FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended MARCH 31, 2003
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 (I.R.S. Employer Identification No.)
incorporation or organization)
CNA PLAZA, CHICAGO, ILLINOIS 60685
(Address of principal executive offices) (Zip Code)
(312) 822-5000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Exchange Act Rule 12b-2). 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:
42,958,957 shares of Common Stock, $.01 par value as of May 2, 2003.
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 March 31, 2003 (Unaudited) and
at December 31, 2002........................................................................... 4
Condensed Consolidated Statements of Income for the Three Months Ended
March 31, 2003 and 2002 (Unaudited)............................................................ 5
Condensed Consolidated Statements of Stockholders' Equity for the Three
Months Ended March 31, 2003 and 2002 (Unaudited)............................................... 6
Condensed Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 2003 and 2002 (Unaudited)............................................................ 7
Notes to Condensed Consolidated Financial Statements
at March 31, 2003 (Unaudited) ................................................................. 8
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................................................... 18
Item 4. Controls and Procedures........................................................................ 32
Part II. Other Information:
Item 1. Legal Proceedings.............................................................................. 33
Item 2. Changes in the Rights of the Company's Security Holders........................................ 33
Item 3. Defaults Upon Senior Securities................................................................ 33
Item 4. Submission of Matters to a Vote of Security Holders............................................ 33
Item 5. Other Information.............................................................................. 33
Item 6. Exhibits and Reports on Form 8-K .............................................................. 33
2
INDEPENDENT ACCOUNTANTS' REPORT
To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois
We have reviewed the accompanying condensed consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of March 31, 2003, and the related
condensed consolidated statements of income, stockholders' equity and cash flows
for the three-month periods ended March 31, 2003 and 2002. 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, 2002, 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 10,
2003, we expressed an unqualified opinion on those consolidated financial
statements and included an explanatory paragraph relating to the Company's
change in accounting for goodwill and indefinite-lived intangible assets in
2002. In our opinion, the information set forth in the accompanying condensed
consolidated balance sheet as of December 31, 2002 is fairly stated, in all
material respects, in relation to the consolidated balance sheet from which it
has been derived.
Deloitte & Touche LLP
Chicago, Illinois
May 5, 2003
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(Unaudited)
March 31, December 31,
2003 2002
----------- ------------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $534,931 and $539,364) $ 567,117 $ 570,538
Equity securities, at fair value (cost: $953 and $852) 849 761
Short-term investments, at cost (approximates fair value)..................... 23,481 50,669
Other investments, at fair value.............................................. 1,260 1,257
Cash.......................................................................... 14,070 14,979
----------- ------------
Total invested assets and cash............................................. 606,777 638,204
Deferred policy acquisition costs............................................... 100,982 96,386
Insurance receivables:
Premiums, including $29,655 and $34,097 from affiliates (net of allowance for
doubtful accounts: $1,730 and $1,365)...................................... 44,345 45,423
Reinsurance, including $19,728 and $15,401 from affiliates.................... 130,723 127,776
Intangible assets (net of accumulated amortization: $25,523 and $25,523)........ 143,785 143,785
Property and equipment, at cost (less accumulated
depreciation: $16,693 and $16,047)............................................ 16,832 17,260
Prepaid reinsurance premiums.................................................... 11,893 13,337
Receivable for securities sold.................................................. -- 3
Other assets.................................................................... 8,176 9,018
----------- ------------
Total assets............................................................. $ 1,063,513 $ 1,091,192
=========== ============
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses.................................... $ 254,118 $ 303,433
Unearned premiums............................................................. 222,896 216,213
----------- ------------
Total reserves............................................................. 477,014 519,646
Debt............................................................................ 60,816 60,816
Deferred income taxes, net...................................................... 32,156 30,727
Payable for securities purchased................................................ 2,389 --
Current income taxes payable.................................................... 7,761 5,123
Reinsurance and other payables to affiliates.................................... 23,413 23,003
Other liabilities............................................................... 30,200 32,738
----------- ------------
Total liabilities.......................................................... $ 633,749 $ 672,053
----------- ------------
Commitments and contingencies (See Note 6)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,388
shares issued and 42,959 shares outstanding at March 31, 2003 and 44,386
shares issued and 42,947 shares outstanding at December 31, 2002 ............. 444 444
Additional paid-in capital...................................................... 255,731 255,765
Retained earnings............................................................... 168,083 158,515
Accumulated other comprehensive income.......................................... 20,853 19,861
Treasury stock, at cost......................................................... (15,347) (15,446)
----------- ------------
Total stockholders' equity................................................. 429,764 419,139
----------- ------------
Total liabilities and stockholders' equity................................. $ 1,063,513 $ 1,091,192
=========== ============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
Three Months Ended
March 31,
----------------------------
2003 2002
---------- ----------
Revenues:
Net earned premium................................................... $ 69,018 $ 67,221
Net investment income................................................ 6,699 7,106
Net realized investment gains (losses)............................... 730 (278)
---------- ----------
Total revenues.................................................... 76,447 74,049
---------- ----------
Expenses:
Net losses and loss adjustment expenses.............................. 18,606 16,647
Net commissions, brokerage and other underwriting expenses........... 44,296 41,552
Interest expense..................................................... 353 458
---------- ----------
Total expenses.................................................... 63,255 58,657
---------- ----------
Income before income taxes............................................. 13,192 15,392
Income taxes........................................................... 3,625 4,835
---------- ----------
Net income............................................................. $ 9,567 $ 10,557
========== ==========
Earnings per share..................................................... $ 0.22 $ 0.25
========== ==========
Earnings per share, assuming dilution.................................. $ 0.22 $ 0.25
========== ==========
Weighted average shares outstanding.................................... 42,957 42,845
========== ==========
Weighted average shares outstanding, assuming dilution................. 42,962 43,025
========== ==========
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
Outstanding Stock Capital Income
----------- ------ ---------- -------------
Balance, December 31, 2001........................................... 42,780 $ 442 $ 254,133
Comprehensive income:
Net income......................................................... -- -- -- $ 10,557
Other comprehensive income:
Change in unrealized losses on securities (after income
taxes), net of reclassification adjustment of $90.................. -- -- -- (1,652)
-------------
Total comprehensive income...................................... $ 8,905
=============
Issuance of treasury stock to employee stock purchase program........ 6
Stock options exercised and other.................................... 96 1 942
Dividends paid to stockholders....................................... -- -- --
------- ------ ----------
Balance, March 31, 2002 42,876 $ 443 $ 255,081
======= ====== ==========
Balance, December 31, 2002........................................... 42,947 $ 444 $ 255,765
Comprehensive income:
Net income......................................................... -- -- -- $ 9,567
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $(958)............... -- -- -- 992
-------------
Total comprehensive income...................................... $ 10,559
=============
Issuance of treasury stock to employee stock purchase program........ 9 -- (38)
Stock options exercised and other.................................... 3 -- 4
------- ------ ----------
Balance, March 31, 2003 42,959 $ 444 $ 255,731
======= ====== ==========
Accumulated
Other Treasury Total
Retained Comprehensive Stock Stockholders'
Earnings Income (Loss) (at cost) Equity
-------- ------------- --------- -------------
Balance, December 31, 2001........................................... $149,128 $ 278 $ (15,553) $ 388,428
Comprehensive income:
Net income......................................................... 10,557 -- -- 10,557
Other comprehensive income:
Change in unrealized losses on securities (after income
taxes), net of reclassification adjustment of $90.................. -- (1,652) -- (1,652)
Total comprehensive income......................................
Issuance of treasury stock to employee stock purchase program........ 52 58
Stock options exercised and other.................................... -- -- -- 943
Dividends paid to stockholders....................................... (6,432) -- -- (6,432)
-------- ------------- --------- -------------
Balance, March 31, 2002 $153,253 $ (1,374) $ (15,501) $ 391,902
======== ============= ========= =============
Balance, December 31, 2002........................................... $158,515 $ 19,861 $ (15,446) $ 419,139
Comprehensive income:
Net income......................................................... 9,567 -- -- 9,567
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $(958)............... -- 992 -- 992
Total comprehensive income......................................
Issuance of treasury stock to employee stock purchase program........ 99 61
Stock options exercised and other.................................... 1 -- -- 5
-------- ------------- --------- -------------
Balance, March 31, 2003 $168,083 $ 20,853 $ (15,347) $ 429,764
======== ============= ========= =============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
Three Months Ended
March 31,
-------------------------------
2003 2002
---------- ----------
OPERATING ACTIVITIES:
Net income.......................................................................... $ 9,567 $ 10,557
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization.................................................... 1,047 977
Accretion of bond discount, net.................................................. 394 195
Net realized investment (gains) losses........................................... (730) 278
Changes in:
Insurance receivables............................................................ (1,869) 5,279
Reserve for unearned premiums.................................................... 6,683 892
Reserve for unpaid losses and loss adjustment expenses........................... (49,315) (3,586)
Deferred policy acquisition costs................................................ (4,596) (3,337)
Deferred income taxes, net....................................................... 891 1,433
Reinsurance and other payables to affiliates..................................... 410 (622)
Prepaid reinsurance premiums..................................................... 1,444 (3,720)
Other assets and liabilities..................................................... 1,023 (2,338)
---------- ----------
Net cash (used in) provided by operating activities............................ (35,051) 6,008
----------- ----------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases........................................................................ (29,097) (63,399)
Maturities....................................................................... 27,055 30,008
Sales............................................................................ 7,335 22,121
Purchases of equity securities...................................................... (123) (14,829)
Proceeds from the sale of equity securities......................................... 18 557
Changes in short-term investments................................................... 27,195 26,304
Purchases of property and equipment................................................. (683) (1,491)
Changes in receivables/payables for securities sold/purchased....................... 2,392 (4,290)
Other, net.......................................................................... (16) (33)
---------- ----------
Net cash provided by (used in) investing activities............................ 34,076 (5,052)
---------- ----------
FINANCING ACTIVITIES:
Employee stock option exercises..................................................... 5 824
Issuance of treasury stock to employee stock purchase plan.......................... 61 57
---------- ----------
Net cash provided by financing activities...................................... 66 881
---------- ----------
Increase (decrease) in cash........................................................... (909) 1,837
Cash at beginning of period........................................................... 14,979 13,159
---------- ----------
Cash at end of period................................................................. $ 14,070 $ 14,996
========== ==========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest......................................................................... $ 121 $ 793
Income taxes..................................................................... $ -- $ --
The accompanying notes are an integral part of these condensed consolidated
financial statements.
7
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2003
(UNAUDITED)
1. SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of CNA
Surety Corporation ("CNA Surety" or the "Company") and all majority-owned
subsidiaries.
Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America ("GAAP") requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
Basis of Presentation
These unaudited Condensed Consolidated Financial Statements should be
read in conjunction with the Consolidated Financial Statements and Notes thereto
included in the Company's 2002 Annual Report to Shareholders. Certain financial
information that is included in annual financial statements prepared in
accordance with GAAP, is not required for interim reporting and has been
condensed or omitted. The accompanying unaudited Condensed Consolidated
Financial Statements reflect, in the opinion of management, all adjustments
necessary for a fair presentation of the interim financial statements. All such
adjustments are of a normal and recurring nature. The financial results for
interim periods may not be indicative of financial results for a full year.
Certain reclassifications have been made to the 2002 Financial Statements to
conform with the presentation in the 2003 Condensed Consolidated Financial
Statements.
Accounting Changes
In August 2001, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 143 entitled
"Accounting for Asset Retirement Obligations" ("SFAS No 143"). SFAS No. 143
addresses accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. The Company adopted the provisions of SFAS No.143 effective January 1,
2003. The adoption of SFAS No. 143 did not have an impact on the Company's
financial position or results of operations.
In November of 2002, the FASB issued FASB Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (an interpretation of FASB SFAS
No. 5, 57, and 107 and rescission of FASB Interpretation No. 34)" ("FIN No.
45"). FIN No. 45 clarifies the requirements of FASB SFAS No. 5, "Accounting for
Contingencies" ("SFAS No. 5") relating to a guarantor's accounting for, and
disclosure of, the issuance of certain types of guarantees. FIN 45 provides for
additional disclosure requirements related to guarantees, effective for
financial periods ending after December 15, 2002. Additionally, FIN 45 outlines
provisions for initial recognition and measurement of the liability incurred in
providing a guarantee. These provisions are to be applied on a prospective basis
to guarantees issued or modified after December 31, 2002. The Company has
adopted the disclosure requirements of FIN No. 45 and the provisions for initial
recognition and measurement for all guarantees issued or modified after December
31, 2002. The adoption of FIN 45 did
8
not have a significant impact on the Company's financial position or results of
operations.
In January of 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51 ("ARB No. 51")" ("FIN No. 46"). As a general rule,
ownership by the parent, either directly or indirectly, of over fifty percent of
the outstanding voting shares of a subsidiary is a condition pointing toward
preparation of consolidated financial statements of the parent and its
subsidiary. FIN 46 clarifies the exceptions to this general rule, as enunciated
in paragraph 2 of ARB No. 51. FIN 46 requires an entity to consolidate a
variable interest entity ("VIE") even though the entity does not, either
directly or indirectly, own over fifty percent of the outstanding voting shares.
FIN 46 defines a VIE as one in which a) the equity investment is not
sufficient to permit the entity to finance its activities without additional
subordinated financial support from other parties which is provided through
other interests that will absorb some or all of the expected losses of the
entity or b) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest i) direct or indirect
ability to make decisions about the entity's activities through voting rights or
similar rights or ii) the obligation to absorb the expected losses of the
entity, if they occur or receive residual returns of the entity, if they occur
or iii) the right to receive the expected residual returns of the entity if they
occur. The primary beneficiary of a VIE is required to consolidate the results
of operations of the VIE. Financial statements issued after January 31, 2003 are
required to disclose the nature, purpose, activities and size of the VIE and
maximum exposure to loss as a result of its involvement with the VIE. The
Company reviewed FIN 46 and is of the opinion that the Company is neither a
primary beneficiary of a VIE nor does it have a significant involvement with a
VIE.
In December 2002, the FASB issued SFAS No. 148 entitled "Accounting for
Stock-Based Compensation, Transition and Disclosure" ("SFAS No.148"). SFAS No.
148 provides alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation.
SFAS No. 148 also amends the disclosure requirements of SFAS No. 123,
"Accounting for Stock-Based Compensation", to require prominent disclosures in
both annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The Company adopted this standard beginning with the 2002 annual
financial statements. The Company has not adopted fair value accounting in 2003.
The Company applies APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations, in accounting for its plans as allowed
for under the provisions of SFAS No. 123. Accordingly, no compensation cost has
been recognized for its stock-based incentive plans as the exercise price of the
granted options equals the market price at the grant date. Had compensation cost
for these plans been determined on the fair value at the grant date for options
granted, the Company's pro forma net income for the three months ended March 31,
2003 and 2002 would have been $9.5 million and $10.5 million, respectively.
Diluted net income per share would have been $0.21 and $0.25 for the three
months ended March 31, 2003 and 2002, respectively.
9
2. INVESTMENTS
The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety at March 31, 2003 and December 31, 2002, by
investment category, were as follows (dollars in thousands):
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
March 31, 2003 or Cost Gains Losses Value
--------------------------------------------------- -------------- ---------- ---------- --------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury................................. $ 16,127 $ 921 $ -- $ 17,048
U.S. Agencies................................. 21,225 389 -- 21,614
Collateralized mortgage obligations........... 111 5 -- 116
Mortgage pass-through securities.............. 17,721 910 -- 18,631
Obligations of states and political subdivisions... 358,877 20,963 (62) 379,778
Corporate bonds.................................... 74,441 6,210 (358) 80,293
Non-agency collateralized mortgage obligations..... 8,989 597 (51) 9,535
Other asset-backed securities:
Second mortgages/home equity loans............... 11,279 713 -- 11,992
Credit card receivables.......................... 4,999 98 -- 5,097
Other............................................ 7,751 734 -- 8,485
Redeemable preferred stock......................... 13,411 1,117 -- 14,528
------------- ---------- ---------- ----------
Total fixed income securities................. 534,931 32,657 (471) 567,117
Equity securities.................................. 953 -- (104) 849
------------- ---------- ---------- ----------
Total......................................... $ 535,884 $ 32,657 $ (575) $ 567,966
============= ========== ========== ==========
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
December 31, 2002 or Cost Gains Losses Value
----------------------------------------------- --------------- ---------- ---------- --------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury................................. $ 16,140 $ 960 $ -- $ 17,100
U.S. Agencies................................. 29,396 537 (3) 29,930
Collateralized mortgage obligations........... 156 7 -- 163
Mortgage pass-through securities.............. 20,981 1,066 -- 22,047
Obligations of states and political subdivisions... 347,918 20,099 (83) 367,934
Corporate bonds.................................... 76,181 6,154 (190) 82,145
Non-agency collateralized mortgage obligations..... 10,497 477 (58) 10,916
Other asset-backed securities:
Second mortgages/home equity loans............... 11,842 614 -- 12,456
Credit card receivables.......................... 5,000 87 -- 5,087
Other............................................ 7,838 653 -- 8,491
Redeemable preferred stock......................... 13,415 854 -- 14,269
------------- ---------- ---------- ----------
Total fixed income securities................. 539,364 31,508 (334) 570,538
Equity securities.................................. 852 -- (91) 761
------------- ---------- ---------- ----------
Total......................................... $ 540,216 $ 31,508 $ (425) $ 571,299
============= ========== ========== ==========
The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
10
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. The Company's Quantitative and Qualitative
Discussion about Market Risk is contained in Item 7A of the Company's 2002 Form
10-K.
3. REINSURANCE
The effect of reinsurance on the Company's written and earned premium
was as follows (dollars in thousands):
Three Months Ended March 31,
-------------------------------------------------------
2003 2002
-------------------------------------------------------
Written Earned Written Earned
----------- ----------- ----------- -----------
Direct........................................................ $ 42,367 $ 36,303 $ 36,772 $ 31,713
Assumed....................................................... 49,304 48,687 45,342 49,541
Ceded......................................................... (14,525) (15,972) (17,721) (14,033)
----------- ----------- ----------- -----------
$ 77,146 $ 69,018 $ 64,393 $ 67,221
=========== =========== =========== ===========
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):
Three Months Ended March 31,
-------------------------------------------------------
2003 2002
------------------------- --------------------------
$ Ratio $ Ratio
----------- ----------- ----------- -----------
Gross losses and loss adjustment expenses..................... $ 27,913 32.8% $ 18,064 22.2%
Ceded amounts................................................. (9,307) 58.2% (1,417) 10.1%
----------- -----------
Net losses and loss adjustment expenses....................... $ 18,606 27.0% $ 16,647 24.8%
=========== ===========
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 Company ("Western Surety") pursuant to intercompany
reinsurance and related agreements.
2003 Third Party Reinsurance Compared to 2002 Third Party Reinsurance
Effective January 1, 2003, CNA Surety entered into a new excess of loss
treaty ("2003 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal on new bonds to $15 million with a
5% co-participation in the $45 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $40
million excess of $20 million per principal coverage ("2002 Excess of Loss
Treaty"). The material differences between the new excess of loss reinsurance
program and the Company's 2002 Excess of Loss Treaty are as follows. The annual
aggregate coverage increases from $100 million in 2002 to $110 million in 2003.
The minimum annual premium for the 2003 Excess of Loss Treaty is $38.0 million
compared to $30.0 million of reinsurance
11
premiums paid in 2002. The 2003 Excess of Loss Treaty provides the Company with
coverage on a per principal basis of 95% of $45 million excess of $15 million
retained by the Company. The contract also includes similar special acceptance
provisions for larger contract accounts contained in the 2002 Excess of Loss
Treaty. In addition to the one large national contract principal and the two
commercial principals excluded (based upon class of business in 2002), the
Company's reinsurers have initially excluded three other contract principals
from the 2003 Excess of Loss Treaty. The three additional contract principals
are in the process of completing asset sales and other reorganization efforts
that management believes will result in the reinsurers' acceptance of two of the
accounts in the treaty. The third contract principal is in run-off and the
Company will not be providing additional surety bonding support.
In March 2003, CNA Financial Corporation ("CNAF") entered into an
agreement to provide a credit facility with the large national contractor to
provide loans to the contractor in a maximum aggregate amount of $86.4 million
(the "Credit Facility"). Of the $86.4 million, $57 million was outstanding at
March 31, 2003. The Credit Facility and all related loans will mature in March
2006. Advances under the Credit Facility bear interest at the prime rate plus
6%. Payment of 3% of the interest is deferred until the Credit Facility matures,
and the remainder is to be paid monthly in cash. Loans under the Credit Facility
are secured by a pledge of substantially all of the assets of the contractor and
certain affiliates. CNA Surety has provided significant surety bond protection
for projects by this contractor through surety bonds underwritten by CCC or its
affiliates. The loans were provided by CNAF to help the contractor meet its
liquidity needs.
In March of 2003, CNAF also purchased the contractor's outstanding bank
debt for $16.4 million. The contractor retired the bank debt by paying CNAF
$16.4 million, with $11.4 million of the payoff amount being funded under the
new Credit Facility and $5 million from money loaned to the contractor by its
shareholders. Under its purchase agreement with the banks, CNAF is also required
to reimburse the banks for any draws upon approximately $6.5 million in
outstanding letters of credit issued by the banks for the contractor's benefit
that expire between May and August of 2003. Any amounts paid by CNAF to the
banks as reimbursements for draws upon the banks' letters of credit will become
obligations of the contractor to CNAF as draws upon the Credit Facility.
Loews has purchased a participation interest in one-third of the loans
and commitments under the new Credit Facility, on a dollar-for-dollar basis, up
to a maximum of $25 million. Although Loews does not have rights against the
contractor directly under the participation agreement, it shares recoveries and
certain fees under the credit facility proportionally with CNAF. The contractor
has initiated a restructuring plan that is intended to reduce costs and improve
cash flow, and a chief restructuring officer has been appointed to manage
execution of the plan. CNA Surety intends to continue to provide surety bonds on
behalf of the contractor during this restructuring period, subject to the
contractor's initial and ongoing compliance with CNA Surety's underwriting
standards. Any losses arising from bonds issued or assumed by the insurance
subsidiaries of CNA Surety to the contractor are excluded from CNA Surety's 2003
Excess of Loss Treaty. As a result, CNA Surety retains the first $60 million of
losses on bonds written with an effective date of September 30, 2002 and prior,
and CCC will incur 100% of losses above that retention level on bonds with
effective dates prior to September 30, 2002. Through facultative reinsurance
contracts with CCC, CNA Surety's exposure on bonds written from October 1, 2002
through December 31, 2002 has been limited to $20 million per bond.
Indemnification and subrogation rights, including rights to contract
proceeds on construction projects in the event of default, reduce CNA Surety's
exposure to loss. While CNA Surety believes that the contractor's restructuring
efforts will be successful and provide sufficient cash flow for its operations,
the contractor's failure to achieve its restructuring plan or perform its
contractual obligations underlying all of the Company's surety bonds could have
a material adverse effect on CNA Surety's future results of
12
operations, cash flows and capital resources. If such failures occur, the
Company estimates that possible losses, net of indemnification and subrogation
recoveries, but before recoveries under reinsurance contracts, could be up to
$200 million. However, the related party reinsurance treaties discussed below
should limit the Company's per principal exposure to approximately $60 million.
Related Party Reinsurance
Intercompany reinsurance agreements together with the Services and
Indemnity Agreement that are described below provide for the transfer of the
surety business written by CCC and CIC to Western Surety. All these agreements
originally were entered into on September 30, 1997 (the "Merger Date"): (i) the
Surety Quota Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop
Loss Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety
Excess of Loss Reinsurance Contract (the "Excess of Loss Contract"). All of
these contracts have expired. Some have been renewed on different terms as
described below.
The Services and Indemnity Agreement provides the Company's insurance
subsidiaries with the authority to perform various administrative, management,
underwriting and claim functions in order to conduct the business of CCC and CIC
and to be reimbursed by CCC for services rendered. In consideration for
providing the foregoing services, CCC has agreed to pay Western Surety a
quarterly fee of $50,000. This agreement expires on December 31, 2003; and is
annually renewable thereafter. There was no amount due to the CNA Surety
insurance subsidiaries as of March 31, 2003.
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. As of March 31, 2003 and December 31, 2002, CNA Surety had an
insurance receivable balance from CCC and CIC of $49.4 million and $49.5
million, respectively. CNA Surety had reinsurance payables to CCC and CIC of
$20.7 million and $24.3 million as of March 31, 2003 and December 31, 2002,
respectively, primarily related to reinsured losses.
Under the terms of the Quota Share Treaty, CCC has guaranteed the loss
and loss adjustment expenses transferred to Western Surety by agreeing to pay
Western Surety, within 30 days following the end of each calendar quarter, the
amount of any adverse development on such reserves, as reestimated as of the end
of such calendar quarter. There was not any adverse reserve development for the
period from September 30, 1997 (date of inception) through December 31, 2002.
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; and is 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 for fronting fees to CCC and CIC on their actual direct acquisition
costs.
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 full accident 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
13
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 March 31, 2003, the Company billed and
received approximately $25 million from CCC under the Stop Loss Contract. This
amount exceeds the Company's current estimate of incurred loss recoverable under
this agreement by $5.9 million, which is reflected as reinsurance payable to CCC
at March 31, 2003.
The Excess of Loss Contracts provided 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 for losses in excess of the $60 million per principal. 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. In consideration
for the reinsurance coverage provided by the Excess of Loss Contracts, the
insurance subsidiaries paid 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 provided 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 following the Merger Date and continued until
September 30, 2002. The discovery period for losses covered by the Excess of
Loss Contracts extends until September 30, 2005.
Effective October 1, 2002, the Company secured replacement excess of
loss protection from CCC for per principal losses that exceed $60 million in two
parts - a) $40 million excess of $60 million and b) $50 million excess of $100
million. This excess of loss protection is primarily necessary to support
contract surety accounts with bonded backlogs or work-in-process in excess of
$60 million. The Company generally limits support 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 cost for these protections
increased significantly as compared to the cost of the previous two Excess of
Loss Contracts. The $40 million excess of $60 million contract is for a three
year term beginning October 1, 2002 and provides annual aggregate coverage of
$80 million and $120 million aggregate coverage for the entire three year term.
The Company will pay CCC annual reinsurance premiums of $12.5 million in year
one and $17.5 million in years two and three, payable quarterly. The Company may
commute the contract at the end of each contract year under certain
circumstances. The reinsurance premium for the coverage provided by the $50
million excess of $100 million contract was $6.0 million. This contract expires
on December 31, 2003.
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 March 31,
-------------------------------
2003 2002
---------- ----------
Reserves at beginning of period:
Gross........................................................ $ 303,433 $ 315,811
Ceded reinsurance............................................ 137,301 166,318
---------- ----------
Net reserves at beginning of period........................ 166,132 149,493
---------- ----------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period............. 18,551 16,665
Increase (decrease) in provision for insured events of prior
periods.................................................... 55 (18)
---------- ----------
Total net incurred...................................... 18,606 16,647
---------- ----------
Net payments attributable to:
Current period events...................................... 505 1,917
Prior period events........................................ 28,056 6,041
---------- ----------
Total net payments...................................... 28,561 7,958
---------- ----------
Net reserves at end of period................................ 156,177 158,182
Ceded reinsurance at end of period........................... 97,941 154,043
---------- ----------
Gross reserves at end of period......................... $ 254,118 $ 312,225
========== ==========
On January 2, 2003, CNA Surety settled litigation brought by J.P.
Morgan Chase & Co. ("Chase") in connection with three surety bonds issued on
behalf of Enron Corporation subsidiaries. The penal sums of the three bonds
totaled approximately $78 million. Although the Company believed it had valid
defenses to the litigation, based on the uncertainty and risk of an adverse jury
verdict, pursuant to the settlement agreement, the Company paid Chase
approximately $40.7 million and assigned its recovery rights in the Enron
bankruptcy to Chase in exchange for a full release of its obligations under the
bonds. The Company has no other exposure related to the Enron Corporation. CNA
Surety's net loss related to the settlement, after anticipated recoveries under
excess of loss reinsurance treaties, was previously fully reserved. Immediately
upon execution of the settlement documents, the Company sent written notice for
reimbursement to its reinsurers. A number of those reinsurers have requested a
variety of documents and reserved their rights before making a decision
concerning coverage of the settlement under the reinsurance treaties. The
Company has provided all requested information. Three reinsurers responsible for
payment of 34% of the treaty proceeds have either paid or committed to pay 100%
of their portions of the claim. Two other reinsurers have sent the Company
letters expressing reservations about the claim. Pursuant to the treaty, the
Company has sent a notice demanding arbitration to those reinsurers. Management
believes none of the reinsurers have valid defenses under the reinsurance
treaties to avoid payment, and that the Company will fully recover all
reinsurance recoverables recorded related to this settlement. As such, the
Company has provided no valuation allowance with respect to these reinsurance
recoverables as of March 31, 2003.
5. DEBT
On September 30, 2002, the Company refinanced $65 million in
outstanding borrowings under its previous credit facility with a new credit
facility (the "2002 Credit Facility"). The 2002 Credit Facility provided an
aggregate of up to $65 million 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
15
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 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.
Effective January 30, 2003, the Company entered into an interest rate
swap on the $30 million Term Loan that fixed the interest rate at 2.75%.
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 2002 Credit Facility, was 0.625% at March 31, 2003 and can vary based
on CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to
0.80%. As of March 31, 2003, the weighted average interest rate was 2.4% on the
$60 million of outstanding borrowings. As of December 31, 2002, the weighted
average interest rate on the 2002 Credit Facility was 2.0% on the $60 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
maintenance of a rating of at least "A" by A.M. Best Company Inc. 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 December 31, 2002, the
Company was in compliance with all restrictions and covenants contained in the
2002 Credit Facility.
In 1999 CNA Surety acquired certain assets of Clark Bonding Company,
Inc., a Charlotte, North Carolina, insurance agency and brokerage doing business
as The Bond Exchange, for $5.9 million. As part of this acquisition, the Company
incurred an additional $1.9 million of debt in the form of a promissory note.
The promissory note matures on July 27, 2004 and has an interest rate of 5.0%.
The balance of this promissory note at March 31, 2003 was $0.8 million.
The consolidated balance sheet reflects total debt of $60.8 million at
March 31, 2003 and December 31, 2002. The weighted average interest rate on
outstanding borrowings was 2.4% and 2.1% at March 31, 2003 and December 31, 2002
respectively.
16
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.
17
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 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 investments, deferred acquisition
costs, goodwill and other intangible assets, reserves for unpaid losses and loss
adjustment expenses and reinsurance. 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.
Investments
Management believes the Company has the ability to hold all fixed
income securities to maturity. However, the Company may dispose of securities
prior to their scheduled maturity due to changes in interest rates, prepayments,
tax and credit considerations, liquidity or regulatory capital requirements, or
other similar factors. As a result, the Company considers all of its fixed
income securities (bonds and redeemable preferred stocks) and equity securities
as available-for-sale. These securities are reported at fair value, with
unrealized gains and losses, net of deferred income taxes, reported as a
separate component of stockholders' equity. Cash flows from purchases, sales and
maturities are reported gross in the investing activities section of the cash
flow statement.
The amortized cost of fixed income securities is determined based on
cost and the cumulative effect of amortization of premiums and accretion of
discounts to maturity. Such amortization and accretion are included in
investment income. For mortgage-backed and certain asset-backed securities, the
Company recognizes income using the effective-yield method based on estimated
cash flows. All securities transactions are recorded on the trade date.
Investment gains or losses realized on the sale of securities are determined
using the specific identification method. Investments with an
other-than-temporary decline in value are written down to fair value, resulting
in losses that are included in realized investment gains and losses.
Short-term investments which generally include U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents, are carried at amortized cost which approximates fair value.
18
Deferred Policy Acquisition Costs
Policy acquisition costs, consisting of commissions, premium taxes and
other underwriting expenses which vary with, and are primarily related to, the
production of business, net of reinsurance commissions, are deferred and
amortized as a charge to income as the related premiums are earned. Anticipated
investment income is considered in the determination of the recoverability of
deferred acquisition costs.
Goodwill and Other Intangible Assets
CNA Surety's Consolidated Balance Sheet as of March 31, 2003 includes
goodwill and identified intangibles of approximately $143.8 million. These
amounts represent goodwill and identified intangibles arising from the
acquisition of Capsure Holdings Corp. ("Capsure"). Prior to 2002, goodwill from
this and other acquisitions were generally amortized as a charge to earnings
over periods not exceeding 30 years. Under Statement of Financial Accounting
Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets"
("SFAS No. 142"), which was adopted by CNA Surety as of January 1, 2002,
periodic amortization ceased, in accordance with an impairment-only accounting
model.
A significant amount of judgment is required in performing goodwill
impairment tests. Such tests include periodically determining or reviewing the
estimated fair value of CNA Surety's reporting units. Under SFAS No. 142, fair
value refers to the amount for which the entire reporting unit may be bought or
sold. There are several methods of estimating fair value, including market
quotations, asset and liability fair values and other valuation techniques, such
as discounted cash flows and multiples of earnings or revenues. If the carrying
amount of a reporting unit, including goodwill, exceeds the estimated fair
value, then individual assets, including identifiable intangible assets, and
liabilities of the reporting unit are estimated at fair value. The excess of the
estimated fair value of the reporting unit over the estimated fair value of net
assets would establish the implied value of goodwill. The excess of the recorded
amount of goodwill over the implied value of goodwill is recorded as an
impairment loss.
Reserves for Unpaid Losses and Loss Adjustment Expenses and Reinsurance
CNA Surety accrues liabilities for unpaid losses and loss adjustment
expenses under its surety and property and casualty insurance contracts based
upon estimates of the ultimate amounts payable under the contracts related to
losses occurring on or before the balance sheet date. As of any balance sheet
date, all claims have not yet been reported and some claims may not be reported
for many years. As a result, the liability for unpaid losses includes
significant estimates for incurred-but-not-reported claims. Additionally,
reported claims are in various stages of the settlement process. Each claim is
settled individually based upon its merits, and certain claim liabilities may
take years to settle, especially if legal action is involved.
The Company uses a variety of techniques to establish the liabilities
for unpaid claims recorded at the balance sheet date. While techniques may vary,
each employs significant judgments and assumptions. Techniques may involve
detailed statistical analysis of past claim reporting, settlement activity,
salvage and subrogation activity, claim frequency and severity data when
sufficient information exists to lend statistical credibility to the analysis.
The analysis may be based upon internal loss experience or industry experience.
Techniques may vary depending on the type of claim being estimated. Liabilities
may also reflect implicit or explicit assumptions regarding the potential
effects of future economic and social inflation, judicial decisions, law
changes, and recent trends in such factors.
Receivables recorded with respect to insurance losses ceded to
reinsurers under reinsurance contracts are estimated in a manner similar to
liabilities for insurance losses and, therefore, are also subject to
uncertainty. In addition to the factors cited above, estimates of reinsurance
recoveries may prove uncollectible if the reinsurer is unable to perform under
the contract. Reinsurance contracts do not relieve
19
the ceding company of its obligations to indemnify its own policyholders.
CNA Surety's Consolidated Balance Sheet includes estimated liabilities for
unpaid losses and loss adjustment expenses of $254.1 million and reinsurance
receivables of $130.7 million at March 31, 2003. Due to the inherent
uncertainties in the process of establishing these amounts, the actual ultimate
claims amounts will differ from the currently recorded amounts. An incremental
percentage change in estimates of this magnitude could result in a material
effect on reported earnings. For example, a 10% increase in the March 31, 2003
net estimate for unpaid losses and loss adjustment expenses would produce
approximately a $15.6 million charge to pre-tax earnings. Future effects from
changes in these estimates will be recorded as a component of losses incurred in
the period such changes are determined to be needed.
FORMATION OF CNA SURETY AND MERGER
In December 1996, CNA Financial Corporation ("CNAF") and 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. 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 34,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety and
USA. The insurance subsidiaries write, on a direct basis or as business assumed
from CCC and CIC, small fidelity and non-contract surety bonds, referred to as
commercial bonds; small, medium and large contract bonds; and errors and
omissions ("E&O") liability insurance. Western Surety is a licensed insurer in
all 50 states, the District of Columbia and Puerto Rico. USA is licensed in 44
states and the District of Columbia. Western Surety's affiliated company, Surety
Bonding Company of America ("SBCA"), is licensed in 28 states and the District
of Columbia.
"SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995
The statements which are not historical facts contained in this Form 10-Q are
forward-looking statements that involve risks and uncertainties, including, but
not limited to, product and policy demand and market response risks, the effect
of economic conditions, the impact of 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
20
the Company's Securities and Exchange Commission filings. No assurance can be
given that the actual results of operations and financial condition will conform
to the forward-looking statements contained herein.
RESULTS OF OPERATIONS
CNA SURETY RESULTS FOR THREE MONTHS ENDED MARCH 31, 2003 AND 2002
The components of income for the Company for the three months ended
March 31, 2003 and 2002 are summarized as follows (dollars in thousands):
Three Months Ended March 31,
2003 2002
---------- ----------
Total revenues................................ $ 76,447 $ 74,049
========== ==========
Underwriting income........................... $ 6,116 $ 9,022
Net investment income......................... 6,699 7,106
Net realized investment gains (losses)........ 730 (278)
Interest expense.............................. 353 458
---------- ----------
Income before income taxes.................... 13,192 15,392
Income taxes.................................. 3,625 4,835
---------- ----------
Net income.................................... $ 9,567 $ 10,557
========== ==========
Net income per share.......................... $ 0.22 $ 0.25
========== ==========
Insurance Underwriting
Underwriting results for the Company for the three months ended March
31, 2003 and 2002 are summarized in the following table (dollars in thousands):
Three Months Ended March 31,
2003 2002
---------- ----------
Gross written premiums............................. $ 91,671 $ 82,114
========== ==========
Net written premiums............................... $ 77,146 $ 64,393
========== ==========
Net earned premiums................................ $ 69,018 $ 67,221
Net losses and loss adjustment expenses............ 18,606 16,647
Net commissions, brokerage and other expenses...... 44,296 41,552
---------- ----------
Underwriting income................................ $ 6,116 $ 9,022
========== ==========
Loss ratio......................................... 27.0% 24.8%
Expense ratio...................................... 64.1 61.8
---------- ----------
Combined ratio..................................... 91.1% 86.6%
========== ==========
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.
21
The commercial surety market includes numerous types of bonds categorized as
court judicial, court fiduciary, public official, license and permit and many
miscellaneous bonds that include guarantees of financial performance. The
Company also writes fidelity bonds that cover losses arising from employee
dishonesty and other insurance products.
Gross written premiums are shown in the table below (dollars in
thousands):
Three Months Ended March 31,
2003 2002
---------- ----------
Contract...................................... $ 41,623 $ 39,380
Commercial.................................... 42,015 35,088
Fidelity and other............................ 8,033 7,646
---------- ----------
$ 91,671 $ 82,114
========== ==========
Gross written premiums increased 11.6%, or $9.6 million, for the three
months ended March 31, 2003 over the comparable period in 2002. Commercial
surety accounted for most of this increase with growth of 19.7%, or $6.9
million, in gross written premiums as compared to 2002. In the first quarter of
2003, the Company experienced 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 of
$900 million for the first quarter of 2003 represents approximately $4 million
in annual premium, assuming an average rate per $1,000 of bond exposure of
$4.70, or 47 basis points. Contract surety increased 5.7%, or $2.2 million, for
the three months ended March 31, 2003 reflecting improving rates. Fidelity and
other products increased 5.1%, or $0.4 million, to $8.0 million for the three
months ended March 31, 2003 as compared to the same period in 2002 due primarily
to an increase in fidelity business.
Net written premiums are shown in the table below (dollars in
thousands):
Three Months Ended March 31,
2003 2002
---------- ----------
Contract...................................... $ 35,039 $ 31,235
Commercial.................................... 34,429 25,849
Fidelity and other............................ 7,678 7,309
---------- ----------
$ 77,146 $ 64,393
========== ==========
For the three months ended March 31, 2003, net written premiums
increased 19.8%, or $12.8 million, to $77.1 million as compared to the same
period in 2002, reflecting the aforementioned gross production changes and lower
ceded written premiums. Ceded written premiums decreased $3.2 million to $14.5
million for the first quarter of 2003 compared to the same period of last year
primarily due to changes in the Company's reinsurance programs. Ceded written
premiums in first quarter 2002 included $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. Net written
premiums for commercial surety increased 33.2%, or $8.6 million, to $34.4
million for the three months ended March 31, 2003. Net written premiums for
contract surety business increased 12.2%, or $3.8 million, to $35.0 million.
Fidelity and other products increased 5.0%, or $0.4 million, to $7.7 million for
the three months ended March 31, 2003 as compared to the same period in 2002.
22
Excess of Loss Reinsurance
Beginning in 1999, the Company has experienced an increase in claim
severity and frequency in the most recent accident years. CNA Surety is paying
higher costs for reinsurance as a result of this loss experience.
The Company's reinsurance program is predominantly comprised of excess
of loss reinsurance contracts that limit the Company's retention on a per
principal basis. The Company's reinsurance coverage is provided by third party
reinsurers and related parties.
2003 Third Party Reinsurance Compared to 2002 Third Party Reinsurance
Effective January 1, 2003, CNA Surety entered into a new excess of loss
treaty ("2003 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal on new bonds to $15 million with a
5% co-participation in the $45 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $40
million excess of $20 million per principal coverage ("2002 Excess of Loss
Treaty"). The material differences between the new excess of loss reinsurance
program and the Company's 2002 Excess of Loss Treaty are as follows. The annual
aggregate coverage increases from $100 million in 2002 to $110 million in 2003.
The minimum annual premium for the 2003 Excess of Loss Treaty is $38.0 million
compared to $30.0 million of reinsurance premiums paid in 2002. The 2003 Excess
of Loss Treaty provides the Company with coverage on a per principal basis of
95% of $45 million excess of $15 million retained by the Company. The contract
also includes similar special acceptance provisions for larger contract accounts
contained in the 2002 Excess of Loss Treaty. In addition to the one large
national contract principal and the two commercial principals excluded (based
upon class of business in 2002), the Company's reinsurers have initially
excluded three other contract principals from the 2003 Excess of Loss Treaty.
The three additional contract principals are in the process of completing asset
sales and other reorganization efforts that management believes will result in
the reinsurers' acceptance of two of the accounts in the treaty. The third
contract principal is in run-off and the Company will not be providing
additional surety bonding support.
In March 2003, CNA Financial Corporation ("CNAF") entered into an
agreement to provide a credit facility with the large national contractor to
provide loans to the contractor in a maximum aggregate amount of $86.4 million
(the "Credit Facility"). Of the $86.4 million, $57 million was outstanding at
March 31, 2003. The Credit Facility and all related loans will mature in March
2006. Advances under the Credit Facility bear interest at the prime rate plus
6%. Payment of 3% of the interest is deferred until the Credit Facility matures,
and the remainder is to be paid monthly in cash. Loans under the Credit Facility
are secured by a pledge of substantially all of the assets of the contractor and
certain affiliates. CNA Surety has provided significant surety bond protection
for projects by this contractor through surety bonds underwritten by CCC or its
affiliates. The loans were provided by CNAF to help the contractor meet its
liquidity needs.
In March of 2003, CNAF also purchased the contractor's outstanding bank
debt for $16.4 million. The contractor retired the bank debt by paying CNAF
$16.4 million, with $11.4 million of the payoff amount being funded under the
new Credit Facility and $5 million from money loaned to the contractor by its
shareholders. Under its purchase agreement with the banks, CNAF is also required
to reimburse the banks for any draws upon approximately $6.5 million in
outstanding letters of credit issued by the banks for the contractor's benefit
that expire between May and August of 2003. Any amounts paid by CNAF to the
banks as reimbursements for draws upon the banks' letters of credit will become
obligations of the contractor to CNAF as draws upon the Credit Facility.
23
Loews has purchased a participation interest in one-third of the loans
and commitments under the new Credit Facility, on a dollar-for-dollar basis, up
to a maximum of $25 million. Although Loews does not have rights against the
contractor directly under the participation agreement, it shares recoveries and
certain fees under the credit facility proportionally with CNAF. The contractor
has initiated a restructuring plan that is intended to reduce costs and improve
cash flow, and a chief restructuring officer has been appointed to manage
execution of the plan. CNA Surety intends to continue to provide surety bonds on
behalf of the contractor during this restructuring period, subject to the
contractor's initial and ongoing compliance with CNA Surety's underwriting
standards. Any losses arising from bonds issued or assumed by the insurance
subsidiaries of CNA Surety to the contractor are excluded from CNA Surety's 2003
Excess of Loss Treaty. As a result, CNA Surety retains the first $60 million of
losses on bonds written with an effective date of September 30, 2002 and prior,
and CCC will incur 100% of losses above that retention level on bonds with
effective dates prior to September 30, 2002. Through facultative reinsurance
contracts with CCC, CNA Surety's exposure on bonds written from October 1, 2002
through December 31, 2002 has been limited to $20 million per bond.
Indemnification and subrogation rights, including rights to contract
proceeds on construction projects in the event of default, reduce CNA Surety's
exposure to loss. While CNA Surety believes that the contractor's restructuring
efforts will be successful and provide sufficient cash flow for its operations,
the contractor's failure to achieve its restructuring plan or perform its
contractual obligations underlying all of the Company's surety bonds could have
a material adverse effect on CNA Surety's future results of operations, cash
flows and capital resources. If such failures occur, the Company estimates that
possible losses, net of indemnification and subrogation recoveries, but before
recoveries under reinsurance contracts, could be up to $200 million. However,
the related party reinsurance treaties discussed below should limit the
Company's per principal exposure to approximately $60 million.
Related Party Reinsurance
Intercompany reinsurance agreements together with the Services and
Indemnity Agreement that are described below provide for the transfer of the
surety business written by CCC and CIC to Western Surety. All these agreements
originally were entered into on September 30, 1997 (the "Merger Date"): (i) the
Surety Quota Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop
Loss Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety
Excess of Loss Reinsurance Contract (the "Excess of Loss Contract"). All of
these contracts have expired. Some have been renewed on different terms as
described below.
The Services and Indemnity Agreement provides the Company's insurance
subsidiaries with the authority to perform various administrative, management,
underwriting and claim functions in order to conduct the business of CCC and CIC
and to be reimbursed by CCC for services rendered. In consideration for
providing the foregoing services, CCC has agreed to pay Western Surety a
quarterly fee of $50,000. This agreement 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; and
is 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 was renewed on October 1, 2002 on substantially
the same terms with an expiration date of December 31, 2003; and is annually
renewable thereafter. The ceding commission paid
24
to CCC and CIC by Western Surety remained at 28% of net written premiums and
contemplates an approximate 4% override commission for fronting fees to CCC and
CIC on top of their actual direct acquisition costs.
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 full accident 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.
The Excess of Loss Contracts provided 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 for losses in excess of the $60 million per principal. 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. In consideration
for the reinsurance coverage provided by the Excess of Loss Contracts, the
insurance subsidiaries paid 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 provided 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 following the Merger Date and continued until
September 30, 2002. The discovery period for losses covered by the Excess of
Loss Contracts extends until September 30, 2005.
Effective October 1, 2002, the Company secured replacement excess of
loss protection from CCC for per principal losses that exceed $60 million in two
parts - a) $40 million excess of $60 million and b) $50 million excess of $100
million. This excess of loss protection is primarily necessary to support
contract surety accounts with bonded backlogs or work-in-process in excess of
$60 million. The Company generally limits support 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 cost for these protections
increased significantly as compared to the cost of the previous two Excess of
Loss Contracts. The $40 million excess of $60 million contract is for a three
year term beginning October 1, 2002 and provides annual aggregate coverage of
$80 million and $120 million aggregate coverage for the entire three year term.
The Company will pay CCC annual reinsurance premiums of $12.5 million in year
one and $17.5 million in years two and three, payable quarterly. The Company may
commute the contract at the end of each contract year under certain
circumstances. The reinsurance premium for the coverage provided by the $50
million excess of $100 million contract was $6.0 million. This contract expires
on December 31, 2003.
25
Underwriting Income
Underwriting income decreased 32.2% to $6.1 million for the three
months ended March 31, 2003 compared to $9.0 million for the same period in
2002. This decrease is primarily due to higher current accident year reserving
and the impact of increased reinsurance costs on net earned premiums. Increased
claim severity in recent years has caused the Company to increase its estimates
of gross and net incurred losses. In addition, these trends adversely impacted
the cost and availability of reinsurance.
The Company's business is subject to certain risks and uncertainties
associated with the current economic environment and corporate credit
conditions. In response to these risks and uncertainties, the Company has
continued with various exposure management initiatives, particularly to reduce
its risks on large commercial accounts. As the following table depicts, the
Company has reduced its exposure, before the effects of reinsurance, by 16% in
2003 on large commercial accounts, which are defined as accounts with exposures
in excess of $10 million:
Number of Accounts Total Exposure (dollars in billions)
As of As of
------------------------- -------------------------------------
March 31, December 31, March 31, December 31, %
Commercial Account Exposure 2003 2002 2003 2002 Reduction
--------------------------- --------- ------------ --------- ------------ ---------
$100 million and larger 12 13 $ 2.2 $ 2.5 13.9%
$50 to $100 million 12 19 0.7 1.2 40.2
$25 to $50 million 16 16 0.6 0.6 -
$10 to $25 million 73 75 1.1 1.2 5.2
--- --- ------- --------
Total 113 123 $ 4.6 $ 5.5 16.3%
=== === ======= ========
With respect to contract surety, the Company's portfolio is
predominantly comprised of contractors with work programs of less than $50
million. "Work program" is the estimated contract value of uncompleted bonded
and unbonded work. Bonded backlog is a measure of the Company's exposure in the
event of default before indemnification, salvage and subrogation recoveries.
The Company continues to manage its exposure to any one contract credit
and aggressively looks for co-surety, shared accounts and other means to support
or reduce larger exposures. Reinsurance, indemnification and subrogation rights,
including rights to contract proceeds on construction projects in the event of
default, exist that substantially reduce CNA Surety's exposure to loss.
26
Net Loss Ratio
The net loss ratios for the three months ended March 31, 2003 and 2002
were 27.0% and 24.8%, respectively. The 2003 loss ratio included $0.1 million of
net unfavorable loss reserve development for the three months ended March 31,
2003. Excluding the impact of loss reserve development, the 2003 net loss ratio
would have been 26.9% for the period ended March 31, 2003. The increase in the
adjusted loss ratio in 2003 resulted from the Company's increased expected
baseline accident year net loss ratio of branch contract and commercial business
due to recent adverse loss trends together with uncertainties with respect to
the economy and credit markets. The Company is using an initial 2003 accident
year net loss ratio of 36.0% for the medium to large commercial and contract
branch business compared to 30.0% in first quarter of 2002. This business
represents about 53% of the Company's 2003 gross premiums.
On January 2, 2003, CNA Surety settled litigation brought by J.P.
Morgan Chase & Co. ("Chase") in connection with three surety bonds issued on
behalf of Enron Corporation subsidiaries. The penal sums of the three bonds
totaled approximately $78 million. Although the Company believed it had valid
defenses to the litigation, based on the uncertainty and risk of an adverse jury
verdict, pursuant to the settlement agreement, the Company paid Chase
approximately $40.7 million and assigned its recovery rights in the Enron
bankruptcy to Chase in exchange for a full release of its obligations under the
bonds. The Company has no other exposure related to the Enron Corporation. CNA
Surety's net loss related to the settlement, after anticipated recoveries under
excess of loss reinsurance treaties, was previously fully reserved. Immediately
upon execution of the settlement documents, the Company sent written notice for
reimbursement to its reinsurers. A number of those reinsurers have requested a
variety of documents and reserved their rights before making a decision
concerning coverage of the settlement under the reinsurance treaties. The
Company has provided all requested information. Three reinsurers responsible for
payment of 34% of the treaty proceeds have either paid or committed to pay 100%
of their portions of the claim. Two other reinsurers have sent the Company
letters expressing reservations about the claim. Pursuant to the treaty, the
Company has sent a notice demanding arbitration to those reinsurers. Management
believes none of the reinsurers have valid defenses under the reinsurance
treaties to avoid payment, and that the Company will fully recover all
reinsurance recoverables recorded related to this settlement. As such, the
Company has provided no valuation allowance with respect to these reinsurance
recoverables as of March 31, 2003.
Expense Ratio
The expense ratio increased to 64.1% for the three months ended March
31, 2003 compared to 61.8% for the same period in 2002. The increase in the
expense ratio for the three months ended March 31, 2003 primarily reflects the
impact of higher reinsurance costs on net earned premiums. Although ceded
written premiums declined $3.2 million, net earned premiums increased 2.7% and
operating expenses increased at a higher rate of 6.6%
Investment Income
For the three months ended March 31, 2003, net investment income was
$6.7 million compared to the three months ended March 31, 2002 of $7.1 million.
The decrease in investment income primarily reflects the impact of lower
investment yields. The annualized pretax yields were 4.7% and 5.1% for the three
months ended March 31, 2003 and 2002, respectively. The annualized after-tax
yields were 3.9% for both the three months ended March 31, 2003 and 2002.
Net realized investment gains were approximately $0.7 million for the
three months ended March 31,
27
2003 compared to net realized investment losses of approximately $0.3 million
for the same period in 2002.
The following summarizes net realized investment gains (losses)
activity:
Three Months Ended March 31,
-------------------------------
2003 2002
---------- ----------
Gross realized investment gains............................. $ 1,261 $ 343
Gross realized investment losses............................ (531) (621)
---------- ----------
Net realized investment gains (losses)...................... $ 730 $ (278)
========== ==========
The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
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 Condensed Consolidated Balance
Sheets and Condensed Consolidated Statements of Income. The Company's
Quantitative and Qualitative Discussion about Market Risk is contained in Item
7A of the 2002 Form 10-K.
Analysis of Other Operations
Interest expense for the three months ended March 31, 2003 decreased
$0.1 million, or 22.9%, as compared to the first quarter in 2002, primarily due
to lower outstanding debt levels and lower interest rates. Average debt
outstanding was $60.8 million for the first quarter of 2003 compared to $76.2
million in the first quarter of 2002. The weighted average interest rate for the
three months ended March 31, 2003 was 2.3% compared to 2.4% for the same period
in 2002.
Income Taxes
Income tax expense was $3.6 million and $4.8 million and the effective
income tax rates were 27.5% and 31.4% for the three months ended March 31, 2003
and 2002, respectively. This decrease in the estimated effective tax rate in
first quarter 2003 primarily relates to anticipated increases in tax exempt
investment income as a proportion of taxable income.
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,
28
operating expenses, federal income taxes, debt service, as well as dividends to
CNA Surety stockholders. In general, surety operations generate premium
collections from customers in advance of cash outlays for claims. Premiums are
invested until such time as funds are required to pay claims and claims
adjusting expenses.
The Company believes that total invested assets, including cash and
short-term investments, are sufficient in the aggregate and have suitably
scheduled maturities to satisfy all policy claims and other operating
liabilities, including dividend and income tax sharing payments of its insurance
subsidiaries. At March 31, 2003, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $561.4 million of fixed income
securities, $16.0 million of short-term investments, $1.3 million of other
investments and $9.0 million of cash. At December 31, 2002, the carrying value
of the Company's insurance subsidiaries' invested assets was comprised of $564.8
million of fixed income securities, $41.9 million of short-term investments,
$1.3 million of other investments and $10.7 million of cash.
Cash flow at the parent company level is derived principally from
dividend and tax sharing payments from its insurance subsidiaries. The principal
obligations at the parent company level are to service debt, pay operating
expenses, including income taxes, and pay dividends to stockholders. At March
31, 2003, the parent company's invested assets consisted of $5.7 million of
fixed income securities, $0.8 million of equity securities, $7.5 million of
short-term investments and $5.1 million of cash. At December 31, 2002, the
parent company's invested assets consisted of $5.7 million of fixed income
securities, $0.8 million of equity securities, $8.8 million of short-term
investments and $4.3 million of cash. As of March 31, 2003 and December 31,
2002, parent company short-term investments and cash included $5.6 million and
$4.8 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 used by operating activities
was $35.1 million for the three months ended March 31, 2003 compared to net cash
flow provided by operating activities of $6.0 million for the comparable period
in 2002. The decrease in net cash flow provided by operating activities
primarily relates to increased net loss payments, primarily related to
settlement of litigation brought by Chase in connection with three surety bonds
issued on behalf of Enron Corporation subsidiaries.
The Company refinanced $65 million in outstanding borrowings under its
previous credit facility under a new credit facility (the "2002 Credit
Facility"). The 2002 Credit Facility provided an aggregate of up to $65 million
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 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.
Outstanding borrowings under the 2002 Credit Facility were $60 million
as of March 31, 2003, consisting of $30 million under the Revolving Credit
Facility and $30 million under the Term Loan Facility. Effective January 28,
2003, the Company entered into an interest rate swap on the $30 million Term
Loan that fixed the interest rate at 2.75%.
29
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 2002 Credit Facility, was 0.625% at March 31, 2003 and can vary based
on CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to
0.80%. As of March 31, 2003, the weighted average interest rate was 2.4% on the
$60 million of outstanding borrowings. As of December 31, 2002, the weighted
average interest rate on the 2002 Credit Facility was 2.0% on the $60 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
maintenance of a rating of at least "A" by A.M. Best Company Inc. 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 March 31, 2003, the
Company was in compliance with all restrictions and covenants contained in the
2002 Credit Facility.
In 1999 CNA Surety acquired certain assets of Clark Bonding Company,
Inc., a Charlotte, North Carolina, insurance agency and brokerage doing business
as The Bond Exchange for $5.9 million. As part of this acquisition, the Company
incurred an additional $1.9 million of debt in the form of a promissory note.
The promissory note matures on July 27, 2004 and has an interest rate of 5.0%.
The balance of this promissory note at March 31, 2003 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.
30
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 2003 is based on
statutory surplus and income at and for the year ended December 31, 2002.
Without prior regulatory approval in 2003, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $32.1 million in the aggregate. CNA Surety did
not receive a dividend from its insurance subsidiaries during the first three
months of 2003 compared to the $12.0 million dividend received during the first
three months of 2002. A dividend of $10.0 million was received by CNA Surety
from its insurance subsidiaries on April 15, 2003.
Combined statutory surplus totaled $240.8 million at March 31, 2003,
resulting in a net written premium to statutory surplus ratio of 1.3 to 1.
Approximately $227 million of the combined surplus relates to Western Surety.
Insurance regulations restrict Western Surety's maximum net retention on a
single surety bond to 10 percent of statutory surplus. Under the 2003 Excess of
Loss Treaty, the Company's net retention on new bonds would generally be $15
million plus a 5% co-participation in the $45 million layer of excess
reinsurance above the Company's retention and this regulation would require
minimum statutory surplus of $172.5 million at Western Surety. This surplus
constraint may limit the amount of future dividends Western Surety could
otherwise pay to CNA Surety.
In accordance with the provisions of intercompany tax sharing
agreements between CNA Surety and its subsidiaries, the tax of each subsidiary
shall be determined based upon each subsidiary's separate return liability.
Intercompany tax payments are made at such times as estimated tax payments would
be required by the Internal Revenue Service ("IRS"). CNA Surety did not receive
any tax sharing payments from its subsidiaries for the three months ended March
31, 2003 and 2002, respectively.
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. U.S. Treasury underwriting limitations are based on an
insurer's statutory surplus. 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 Surety Quota Share Treaty
between CCC and Western Surety Company, CNA Surety has access to CCC and its
affiliates' U.S. Department of Treasury underwriting limitations. The Surety
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. Effective July
1, 2002 through June 30, 2003, the underwriting limitations of CCC and its
affiliates total $382.9 million. CNA Surety management believes that the
foregoing U.S. Treasury underwriting limitations are sufficient for the conduct
of its business.
Subject to the aforementioned uncertainties concerning the Company's
per principal net retentions, 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.
31
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.
32
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) Revised 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.
99(1) Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002-Chief Executive Officer.
99(2) Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002-Chief Financial Officer.
(b) Reports on Form 8-K:
January 3, 2003; CNA Surety Corporation Press Release
issued on January 2, 2003.
February 11, 2003; CNA Surety Corporation Press Releases
issued on February 10, 2003.
33
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
------------------------------------------
Mark C. Vonnahme
President and Chief Executive Officer
/s/ John S. Heneghan
------------------------------------------
John S. Heneghan
Vice President and Chief Financial Officer
Date: May 14, 2003
34
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 officer 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: May 14, 2003
/s/ Mark C. Vonnahme
--------------------
Mark C. Vonnahme
President and Chief Executive Officer
35
I, John S. Heneghan, 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 officer 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: May 14, 2003
/s/ John S. Heneghan
--------------------
John S. Heneghan
Vice President and Chief Financial Officer
36