862 55,649 55,617
Ceded......................................................... (10,643) (9,557) (3,933) (4,967)
----------- ----------- ----------- -----------
$ 86,386 $ 79,196 $ 84,058 $ 81,931
=========== =========== =========== ===========
Nine Months Ended September 30,
-------------------------------------------------------
2002 2001
------------------------- --------------------------
Written Earned Written Earned
----------- ----------- ----------- ------------
Direct........................................................ $ 111,317 $ 100,578 $ 96,498 $ 88,287
Assumed....................................................... 163,278 154,365 152,759 159,703
Ceded......................................................... (37,421) (32,784) (11,748) (10,460)
----------- ----------- ----------- -----------
$ 237,174 $ 222,159 $ 237,509 $ 237,530
=========== =========== =========== ===========
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,
-------------------------------------------------------
2002 2001
------------------------- --------------------------
$ Ratio $ Ratio
----------- ----------- ----------- ------------
Gross losses and loss adjustment expenses..................... $ 45,733 51.5% $ 38,559 44.4%
Ceded amounts................................................. (10,353) 108.3 (21,491) 432.7
----------- --------- ----------- ----------
Net losses and loss adjustment expenses....................... $ 35,380 44.7% $ 17,068 20.8%
=========== ========= =========== ==========
Nine Months Ended September 30,
-------------------------------------------------------
2002 2001
------------------------- --------------------------
$ Ratio $ Ratio
----------- ----------- ----------- ------------
Gross losses and loss adjustment expenses..................... $ 86,889 34.1% $ 89,243 36.0%
Ceded amounts................................................. (15,256) 46.5 (39,276) 375.5
----------- --------- ----------- ----------
Net losses and loss adjustment expenses....................... $ 71,633 32.2% $ 49,967 21.0%
=========== --------- =========== ==========
Assumed premiums primarily includes all surety business written or renewed,
net of reinsurance, by Continental Casualty Company ("CCC") and The Continental
Insurance Company ("CIC"), and their affiliates, that is reinsured by Western
Surety pursuant to intercompany reinsurance and related agreements.
The Company's ceded reinsurance program changed significantly in 2002 as
compared to 2001. As a result, ceded written and earned premiums increased in
the three- and nine-month periods of 2002 as compared to the same periods in
2001. Ceded written premiums increased $6.7 million and $25.7 million to $10.6
million and $37.4 million, respectively, for the three- and nine-month periods
ended September 30, 2002. The increase in ceded written premiums for the third
quarter included $7.5 million for the Company's new $40 million excess of $20
million per principal excess of loss coverage. The increase in ceded written
premiums for the nine months ended September 30, 2002 included $22.5 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.
11
The material differences between the 2002 excess of loss reinsurance
program and the Company's 2001 program are as follows. The annual aggregate
coverage decreased 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. Subject to state
insurance department regulatory approval, CCC is providing reinsurance coverage
(the "10% Quota Share Agreement") to the Company for 10% of any losses between
$20 million and $60 million with respect to single large surety bonds written
effective January 1, 2002 and thereafter. CCC receives 10% of the written
premium the Company received in exchange for the coverage provided.
In addition, the terms of the 2002 excess of loss reinsurance program
required a special acceptance process for certain larger contract accounts
in-force at the inception date of the treaty. The reinsurers conducted an
underwriting file review and approval process for these risks that would
otherwise be excluded. This file review process resulted in one large contract
principal being excluded from the 2002 treaty. In addition, the 2002 treaty
excludes certain classes of business relating to two other principals. The
Company no longer writes these classes but has exposures that are in run-off.
Should the Company incur a loss on these excluded principals, the Company would
be subject to a maximum retention of $60 million per principal. The higher net
retention of $20 million 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.
In connection with the changes in the Company's reinsurance program, CNA
Surety purchased extended discovery coverage, available under the excess of loss
reinsurance coverage in place in 2001, at a cost of approximately $8.5 million.
This covers losses on surety bonds written prior to January 1, 2002 and
discovered in the two years after January 1, 2002. This also covers adverse
development on losses discovered prior to December 31, 2001. The limit of this
extended discovery coverage is the unused portion of the annual aggregate limit
of $115 million under the 2001 excess of loss treaty. This limit has two layers
comprised of a $65 million aggregate limit for per principal losses between $5
million and $25 million and $50 million aggregate for per principal losses
between $25 million and $60 million. Subject to the outcome of claim litigation
and adjusting activities with respect to the Company's $77.9 million of maximum
gross exposure (approximately $7.8 million of net exposure) to Enron and based
upon its current claim estimates of other discovered losses, the Company
estimates that as of September 30, 2002 the first layer of the annual aggregate
has been exhausted and approximately $14 million of limit remains under the
second layer to cover adverse development on losses discovered prior to December
31, 2001 as well as newly discovered losses. It is reasonably possible that this
extended discovery coverage could be insufficient to fully cover all adverse
development that could occur on losses discovered prior to December 31, 2001,
particularly if the Company's claim liability on the Enron matter is adjusted at
its maximum gross exposure. The unfavorable resolution of these uncertainties
could have a material adverse impact on the Company's future results of
operations and cash flows.
Intercompany reinsurance agreements together with the Services and
Indemnity Agreement that is described below provide for the transfer of the
surety business written by CCC and CIC to Western Surety. These reinsurance
agreements were all originally entered into on September 30, 1997 (the "Merger
Date") and are as follows: (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").
12
The Services and Indemnity Agreement provides the 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 the Western Surety a quarterly fee of
$50,000. This agreement had an original term of five years that expired on
September 30, 2002 and was renewed October 1, 2002 on substantially the same
terms with an expiration date of December 31, 2003; annually renewable
thereafter.
Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all
surety business written or renewed by CCC and CIC after the Merger Date. 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 28% of net written premiums written on such business.
The Quota Share Treaty had an original term of five years from the Merger
Date and was renewed on October 1, 2002 on substantially the same terms with an
expiration date of December 31, 2003; annually renewable thereafter. The ceding
commission paid to CCC and CIC by Western Surety remained at 28% of net written
premiums and contemplates an approximate 4% override commission to CCC and CIC
on their actual direct acquisition costs for the nine months ended September 30,
2002.
Although renewed on substantially the same terms, both the Quota Share
Treaty and the Services and Indemnity Agreements must be approved by the
insurance departments of the states in which Western Surety and CCC are
domiciled (South Dakota and Illinois, respectively) because they are related
party transactions. The 10% Quota Share Agreement also must be approved by South
Dakota and Illinois.
The Stop Loss Contract terminated on December 31, 2000 and was not renewed.
The Stop Loss Contract protected the insurance subsidiaries from adverse loss
experience 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 fiscal years following the Merger Date. In
the event the insurance subsidiaries' accident year net loss ratio exceeds 24%
in any of 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 their 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. As of September 30, 2002, the Company had an estimated unpaid loss
recoverable balance of approximately $8.0 million under the Stop Loss Contract
of which $2.5 million was billed in October 2002.
The Excess of Loss Contract provides the insurance subsidiaries of CNA
Surety with the capacity to underwrite large surety bond exposures by providing
reinsurance support from CCC. The Excess of Loss Contract provides $75 million
of coverage in excess of the $40 million of coverage provided to the insurance
subsidiaries in 2002 by third party reinsurers, which is in turn in excess of
the $20 million of per principal losses retained by the CNA Surety insurance
subsidiaries. Subsequent to the Merger Date, the Company entered into a second
excess of loss contract with CCC ("Second Excess of Loss Contract"). The Second
Excess of Loss Contract provides additional coverage for principal losses that
exceed the foregoing
13
coverage of $75 million per principal provided by the Excess of Loss Contract,
or aggregate losses per principal in excess of $135 million. CCC is also
obligated to act as a joint insurer, or "co-surety," for business covered by the
Excess of Loss Contract when requested by the CNA Surety insurance subsidiaries.
In consideration for the reinsurance coverage provided by the Excess of Loss
Contracts, the insurance subsidiaries pay to CCC, on a quarterly basis, a
premium equal to 1% of the net written premiums applicable to the Excess of Loss
Contract, subject to a minimum premium of $20,000 and $5,000 per quarter under
the Excess of Loss Contract and Second Excess of Loss Contract, respectively.
The two Excess of Loss Contracts collectively provide coverage for losses
discovered on surety bonds in force as of the Merger Date and for losses
discovered on new and renewal business written during the term of the Excess of
Loss Contracts. Both Excess of Loss Contracts commenced immediately following
the Merger Date and continue for a period of five years from the Merger Date or
until September 30, 2002. The discovery period for losses covered by the Excess
of Loss contracts extends until three years after the September 30, 2002
expiration date of the contracts.
The Company is pursuing replacement excess of loss protection for new and
renewal bonds for per principal exposures that exceed $60 million since October
party reinsurers and b) $50 million excess of $100 million with CCC. This excess
of loss protection is primarily necessary to support new and renewal bonds for
contract surety accounts with bonded backlogs or work-in-process in excess of
$60 million. The Company generally limits support to new and renewal bonds to
large commercial surety accounts to $25 million. In addition to the foregoing
structural changes in its high layer excess of loss reinsurance programs, the
Company anticipates the cost for these protections to increase significantly as
compared to the cost of the previous two Excess of Loss Contracts. The $50
million excess of $100 million surety excess of loss contract with CCC has been
executed. This agreement must be approved by the insurance departments of the
states in which Western Surety and CCC are domiciled because it is a related
party transaction. The failure to fully secure suitable replacement excess of
loss reinsurance coverage may have a material adverse impact on the Company's
future results of operations and financial condition.
14
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 Nine Months Ended
September 30, September 30,
--------------------------------------------------------------
2002 2001 2002 2001
--------------- ------------------------------ ---------------
Reserves at beginning of period:
Gross........................................................ $ 308,746 $ 206,523 $ 315,811 $ 204,457
Ceded reinsurance............................................ 148,673 75,128 166,318 70,159
---------- ---------- ---------- ----------
Net reserves at beginning of period........................ 160,073 131,395 149,493 134,298
---------- ---------- ---------- ----------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period............. 31,222 16,542 66,566 49,596
Increase in provision for insured events of prior periods.. 4,158 526 5,067 371
---------- ---------- ---------- ----------
Total net incurred...................................... 35,380 17,068 71,633 49,967
---------- ---------- ---------- ----------
Net payments attributable to:
Current period events...................................... 2,267 5,780 5,340 13,018
Prior period events........................................ 18,027 11,163 40,627 39,727
---------- ---------- ---------- ----------
Total net payments...................................... 20,294 16,943 45,967 52,745
---------- ---------- ---------- ----------
Net reserves at end of period................................ 175,159 131,520 175,159 131,520
Ceded reinsurance at end of period........................... 162,775 87,905 162,775 87,905
---------- ---------- ---------- ----------
Gross reserves at end of period $ 337,934 $ 219,425 $ 337,934 $ 219,425
========== ========== ========= ==========
5. DEBT
CNA Surety's bank borrowings were previously under a five-year unsecured
revolving credit facility effective September 30, 1997 (the "1997 Credit
Facility") that provided for borrowings of up to $130 million. The Company paid
down outstanding borrowings under the 1997 Credit Facility by $10 million to $65
million on July 29, 2002. The 1997 Credit Facility matured September 30, 2002.
The Company refinanced $65 million in outstanding borrowings under the 1997
Credit Facility under a new credit facility (the "2002 Credit Facility"). The
2002 Credit Facility provided an aggregate of up to $65,000,000 in initial
borrowings divided between a 364 day revolving credit facility (the "Revolving
Credit Facility") of $35 million and a three year term loan facility (the "Term
Loan") of $30 million. The Revolving Credit Facility may be extended, with the
consent of lenders, for up to two additional periods of up to 364 days each, but
in no case shall the Revolving Credit Facility be extended to mature on a date
later than three years from the effective date of the Revolving Credit Facility.
The Revolving Credit Facility may be increased from time to time, at the
Company's option, by the amount of amortization under the Term Loan facility.
Such increase is subject to consent by each Revolving Credit Bank, and will take
place upon receipt by the Banks of the respective installment payments under the
Term Loan facility. Of the $65 million in outstanding borrowings, $15 million is
contingent upon a guaranty by CNA Financial which expires on November 30, 2002.
15
Amortization of the Term Loan will take place at $10,000,000 per year, in
equal semi-annual installments of $5,000,000 on the following dates:
Date Amortization Outstanding Balance
---- ------------ -------------------
June 30, 2003 $5,000,000 $25,000,000
September 30, 2003 5,000,000 20,000,000
March 31, 2004 5,000,000 15,000,000
September 30, 2004 5,000,000 10,000,000
March 31, 2005 5,000,000 5,000,000
September 30, 2005 5,000,000 0
The interest rate on borrowings under the 2002 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 a facility fee and utilization
fee on the Revolving Credit Facility, was 0.625% at September 30, 2002 and can
vary based on CNA Surety's leverage ratio (debt to total capitalization) from
0.48% to 0.80%. As of September 30, 2002, the weighted average interest rate was
2.4% on the $65 million of outstanding borrowings. As of December 31, 2001, the
weighted average interest rate on the 1997 Credit Facility was 2.5% on the $75.0
million of outstanding borrowings.
The 2002 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 September 30, 2002,
management believes that the Company was in compliance with all restrictions or
covenants contained in the credit facility agreement.
On November 30, 2002, $15 million of the total loans will become due and
payable if not repaid or refinanced prior to that date. CNA Surety's largest
shareholder, CNA Financial Corporation, has guaranteed CNA Surety's obligation
to repay $15 million of loans through November 30, 2002. If CNA Financial is
required to perform on its guaranty, any such amounts will be treated as loans
from CNA Financial Corporation to CNA Surety and will carry significant interest
and penalties. CNA Surety is exploring other capital opportunities to repay or
refinance $15 million of loans.
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 September 30, 2002 was $0.8 million.
The consolidated balance sheet reflects total debt of $65.8 and $76.2
million at September 30, 2002 and December 31, 2001, respectively. The weighted
average interest rate on outstanding borrowings was 2.4% and 2.6% at September
30, 2002 and December 31, 2001 respectively.
6. 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.
16
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.
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 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 90% 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.
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
17
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 significant increases in corporate
defaults on a national or global basis, the impact of competitive products,
policies and pricing, product and policy development, regulatory changes and
conditions including underwriting limitations imposed by the U.S. Department of
Treasury, 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, the cost and availability of reinsurance
contracts on reasonable terms 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.
18
RESULTS OF OPERATIONS
CNA SURETY RESULTS FOR THREE- AND NINE- MONTHS ENDED SEPTEMBER 30, 2002 AND
2001
The components of net income for the Company for the three and nine months
ended September 30, 2002 and 2001 are summarized as follows (dollars in
thousands, except per share amounts):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- --------------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
Total revenues................................ $ 85,529 $ 89,386 $ 244,042 $ 260,363
========== ========== ========== ==========
Underwriting income (loss).................... $ (2,211) $ 13,115 $ 17,353 $ 40,794
Net investment income......................... 7,031 7,088 21,258 22,303
Net realized investment gains (losses)........ (698) 367 625 530
Interest expense.............................. 407 803 1,310 3,348
Amortization of intangible assets............. -- 1,525 -- 4,573
---------- ---------- ---------- ----------
Income before income taxes.................... 3,715 18,242 37,926 55,706
Income taxes.................................. 1,098 6,228 11,850 19,405
---------- ---------- ---------- ----------
Net income.................................... $ 2,617 $ 12,014 $ 26,076 $ 36,301
========== ========== ========== ==========
Net income per share.......................... $ 0.06 $ 0.28 $ 0.61 $ 0.85
========== ========== ========== ==========
Insurance Underwriting
Underwriting results for the Company for the three and nine months ended
September 30, 2002 and 2001 are summarized in the following table (dollars in
thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------ -------------------------
2002 2001 2002 2001
--------- --------- --------- ---------
Gross written premiums........................ $ 97,029 $ 87,991 $274,595 $ 249,257
========= ========= ======== =========
Net written premiums.......................... $ 86,386 $ 84,058 $ 237,174 $ 237,509
========= ========= ========= =========
Net earned premiums........................... $ 79,196 $ 81,931 $ 222,159 $237,530
Net losses and loss adjustment expenses....... 35,380 17,068 71,633 49,967
Net commissions, brokerage and other.......... 46,027 51,748 133,173 146,769
--------- --------- --------- ---------
Underwriting income (loss).................... $ (2,211) $ 13,115 $ 17,353 $ 40,794
========== ========= ========= =========
Loss ratio.................................... 44.7% 20.8% 32.2% 21.0%
Expense ratio................................. 58.1 63.2 60.0 61.8
--------- --------- --------- ---------
Combined ratio................................ 102.8% 84.0% 92.2% 82.8%
========= ========= ========= =========
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
19
financial performance. The Company also writes fidelity bonds that 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 Nine Months Ended
September 30, September 30,
------------------------- --------------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
Contract...................................... $ 55,503 $ 48,655 $ 148,773 $ 134,999
Commercial.................................... 34,630 32,510 104,615 92,933
Fidelity and other............................ 6,896 6,826 21,207 21,325
---------- ---------- ---------- ----------
$ 97,029 $ 87,991 $ 274,595 $ 249,257
========== ========== ========== ==========
Gross written premiums increased 10.3%, or $9.0 million, for the three
months ended September 30, 2002 over the comparable period in 2001. Gross
written premiums for contract surety increased 14.1%, or $6.8 million,
reflecting growth in public construction spending and improving rates. Gross
written premiums for commercial surety increased 6.5%, or $2.1 million, for the
three months ended September 30, 2002 reflecting continued volume growth of
small commercial products and improving rates on large commercial bonds
partially offset by the impacts of the Company's ongoing efforts to reduce
aggregate exposures on large commercial accounts. The estimated impact of the
Company's exposure reduction efforts to date represents approximately $9 million
in annual premium, assuming an average rate per $1,000 of bond exposure of
$2.84, or 28 basis points. Fidelity and other products increased 1.0% to $6.9
million for the three months ended September 30, 2002 as compared to the same
period in 2001 due primarily to an increase in fidelity business partially
offset by the discontinuance of the Company's agents' E&O business.
Gross written premiums increased 10.2%, or $25.3 million, for the nine
months ended September 30, 2002 over the comparable period in 2001. Gross
written premiums for commercial surety and contract surety increased 12.6%, or
$11.7 million, and 10.2%, or $13.8 million, respectively for the nine months
ended September 30, 2002 reflecting trends comparable to the quarter. Fidelity
and other products decreased 0.6% to $21.2 million for the nine months ended
September 30, 2002 as compared to the same period in 2001 due primarily to the
discontinuance of the Company's agents' E&O business.
Net written premiums are shown in the table below (dollars in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- --------------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
Contract...................................... $ 50,527 $ 45,722 $ 131,709 $ 125,001
Commercial.................................... 29,289 31,510 85,232 91,183
Fidelity and other............................ 6,570 6,826 20,233 21,325
---------- ---------- ---------- ----------
$ 86,386 $ 84,058 $ 237,174 $ 237,509
========== ========== ========== ==========
For the three months ended September 30, 2002, net written premiums
increased 2.8% to $86.4 million as compared to the same period in 2001,
reflecting the aforementioned gross production changes partially offset by
higher reinsurance costs. Ceded written premiums increased $6.7 million to $10.6
million for the three months ended September 30, 2002. Ceded written premiums in
the current quarter include $7.5 million for the Company's $40 million excess of
$20 million per principal excess of loss coverage. Net written premiums for
contract surety business increased 10.5% to $50.5 million. Net written premiums
for commercial surety decreased 7.0% to $29.3 million for the three months ended
September 30, 2002. Fidelity and other products decreased 3.8% to $6.6 million
for the three months ended September 30, 2002 as compared to the same period in
2001.
20
For the nine months ended September 30, 2002, net written premiums
decreased 0.1% to $237.2 million as compared to the same period in 2001,
reflecting the effects of higher reinsurance costs and the Company's efforts to
reduce large commercial bond exposures. Ceded written premiums increased $25.7
million to $37.4 million for the nine months ended September 30, 2002. Ceded
written premiums for the first nine months of 2002 include $22.5 million for the
Company's $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. Net
written premiums for contract surety business increased 5.4% to $131.7 million.
Net written premiums for commercial surety decreased 6.5% to $85.2 million for
the first nine months in 2002. Fidelity and other products decreased 5.1% to
$20.2 million for the first nine months in 2002 as compared to the same period
in 2001.
The material differences between the 2002 excess of loss reinsurance
program and the Company's 2001 program are as follows. The annual aggregate
coverage decreased 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. Subject to state
insurance department regulatory approval, CCC is providing reinsurance coverage
through the 10% Quota Share Treaty to the Company for 10% of any losses between
$20 million and $60 million with respect to single large surety bonds written
effective January 1, 2002 and thereafter. CCC receives 10% of the written
premium the Company received in exchange for the coverage provided.
In addition, the terms of the 2002 excess of loss reinsurance program
required a special acceptance process for certain larger contract accounts
in-force at the inception date of the treaty. The reinsurers conducted an
underwriting file review and approval process for these risks that would
otherwise be excluded. This file review process resulted in one large contract
principal being excluded from the 2002 treaty. In addition, the 2002 treaty
excludes certain classes of businesses relating to two other principals. The
Company no longer writes these classes but has exposures that are in run-off.
Should the Company incur a loss on these excluded principals, the Company would
be subject to a maximum retention of $60 million per principal. The higher net
retention per principal of $20 million 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.
In connection with the changes in the Company's reinsurance program, CNA
Surety purchased extended discovery coverage, available under the excess of loss
reinsurance coverage in place in 2001, at a cost of approximately $8.5 million.
This covers losses on surety bonds written prior to January 1, 2002 and
discovered in the two years after January 1, 2002. This also covers adverse
development on losses discovered prior to December 31, 2001. The limit of this
extended discovery coverage is the unused portion of the annual aggregate limit
of $115 million under the 2001 excess of loss treaty. This limit has two layers
comprised of a $65 million aggregate limit for per principal losses between $5
million and $25 million and $50 million aggregate for per principal losses
between $25 million and $60 million. Subject to the outcome of claim litigation
and adjusting activities with respect to the Company's $77.9 million of maximum
gross exposure (approximately $7.8 million of net exposure) to Enron and based
upon its current claim estimates of other discovered losses, the Company
estimates that as of September 30, 2002 the first layer of the annual aggregate
has been exhausted and approximately $14 million of limit remains under the
second layer to cover adverse development on losses discovered prior to December
31, 2001 as well as
21
newly discovered losses. It is reasonably possible that this extended discovery
coverage could be insufficient to fully cover all adverse development that
could occur on losses discovered prior to December 31, 2001, particularly if the
Company's claim liability on the Enron matter is adjusted at its maximum gross
exposure. The unfavorable resolution of these uncertainties could have a
material adverse impact on the Company's future results of operations and cash
flows.
These intercompany reinsurance agreements together with the Services and
Indemnity Agreement, that is described below, provide for the transfer of the
surety business written by CCC and CIC to Western Surety. These reinsurance
agreements were all originally entered into on September 30, 1997 (the "Merger
Date") and are as follows: (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").
The Services and Indemnity Agreement provides the 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 the Western Surety a quarterly fee of
$50,000. This agreement had an original term of five years that expired on
September 30, 2002; and was renewed on October 1, 2002 on substantially the same
terms with an expiration date of December 31, 2003; annually renewable
thereafter.
Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all
surety business written or renewed by CCC and CIC after the Merger Date. 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 28% of net written premiums written on such business.
The Quota Share Treaty had an original term of five years from the Merger
Date and was renewed on October 1, 2002 on substantially the same terms with an
expiration date of December 31, 2003; annually renewable thereafter. The ceding
commission paid to CCC and CIC by Western Surety remained at 28% of net written
premiums and contemplates an approximate 4% override commission to CCC and CIC
on their actual direct acquisition costs for the nine months ended September 30,
2002.
Although renewed on substantially the same terms, both the Quota Share
Treaty and the Services and Indemnity Agreements must be approved by the
insurance departments of the states in which Western Surety and CCC are
domiciled (South Dakota and Illinois, respectively) because they are related
party transactions. The 10% Quota Share Agreement also must be approved by South
Dakota and Illinois.
The Stop Loss Contract terminated on December 31, 2000 and was not renewed.
The Stop Loss Contract protected the insurance subsidiaries from adverse loss
experience 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 fiscal years following the Merger Date. In
the event the insurance subsidiaries' accident year net loss ratio exceeds 24%
in any of 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 their 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
22
have paid CCC all required annual premiums. As of September 30, 2002, the
Company had an estimated unpaid loss recoverable balance of approximately $8.0
million under the Stop Loss Contract of which $2.5 million was billed in October
2002.
The Excess of Loss Contract provides the insurance subsidiaries of CNA
Surety with the capacity to underwrite large surety bond exposures by providing
reinsurance support from CCC. The Excess of Loss Contract provides $75 million
of coverage in excess of the $40 million of coverage provided to the insurance
subsidiaries in 2002 by third party reinsurers, which is in turn in excess of
the $20 million of per principal losses retained by the CNA Surety insurance
subsidiaries. Subsequent to the Merger Date, the Company entered into a second
excess of loss contract with CCC ("Second Excess of Loss Contract"). The Second
Excess of Loss Contract provides additional coverage for principal losses that
exceed the foregoing coverage of $75 million per principal provided by the
Excess of Loss Contract, or aggregate losses per principal in excess of $135
million. CCC is also obligated to act as a joint insurer, or "co-surety," for
business covered by the Excess of Loss Contract when requested by the CNA Surety
insurance subsidiaries. In consideration for the reinsurance coverage provided
by the Excess of Loss Contracts, the insurance subsidiaries pay to CCC, on a
quarterly basis, a premium equal to 1% of the net written premiums applicable to
the Excess of Loss Contract, subject to a minimum premium of $20,000 and $5,000
per quarter under the Excess of Loss Contract and Second Excess of Loss
Contract, respectively. The two Excess of Loss Contracts collectively provide
coverage for losses discovered on surety bonds in force as of the Merger Date
and for losses discovered on new and renewal business written during the term of
the Excess of Loss Contracts. Both Excess of Loss Contracts commenced
immediately following the Merger Date and continue for a period of five years
from the Merger Date or until September 30, 2002. The discovery period for
losses covered by the Excess of Loss contracts extends until three years after
the September 30, 2002 expiration date of the contracts.
The Company is pursuing replacement excess of loss protection for new and
renewal bonds for per principal exposures that exceed $60 million since October
1, 2002 in two primary parts - a) $40 million excess of $60 million with third
party reinsurers and b) $50 million excess of $100 million with CCC. This excess
of loss protection is primarily necessary to support new and renewal bonds for
contract surety accounts with bonded backlogs or work-in-process in excess of
$60 million. The Company generally limits support to new and renewal bonds to
large commercial surety accounts to $25 million. In addition to the foregoing
structural changes in its high layer excess of loss reinsurance programs, the
Company anticipates the cost to these protections to increase significantly as
compared to the cost of the previous two Excess of Loss Contracts. The $50
million excess of $100 million surety excess of loss contract with CCC has
been executed. This agreement must be approved by the insurance departments of
the states in which Western Surety and CCC are domiciled because it is a related
party transaction. The failure to fully secure suitable replacement excess of
loss reinsurance coverage may have a material adverse impact on the Company's
future results of operations and financial condition.
Underwriting Income
Underwriting results decreased 116.9% to a loss of $2.2 million for the
three months ended September 30, 2002 compared to $13.1 million for the same
period in 2001. Underwriting income decreased 57.5% to $17.4 million for the
nine months ended September 30, 2002 compared to the same period in 2001. These
decreases are primarily due to estimated net incurred losses of $12.0 million
related to the September, 2002 bankruptcy filing of a national trucking concern.
In addition, the Company recorded net unfavorable loss reserve development for
prior accident years of $4.2 million and $5.1 million for the three and
nine-month period ended September 30, 2002. Underwriting results also reflect
the increased reinsurance costs on net earned premium partially offset by
reduced acquisition and underwriting expenses.
As the foregoing underwriting results indicate, the Company's business is
subject to certain risks and
23
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, particularly to reduce its
risks on large commercial accounts. As the following table depicts, the Company
has reduced its exposure by 33% in the first nine months of 2002 (dollars in
billions):
Number of Accounts Total Exposure
------------------ -----------------------------------
Commercial Account Exposure Dec-01 Sep-02 Dec-01 Sep-02 % Reduction
--------------------------- ------ ------ ------ ------ -----------
$100MM + 20 13 $ 5.0 $ 2.7 46.0%
$50MM to $100MM 27 21 1.8 1.5 16.7
$25MM to $50MM 35 20 1.2 0.7 41.7
$10MM to $25MM 80 82 1.3 1.3 --
------ ------ ------ ------
Total 162 136 $ 9.3 $ 6.2 33.3
====== ====== ====== ======
Net Loss Ratio
The net loss ratios for the three months ended September 30, 2002 and 2001
were 44.7% and 20.8%, respectively. The loss ratios included $4.2 million and
$0.5 million of net unfavorable loss reserve development for the three months
ended September 30, 2002 and 2001, respectively. Excluding the impact of loss
reserve development, the net loss ratios would have been 39.4% and 20.2% for the
period ended September 30, 2002 and September 30, 2001, respectively. For the
nine months ended September 30, 2002 and 2001, the net loss ratios were 32.2%
and 21.0%, respectively. The loss ratios included $5.1 million and $0.4 million
of net unfavorable reserve development for the nine months ended September 30,
2002 and 2001, respectively. Excluding the impact of loss reserve development,
the loss ratios would have been 29.9% and 20.8% for the nine-month periods ended
September 30, 2002 and September 30, 2001, respectively. The net adverse loss
reserve development in 2002 includes $2.4 million associated with the assumed
international credit and surety business from CNA Re that was discontinued in
mid-2000. The remainder is primarily related to our small and specialty contract
business. The increases in the adjusted loss ratio for the three and nine month
periods in 2002 of 15.2 percentage points and 5.4 percentage points relate
primarily to estimated net incurred losses of $12.0 million with respect to the
bankruptcy filing of a large commercial account.
For the first nine months of 2002, the Company used an initial 2002
accident year net loss ratio of 30.0 percent for its 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 59% of our gross
premiums. These higher net retentions in 2002 may increase the variability of
our quarterly results of operations and cash flows.
The previously mentioned $12.0 million bankruptcy loss incurred in the
third quarter of 2002 raised the estimated branch contract and commercial net
accident year loss ratio to approximately 40 percent for the nine months ended
September 30, 2002. Due to the occurrence of this loss and other adverse loss
trends, together with the uncertain outlook for the economy and credit markets,
the Company has raised its expected baseline accident year net loss ratio on the
branch contract and commercial business to 36.0 percent from an initial 2002
accident year net loss ratio of 30.0 percent.
24
Expense Ratio
The expense ratio decreased to 58.1% for the three months ended September
30, 2002 compared to 63.2% for the same period in 2001. For the nine months
ended September 30, 2002, the expense ratio decreased to 60.0% from 61.8% for
the same period in 2001. The decrease in the expense ratio for the three and
nine months ended September 30, 2002 primarily reflects reduced acquisition and
underwriting expenses which were partially offset by the effect of higher
reinsurance costs on net earned premiums. Net earned premiums declined 3.3% and
6.5% and operating expenses decreased at a higher rate of 11.1% and 9.3% for the
three and nine months ended September 30, 2002, respectively.
Investment Income
For the three months ended September 30, 2002, net investment income was
$7.0 million compared to the three months ended September 30, 2001 of $7.1
million. The slight 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 4.8% and 5.2% for the three months ended
September 30, 2002 and 2001, respectively. The annualized after-tax yields for
the Company's equity and fixed income portfolio were 3.8% and 4.0% for the three
months ended September 30, 2002 and 2001. Net investment income for the nine
months ended September 30, 2002 and 2001 was $21.3 million and $22.3 million,
respectively. The annualized pretax yields were 4.9% and 5.4% for the nine
months ended September 30, 2002 and 2001. The annualized after-tax yields for
the Company's equity and fixed income portfolio were 3.8% and 4.0% for the nine
months ended September 30, 2002 and 2001, respectively.
Net realized investment losses were approximately $0.7 million for the
three months ended September 30, 2002 compared to net realized investment gains
of approximately $0.4 for the same period in 2001. Net realized investment gains
were approximately $0.6 million for the nine months ended September 30, 2002
compared to $0.5 million for the same period in 2001.
The Company's objectives with respect to the management of the fixed
maturity and equity portfolios is to maximize return on the fixed maturity
portfolio, and to match equity index returns for the equity portfolio, relative
to underlying liabilities and respective liquidity and capital needs. In
achieving these goals, assets may be sold to take advantage of market conditions
or other investment opportunities or credit and tax considerations. This
activity will produce realized gains and losses.
CNA Surety classifies its fixed maturity securities and its equity
securities as available-for-sale, and as such, they are carried at fair value.
The amortized cost of fixed maturity securities is adjusted for amortization of
premiums and accretion of discounts to maturity, which is included in net
investment income. Changes in fair value are reported as a component of other
comprehensive income.
Invested assets are exposed to various risks, such as interest rate, market
and credit. 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 Consolidated Balance Sheets and Consolidated
Statements of Income.
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.
25
Amortization expense was $1.4 million and $4.3 million for the three and nine
months ended September 30, 2001. The Company completed its goodwill-related
impairment tests by June 30, 2002 and no impairment was indicated. 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 decreased 49.3% for the third quarter of 2002 as compared
to the same period in 2001, primarily due to lower interest rates and lower
outstanding debt levels. Average debt outstanding was $65.9 million for the
third quarter in 2002 compared to $76.3 million in the third quarter of 2001.
The weighted average interest rate for the three months ended September 30, 2002
was 2.1% compared to 3.9% for the same period in 2001. Interest expense
decreased 60.9% for the first nine months of 2002 as compared to the same period
in 2001. Average debt outstanding was $72.7 million for the first nine months in
2002 compared to $85.0 million in the first nine months of 2001. The weighted
average interest rate for the nine months ended September 30, 2002 was 2.1%
compared to 4.9% for the same period in 2001.
Income Taxes
Income tax expense was $1.1 million and $6.2 million and the effective
income tax rates were 29.6% and 34.1% for the three months ended September 30,
2002 and 2001, respectively. For the nine months ended September 30, 2002 and
2001, income tax expense was $11.9 million and $19.4 million and the effective
income tax rates were 31.2% and 34.8%, respectively. The decrease in the
estimated effective tax rate in 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 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 September 30, 2002, the carrying value of the Company's
insurance subsidiaries' invested assets was comprised of $510.4 million of fixed
income securities, $44.8 million of equity securities, $42.6 million of
short-term investments, $7.0 million of other investments and $5.2 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
September 30, 2002, the parent company's invested assets consisted of $5.8
million of fixed income securities, $0.6
26
million of equity securities, $18.2 million of short-term investments and $9.2
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 September 30, 2002 and
December 31, 2001, parent company short-term investments and cash included $11.8
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 $73.6 million for the nine months ended September 30, 2002 and $36.0 million
for the comparable period in 2001. The increase in net cash flow provided by
operating activities primarily relates to an increase in loss reserves,
collections of reinsurance recoverables and an increase in unearned premium
reserves.
CNA Surety's bank borrowings were previously under a five-year unsecured
revolving credit facility effective September 30, 1997 (the "1997 Credit
Facility") that provided for borrowings of up to $130 million. The Company paid
down outstanding borrowings under the 1997 Credit Facility by $10 million to $65
million on July 29, 2002. The 1997 Credit Facility matured September 30, 2002.
The Company refinanced $65 million in outstanding borrowings under the 1997
Credit Facility under a new credit facility (the 2002 Credit Facility). The 2002
Credit Facility provided an aggregate of up to $65,000,000 in initial borrowings
divided between a 364 day revolving credit facility (the "Revolving Credit
Facility") of $35 million and a three year term loan facility (the "Term Loan")
of $30 million. The Revolving Credit Facility may be extended, with the consent
of lenders, for up to two additional periods of up to 364 days each, but in no
case shall the Revolving Credit Facility be extended to mature on a date later
than three years from the effective date of the Revolving Credit Facility. The
Revolving Credit Facility may be increased from time to time, at the Company's
option, by the amount of amortization under the Term Loan facility. Such
increase is subject to consent by each Revolving Credit Bank, and will take
place upon receipt by the Banks of the respective installment payments under the
Term Loan facility. Of the $65 million in outstanding borrowings, $15 million is
contingent upon a guarantee by CNA Financial which expires on November 30, 2002.
Amortization of the Term Loan will take place at $10,000,000 per year, in
equal semi-annual installments of $5,000,000 on the following dates:
Date Amortization Outstanding Balance
---- ------------ -------------------
June 30, 2003 $5,000,000 $25,000,000
September 30, 2003 5,000,000 20,000,000
March 31, 2004 5,000,000 15,000,000
September 30, 2004 5,000,000 10,000,000
March 31, 2005 5,000,000 5,000,000
September 30, 2005 5,000,000 0
The interest rate on borrowings under the 2002 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 a facility fee and utilization
fee on the Revolving Credit Facility, was 0.625% at September 30, 2002 and can
vary based on CNA Surety's leverage ratio (debt to total capitalization) from
0.48% to 0.80%. As of September 30, 2002, the weighted average interest rate was
2.4% on the $65 million of outstanding borrowings. As of December 31, 2001, the
weighted average interest rate on the 1997 Credit Facility was 2.5% on the $75.0
million of outstanding borrowings.
27
The 2002 Credit Facility contains, among other conditions, limitations on
CNA Surety with respect to the incurrence of additional indebtedness and
maintenance of a rating of at least "A" by A.M. Best Company for each of the
Company's insurance subsidiaries. The 2002 Credit Facility also requires the
maintenance of certain financial ratios as follows: a) maximum funded debt to
total capitalization ratio of 25%, b) minimum net worth of $350.0 million and c)
minimum fixed charge coverage ratio of 2.5 times. As of September 30, 2002, the
Company was in compliance with all restrictions and covenants contained in the
2002 Credit Facility agreement.
On November 30, 2002, $15 million of the total loans will become due and
payable if not repaid or refinanced prior to that date. CNA Surety's largest
shareholder, CNA Financial Corporation, has guaranteed CNA Surety's obligation
to repay $15 million of loans through November 30, 2002. If CNA Financial is
required to perform on its guaranty, any such amounts will be treated as loans
from CNA Financial Corporation to CNA Surety and will carry significant interest
and penalties. CNA Surety is exploring other capital opportunities to repay or
refinance $15 million of loans.
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 September 30, 2002 was $0.8 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 $21.5 million and $35.0 million in dividends from its insurance
subsidiaries during the first nine months of 2002 and 2001, respectively.
Combined statutory surplus totaled $222 million at quarter-end, resulting
in a net written premium to statutory surplus ratio of 1.4 to 1. Approximately
$202 million of the combined surplus relates to Western Surety. From a
regulatory standpoint, the Company must continue to maintain Western Surety's
surplus at this level. Insurance regulations restrict Western Surety's maximum
net retention on a single surety bond
28
to 10 percent of statutory surplus. So long as the Company's net retention per
principal remains at $20 million under its excess of loss reinsurance program,
this regulation would require minimum statutory surplus of $200 million at
Western Surety. This surplus constraint may limit the amount of future dividends
Western Surety could otherwise pay to CNA Surety Corporation.
In light of the current and expected business conditions and after a
complete review of factors, such as the Company's financial condition, projected
earnings, capital and surplus requirements, debt service obligations and other
considerations it deems relevant, it is likely the Board of Directors of the
Company will reassess the level of dividends paid to common shareholders of CNA
Surety.
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 received tax sharing
payments from its subsidiaries of $9.9 million for the nine months ended
September 30, 2002 and $18.2 million for the same period in 2001.
Western Surety, SBCA and USA each qualifies as an acceptable surety for
federal and other public works project bonds pursuant to U.S. Department of
Treasury regulations. The underwriting limitations of Western Surety, SBCA and
USA, based on each insurer's statutory surplus, were $16.9 million, $0.4 million
and $1.7 million, respectively, for the twelve-month period ended June 30, 2002.
Effective July 1, 2002 through June 30, 2003, the underwriting limitations of
Western Surety, SBCA and USA are $20.7 million, $0.5 million and $1.3 million,
respectively. Through the Quota Share Reinsurance Agreement between CCC and
Western Surety Company, CNA Surety has access to CCC and its affiliates' U.S.
Department of Treasury underwriting limitations. The Quota Share Treaty had an
original term of five years from the Merger Date and was renewed on October 1,
2002 on substantially the same terms. The underwriting limitations of CCC and
its affiliates totaled $616.0 million for the twelve months ended June 30, 2002.
Effective July 1, 2002 through June 30, 2003, the underwriting limitations of
CCC and its affiliates total $382.9 million. The decrease in underwriting
limitations for CCC and its affiliates is principally due to decreases in
statutory surplus during 2001 as result of charges associated with changes in
estimates with respect to prior year loss reserves and related accruals for
retrospective premiums. The CNA Surety management believes that the foregoing US
Treasury underwriting limitations are sufficient for the conduct of its business
and that the reduction in underwriting capacity of CCC and affiliates will not
have a material adverse impact on the Company's results of operations.
Subject to the aforementioned uncertainties concerning bank financing and
replacement excess of loss reinsurance coverage, 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.
29
CONTROLS AND PROCEDURES
The Company, under the direction of the Chief Executive Officer and the
Chief Financial Officer, has established disclosure controls and procedures that
are designed to ensure that information required to be disclosed by the Company
in the reports that it files or submits under the Securities Exchange Act of
1934 is recorded, processed, summarized and reported within the time periods
specified in the SEC's rules and forms. The disclosure controls and procedures
are also intended to ensure that such information is accumulated and
communicated to the Company's management, including the Chief Executive Officer
and the Chief Financial Officer, as appropriate to allow timely decisions
regarding required disclosures.
Within 90 days before the filing of this Report, the Chief Executive
Officer and the Chief Financial Officer have reviewed and evaluated the
Company's disclosure controls and procedures. Based on this review and
evaluation, the Chief Executive Officer and the Chief Financial Officer have
concluded that the Company's disclosure controls and procedures are operating
effectively.
In addition, there have been no significant changes in the Company's
internal controls or in other factors that could significantly affect these
controls subsequent to the date of the most recent evaluation. No significant
deficiencies or material weaknesses in the internal controls were identified
during the evaluation and, as a consequence, no corrective action is required.
30
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: -
10(1) Form of 10% Quota Share Treaty by and between Western
Surety Company and Continental Casualty Company**
10(2) Form of Surety Quota Share Treaty by and between
Western Surety Company and Continental Casualty Company
10(3) Credit Agreement between CNA Surety Corporation and
LaSalle Bank National Association
10(4) Note Purchase Agreement between CNA Surety Corporation
and CNA Financial Corporation
10(5) Form of Services and Indemnity Agreement by and
between Western Surety Company and Continental Casualty
Company
10(6) Form of Surety Excess of Loss Reinsurance Contract by
and between Western Surety Company, Universal Surety of
America, Surety Bonding Company of America and Continental
Casualty Company
(b) Reports on Form 8-K:
August 5, 2002; CNA Surety Corporation Press Release issued
on August 5, 2002.
August 12, 2002; Certification pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 for the Chief Executive Officer
and the Chief Financial Officer issued on August 12, 2002.
** Confidential treatment has been granted for portions of this document
pursuant to Exchange Act Rule 24b-2. The redacted material has been filed
separately with the Securities and Exchange Commission.
31
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/ Mark C. Vonnahme
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Mark C. Vonnahme
President and Chief Executive Officer
/s/ John S. Heneghan
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John S. Heneghan
Vice President and Chief Financial Officer
Date: November 14, 2002
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
I, Mark C. Vonnahme, certify that:
1. I have reviewed this quarterly report on Form 10-Q of CNA Surety Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 14, 2002
/s/ Mark C. Vonnahme
-------------------------------------
Mark C. Vonnahme
President and Chief Executive Officer
I, John S. Heneghan:
1. I have reviewed this quarterly report on Form 10-Q of CNA Surety Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 14, 2002
/s/ John S. Heneghan
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John S. Heneghan
Vice President and Chief Financial Officer