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 JUNE 30, 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:
42,967,383 shares of Common Stock, $.01 par value as of August 4, 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 June 30, 2003 (Unaudited) and
at December 31, 2002........................................................... 4
Condensed Consolidated Statements of Income for the Three- and Six- Months
Ended June 30, 2003 and 2002 (Unaudited)....................................... 5
Condensed Consolidated Statements of Stockholders' Equity for the
Six-Months Ended June 30, 2003 and 2002 (Unaudited)............................ 6
Condensed Consolidated Statements of Cash Flows for the Six Months Ended
June 30, 2003 and 2002 (Unaudited)............................................. 7
Notes to Condensed Consolidated Financial Statements
at June 30, 2003 (Unaudited) .................................................. 8
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................................... 20
Item 3. Quantitative and Qualitative Discussions About Market Risk..................... 36
Item 4. Controls and Procedures........................................................ 38
Part II. Other Information:
Item 1. Legal Proceedings.............................................................. 39
Item 2. Changes in the Rights of the Company's Security Holders........................ 39
Item 3. Defaults Upon Senior Securities................................................ 39
Item 4. Submission of Matters to a Vote of Security Holders............................ 39
Item 5. Other Information.............................................................. 39
Item 6. Exhibits and Reports on Form 8-K .............................................. 39
2
ITEM 1. FINANCIAL STATEMENTS
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 June 30, 2003, and the related
condensed consolidated statements of income, stockholders' equity and cash flows
for the three- and six- month periods ended June 30, 2003 and 2002. These
interim 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
August 4, 2003
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(Unaudited)
June 30, December 31,
2003 2002
----------- ------------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $510,383 and $539,364) $ 553,493 $ 570,538
Equity securities, at fair value (cost: $983 and $852) ....................... 963 761
Short-term investments, at cost (approximates fair value) .................... 58,455 50,669
Other investments, at fair value ............................................. 1,129 1,257
Cash ......................................................................... 7,796 14,979
----------- -----------
Total invested assets and cash ............................................ 621,836 638,204
Deferred policy acquisition costs ............................................... 104,545 96,386
Insurance receivables:
Premiums, including $28,690 and $34,097 from affiliates (net of allowance for
doubtful accounts: $1,582 and $1,365) ..................................... 46,790 45,423
Reinsurance, including $36,860 and $15,401 from affiliates ................... 133,895 127,776
Intangible assets (net of accumulated amortization: $25,523 and $25,523) ........ 143,785 143,785
Property and equipment, at cost (less accumulated depreciation: $17,482
and $16,047) ................................................................. 16,144 17,260
Prepaid reinsurance premiums .................................................... 10,960 13,337
Receivable for securities sold .................................................. 3,034 3
Other assets .................................................................... 8,860 9,018
----------- -----------
Total assets ........................................................... $ 1,089,849 $ 1,091,192
=========== ===========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses ................................... $ 277,210 $ 303,433
Unearned premiums ............................................................ 228,416 216,213
----------- -----------
Total reserves ............................................................ 505,626 519,646
Debt ............................................................................ 55,816 60,816
Deferred income taxes, net ...................................................... 36,618 30,727
Current income taxes payable .................................................... 5,537 5,123
Reinsurance and other payables to affiliates .................................... 7,028 23,003
Other liabilities ............................................................... 32,043 32,738
----------- -----------
Total liabilities ......................................................... $ 642,668 $ 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 June 30, 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 ............................................................... 178,344 158,515
Accumulated other comprehensive income .......................................... 28,009 19,861
Treasury stock, at cost ......................................................... (15,347) (15,446)
----------- -----------
Total stockholders' equity ................................................ 447,181 419,139
----------- -----------
Total liabilities and stockholders' equity ................................ $ 1,089,849 $ 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 Six Months Ended
June 30, June 30,
--------------------- ---------------------
2003 2002 2003 2002
-------- -------- -------- --------
Revenues:
Net earned premium ....................................... $ 74,658 $ 75,742 $143,676 $142,963
Net investment income .................................... 6,652 7,121 13,351 14,227
Net realized investment gains ............................ 1,098 1,601 1,828 1,323
-------- -------- -------- --------
Total revenues ........................................ 82,408 84,464 158,855 158,513
-------- -------- -------- --------
Expenses:
Net losses and loss adjustment expenses .................. 20,235 19,606 38,841 36,253
Net commissions, brokerage and other underwriting expenses 47,940 45,594 92,236 87,146
Interest expense ......................................... 455 445 808 903
-------- -------- -------- --------
Total expenses ........................................ 68,630 65,645 131,885 124,302
-------- -------- -------- --------
Income before income taxes .................................. 13,778 18,819 26,970 34,211
Income taxes ................................................ 3,517 5,917 7,142 10,752
-------- -------- -------- --------
Net income .................................................. $ 10,261 $ 12,902 $ 19,828 $ 23,459
======== ======== ======== ========
Earnings per share .......................................... $ 0.24 $ 0.30 $ 0.46 $ 0.55
======== ======== ======== ========
Earnings per share, assuming dilution ....................... $ 0.24 $ 0.30 $ 0.46 $ 0.55
======== ======== ======== ========
Weighted average shares outstanding ......................... 42,959 42,900 42,958 42,868
======== ======== ======== ========
Weighted average shares outstanding, assuming dilution ...... 42,963 43,066 42,963 43,038
======== ======== ======== ========
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 ........................................................ -- -- -- $ 23,459
Other comprehensive income:
Change in unrealized losses on securities (after income taxes), net
of reclassification adjustment of $428 ............................ -- -- -- 5,888
---------
Total comprehensive income ..................................... $ 29,347
=========
Issuance of treasury stock to employee stock purchase program ........ 5 6
Stock options exercised and other .................................... 130 2 1,387
Dividends paid to stockholders ....................................... -- -- --
------ --------- ---------
Balance, June 30, 2002 ............................................... 42,915 $ 444 $ 255,526
====== ========= =========
Balance, December 31, 2002 ........................................... 42,947 $ 444 $ 255,765
Comprehensive income:
Net income ........................................................ -- -- -- $ 19,828
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of $(1,634) ........................ -- -- -- 8,148
---------
Total comprehensive income ..................................... $ 27,976
=========
Issuance of treasury stock to employee stock purchase program ........ 9 -- (38)
Stock options exercised and other .................................... 3 -- 4
--------- --------- ---------
Balance, June 30, 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 ........................................................ 23,459 -- -- 23,459
Other comprehensive income:
Change in unrealized losses on securities (after income taxes), net
of reclassification adjustment of $428 ............................ -- 5,888 -- 5,888
Total comprehensive income .....................................
Issuance of treasury stock to employee stock purchase program ........ 53 59
Stock options exercised and other .................................... -- -- -- 1,389
Dividends paid to stockholders ....................................... (12,869) -- -- (12,869)
--------- --------- --------- ---------
Balance, June 30, 2002 ............................................... $ 159,718 $ 6,166 $ (15,500) $ 406,354
========= ========= ========= =========
Balance, December 31, 2002 ........................................... $ 158,515 $ 19,861 $ (15,446) $ 419,139
Comprehensive income:
Net income ........................................................ 19,828 -- -- 19,828
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of $(1,634) ........................ -- 8,148 -- 8,148
Total comprehensive income .....................................
Issuance of treasury stock to employee stock purchase program ........ 99 61
Stock options exercised and other .................................... 1 -- -- 5
--------- --------- --------- ---------
Balance, June 30, 2003 ............................................... $ 178,344 $ 28,009 $ (15,347) $ 447,181
========= ========= ========= =========
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)
Six Months Ended
June 30,
--------- ---------
2003 2002
--------- ---------
OPERATING ACTIVITIES:
Net income ...................................................................... $ 19,828 $ 23,459
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization ................................................ 2,090 1,929
Accretion of bond discount, net .............................................. 915 410
Net realized investment (gains) losses ....................................... (1,828) (1,323)
Changes in:
Insurance receivables ........................................................ (7,486) 20,740
Reserve for unearned premiums ................................................ 12,203 11,412
Reserve for unpaid losses and loss adjustment expenses ....................... (26,223) (7,065)
Deferred policy acquisition costs ............................................ (8,159) (7,360)
Deferred income taxes, net ................................................... 1,500 2,808
Reinsurance and other payables to affiliates ................................. (15,975) 82
Prepaid reinsurance premiums ................................................. 2,377 (3,586)
Other assets and liabilities ................................................. 146 (4,516)
--------- ---------
Net cash (used in) provided by operating activities ....................... (20,612) 36,990
--------- ---------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases .................................................................... (38,359) (107,363)
Maturities ................................................................... 15,370 69,426
Sales ........................................................................ 53,321 36,382
Purchases of equity securities .................................................. (225) (17,786)
Proceeds from the sale of equity securities ..................................... 88 1,465
Changes in short-term investments ............................................... (7,779) (982)
Purchases of property and equipment ............................................. (1,104) (2,120)
Changes in receivables/payables for securities sold/purchased ................... (3,031) (10,939)
Other, net ...................................................................... 82 118
--------- ---------
Net cash provided by (used in) investing activities ....................... 18,363 (31,799)
--------- ---------
FINANCING ACTIVITIES:
Principal payments on debt ...................................................... (5,000) --
Dividends to stockholders ....................................................... -- (6,431)
Employee stock option exercises ................................................. 5 1,266
Issuance of treasury stock to employee stock purchase plan ...................... 61 59
--------- ---------
Net cash used in financing activities ..................................... (4,934) (5,106)
--------- ---------
Increase (decrease) in cash ........................................................ (7,183) 85
Cash at beginning of period ........................................................ 14,979 13,159
--------- ---------
Cash at end of period .............................................................. $ 7,796 $ 13,244
========= =========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest ..................................................................... $ 555 $ 1,195
Income taxes ................................................................. $ 5,000 $ 7,000
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
JUNE 30, 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 not have a significant impact on the
Company's financial position or results of operations.
8
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 No. 46 clarifies the exceptions to this general rule, as
enunciated in paragraph 2 of ARB No. 51. FIN No. 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 No. 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 No. 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 six months ended June 30,
2003 and 2002 would have been $19.7 million and $23.4 million, respectively.
Diluted net income per share would have been $0.45 and $0.55 for the six months
ended June 30, 2003 and 2002, respectively.
In April of 2003, the FASB issued SFAS No. 149 entitled "Amendment of
Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS No.149").
SFAS No. 149 amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under SFAS No. 133 entitled "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 149 is effective
for contracts entered into or modified after June 30, 2003 and for hedging
relationships designated after June 30, 2003. The Company does not anticipate
that the adoption of SFAS No. 149 to have a significant impact on the Company's
financial position or results of operations.
In May of 2003, the FASB issued SFAS No. 150 entitled "Accounting for
Certain Financial
9
Instruments with Characteristics of both Liabilities and Equity" ("SFAS No.
150"). SFAS No. 150 establishes standards for how an issuer of financial
instruments classifies and measures in its statement of financial position
certain instruments with characteristics of both liabilities and equity. SFAS
No. 150 modifies the accounting and financial statement disclosures of certain
financial instruments that, under previous guidance, issuers could account for
as equity. SFAS No. 150 affects the issuer's accounting for three types of
financial instruments that are required to be accounted for as liabilities.
SFAS No. 150 is effective for all financial instruments entered into or
modified after May 31, 2003. For all financial instruments entered into prior to
May 31, 2003, SFAS 150 is effective at the beginning of the first interim period
beginning after June 15, 2003, which for CNA Surety begins July 1, 2003. The
Company does not have any financial instruments outstanding to which provisions
of SFAS 150 apply, therefore the adoption of SFAS 150 is not expected to have
any impact on the Company's financial position or results of operations.
10
2. INVESTMENTS
The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety at June 30, 2003 and December 31, 2002, by
investment category, were as follows (dollars in thousands):
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
June 30, 2003 or Cost Gains Losses Value
------------------------------------------------ -------------- ---------- ---------- -------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury ............................ $ 16,113 $ 1,152 $ -- $ 17,265
U.S. Agencies ............................ 6,555 345 (16) 6,884
Collateralized mortgage obligations ...... 90 3 -- 93
Mortgage pass-through securities ......... 13,758 714 -- 14,472
Obligations of states and political
subdivisions................................. 360,720 29,762 (87) 390,395
Corporate bonds ................................ 68,317 7,412 (8) 75,721
Non-agency collateralized mortgage obligations.. 8,787 634 (35) 9,386
Other asset-backed securities:
Second mortgages/home equity loans .......... 10,139 652 -- 10,791
Credit card receivables ..................... 5,000 97 -- 5,097
Other ....................................... 7,498 945 -- 8,443
Redeemable preferred stock ..................... 13,406 1,540 -- 14,946
-------- -------- -------- --------
Total fixed income securities ............ 510,383 43,256 (146) 553,493
Equity securities .............................. 983 -- (20) 963
-------- -------- -------- --------
Total .................................... $511,366 $ 43,256 $ (166) $554,456
======== ======== ======== ========
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 fixed income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
CNA Surety classifies its fixed income securities and its equity
securities as available-for-sale, and as
11
such, they are carried at fair value. The amortized cost of fixed income
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 3 of this Form 10-Q.
3. REINSURANCE
The effect of reinsurance on the Company's written and earned premium was
as follows (dollars in thousands):
Three Months Ended June 30,
--------------------------------------------------
2003 2002
--------------------------------------------------
Written Earned Written Earned
-------- -------- -------- --------
Direct ........ $ 46,398 $ 39,212 $ 36,521 $ 32,975
Assumed ....... 51,048 52,718 58,931 51,961
Ceded ......... (16,337) (17,272) (9,057) (9,194)
-------- -------- -------- --------
$ 81,109 $ 74,658 $ 86,395 $ 75,742
======== ======== ======== ========
Six Months Ended June 30,
-----------------------------------------------------
2003 2002
------------------------ ------------------------
Written Earned Written Earned
--------- --------- --------- ---------
Direct ........ $ 88,765 $ 75,515 $ 73,293 $ 64,688
Assumed ....... 100,352 101,405 104,273 101,502
Ceded ......... (30,862) (33,244) (26,778) (23,227)
--------- --------- --------- ---------
$ 158,255 $ 143,676 $ 150,788 $ 142,963
========= ========= ========= =========
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 June 30,
---------------------------------------------
2003 2002
--------------------- -------------------
$ Ratio $ Ratio
-------- ------- -------- -----
Gross losses and loss adjustment expenses ........ $ 44,006 47.9% $ 23,092 27.2%
Ceded amounts .................................... (23,771) 137.6% (3,486) 37.9%
-------- --------
Net losses and loss adjustment expenses .......... $ 20,235 27.1% $ 19,606 25.9%
======== ========
Six Months Ended June 30,
----------------------------------------------
2003 2002
----------------------------------------------
$ Ratio $ Ratio
-------- ----- -------- -----
Gross losses and loss adjustment expenses ........ $ 71,919 40.7% $ 41,156 24.8%
Ceded amounts .................................... (33,078) 99.5% (4,903) 21.1%
-------- --------
Net losses and loss adjustment expenses .......... $ 38,841 27.0% $ 36,253 25.4%
======== ========
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
12
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 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
also excluded three other contract principals from the 2003 Excess of Loss
Treaty for a total of six excluded principals. Of the two commercial principals,
one is a domestic electric utility with an estimated bonded exposure of $54
million and is currently rated B by Standard and Poor's ("S&P"). The other is a
foreign industrial concern with an estimated bonded exposure in excess of the
Company's $60 million net retention per principal under the applicable
reinsurance contracts. Management estimates that this concern has an equivalent
S&P rating of B+. With respect to the three contract principals other than the
large national contractor, two principals have substantially completed asset
sales, debt reductions and other reorganization efforts. Each of these four
principals continues to perform their contractual obligations underlying the
Company's surety bonds.
The third contract principal is in claim and the claim adjustment process
is in its early stages. Based upon currently available information, management
believes that the reasonably possible net loss ranges from zero to $15.0
million, or equivalent to the Company's current per principal net retention
under the 2003 Excess of Loss Treaty.
In March 2003, CNA Financial Corporation ("CNAF") entered into a credit
agreement with the large national contractor, which undertakes projects for the
construction of government and private facilities, to provide loans to the
contractor in a maximum aggregate amount of $86.4 million (the "Credit
Facility"). Of the $86.4 million capacity, $62.1 million, including accrued
interest, was outstanding at June 30, 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.
In addition, in June of 2003, CNAF and one of its subsidiaries provided
repayment guarantees to certain creditors of the contractor and a subsidiary of
the contractor amounting to $8.7 million. Such guarantees were provided in order
to allow the contractor to receive financial accommodations from a creditor and
in order to comply with certain regulatory requirements. Under the terms of the
guarantees, any payments made by CNAF, or any of its subsidiaries, would be
considered a draw under the Credit Facility.
13
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 Corporation ("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, exist that reduce CNA
Surety's exposure to loss. While CNA Surety believes that the contractor's
restructuring efforts are expected to 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
14
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 June 30, 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 June 30, 2003 and December 31, 2002, CNA Surety had an insurance receivable
balance from CCC and CIC of $65.6 million and $49.5 million, respectively. CNA
Surety had reinsurance payables to CCC and CIC of $5.9 million and $24.3 million
as of June 30, 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 June 30, 2003.
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 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 June 30, 2003, the Company had an estimated unpaid loss
recoverable balance of approximately $13.3 million under the Stop Loss Contract.
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
15
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.
16
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 Six Months Ended
June 30, June 30,
-------------------------- -------------------------
2003 2002 2003 2002
---------- ---------- ---------- ---------
Reserves at beginning of period:
Gross........................................................ 254,118 $ 312,225 $ 303,433 $ 315,811
Ceded reinsurance............................................ 97,941 154,043 137,301 166,318
---------- ---------- ---------- ---------
Net reserves at beginning of period........................ $ 156,177 158,182 166,132 149,493
========== ========== ========== =========
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period............. 19,950 18,679 38,501 35,344
Increase in provision for insured events of prior periods.. 285 927 340 909
---------- ---------- ---------- ---------
Total net incurred...................................... 20,235 19,606 38,841 36,253
---------- ---------- ---------- ---------
Net payments attributable to:
Current period events...................................... (1,238) 1,156 (733) 3,073
Prior period events........................................ 16,896 16,559 44,952 22,600
---------- ---------- ---------- ---------
Total net payments...................................... 15,658 17,715 44,219 25,673
---------- ---------- ---------- ---------
Net reserves at end of period................................ 160,754 160,073 160,754 160,073
Ceded reinsurance at end of period........................... 116,456 148,673 116,456 148,673
---------- ---------- ---------- ---------
Gross reserves at end of period $ 277,210 $ 308,746 $ 277,210 $ 308,746
========== ========== ========== =========
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 paid their portions of the claim. Two other reinsurers have
sent the Company letters expressing reservations about the claim. One reinsurer
has denied coverage. Pursuant to the treaty, the Company has sent a notice
demanding arbitration to all the reinsurers that have not paid. 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 June 30, 2003.
The company received claims on self insured workers compensation bonds
furnished on behalf of three companies that have either recently filed for
bankruptcy or have affiliates that filed for bankruptcy. The bonds were written
in the 1970s and 1980s. The Company is in the process of investigating the total
bond exposures involved, the underlying workers' claims that may be asserted
against each bond, the ability of the principals to meet their contractual
obligations underlying the Company's surety bonds and available reinsurance
coverage. The Company currently has insufficient information to fully complete
its claim evaluations, but the initial analysis indicates that the gross amount
of exposure consists of approximately $46 million in bonds. Based upon currently
available information, management believes
17
that the ultimate claims made under these bonds will be less than the total face
amount of the bonds and that required claim payments would occur over a number
of years. The resolution of these matters could have a material adverse impact
on the future results of operations and financial position of the Company.
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 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. As a result, the current effective interest rate
on the term loan as of June 30, 2003 was 2.58%.
The Term Loan balance was reduced by $5 million on June 30, 2003 according
to the scheduled amortization. Further 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
---- ------------ -------------------
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 June 30, 2003 and can vary based
on CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to
0.80%. As of June 30, 2003, the weighted average interest rate was 2.2% on the
$55 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 June 30, 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
18
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 June 30, 2003 was $0.8 million.
The consolidated balance sheet reflects total debt of $55.8 million at June
30, 2003 and $60.8 million at December 31, 2002. The weighted average interest
rate on outstanding borrowings was 2.3% and 2.0% at June 30, 2003 and December
31, 2002 respectively.
6. COMMITMENTS AND CONTINGENCIES
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.
19
CNA SURETY CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
The following is a discussion and analysis of CNA Surety Corporation ("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.
20
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 June 30, 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 the ceding company of its obligations to
indemnify its own policyholders.
21
CNA Surety's Consolidated Balance Sheet includes estimated liabilities for
unpaid losses and loss adjustment expenses of $277.2 million and reinsurance
receivables of $133.9 million at June 30, 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 June 30, 2003
net estimate for unpaid losses and loss adjustment expenses would produce
approximately a $16.1 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 ("Loews") 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 subsidiary is Western Surety. 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.
FINANCIAL STRENGTH RATINGS
A.M. BEST COMPANY, INC. ("A.M. BEST")
Western Surety is currently rated A+ (Superior), by A.M. Best. An A+ (Superior)
rating is assigned to those companies which A.M. Best believes have achieved
superior overall performance when compared to the norms of the property and
casualty insurance industry. A+ (Superior) rated insurers have been shown to be
among the strongest in ability to meet policyholder and other contractual
obligations. Through intercompany reinsurance and related agreements, CNA
Surety's customers have access to CCC's broader underwriting capacity. CCC is
currently rated A (Excellent) by A.M. Best. A.M. Best's letter ratings range
from A++ (Superior) to F (In Liquidation) with A++ being highest.
STANDARD AND POOR'S ("S&P")
CCC and Western Surety are both currently rated A- (Strong), by S&P. On August
7, 2003, S & P placed CCC and Western Surety on credit watch with negative
implications. S&P's letter ratings range from AAA+ (Extremely Strong) to CC
(Extremely Weak) with AAA+ being highest. Ratings from 'AA' to 'CCC' may be
modified by the addition of a plus or minus sign to show relative standing
within the major rating categories. An insurer rated 'A' has strong financial
security characteristics, but is somewhat more likely to be affected by adverse
business conditions than are insurers with higher ratings.
"SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995
The statements which are not historical facts contained in this Form 10-Q are
forward-looking statements that involve risks and uncertainties, including, but
not limited to, product and policy demand and market response risks, the effect
of economic conditions, the impact of significant increases in corporate
defaults on a national or global basis, the impact of competitive products,
policies and pricing, product and policy development, regulatory changes and
conditions including underwriting limitations imposed by the U.S. Department of
Treasury, rating agency policies and practices, development of claims and the
effect on loss reserves, the performance of reinsurance companies under
reinsurance contracts with the Company, the cost and availability of reinsurance
contracts on reasonable terms, investment portfolio developments and reaction to
market conditions, the results of financing efforts, the actual closing of
contemplated transactions and agreements, the effect of the Company's accounting
policies, and other risks detailed in the Company's Securities and Exchange
Commission filings. No assurance can be given that the actual results of
operations and financial condition will conform to the forward-looking
statements contained herein.
22
RESULTS OF OPERATIONS
Financial Measures
The Management's Discussion and Analysis of Financial Condition and Results
of Operations ("MD&A") discusses certain generally accepted accounting
principles ("GAAP") and non-GAAP financial measures in order to provide
information used by management to monitor the Company's operating performance.
Management utilizes various financial measures to monitor the Company's
insurance operations and investment portfolio. Underwriting results, which are
derived from certain income statement amounts, are considered a non-GAAP
financial measure and are used by management to monitor performance of the
Company's insurance operations. The Company's investment portfolio is monitored
through analysis of various quantitative and qualitative factors and certain
decisions related to the sale or impairment of investments produce realized
gains and losses, which is also a component used in the calculation of net
income and is a non-GAAP financial measure.
Underwriting results are computed as net earned premiums less net loss and
loss adjustment expenses and net commissions, brokerage and other underwriting
expenses. Management uses underwriting income to monitor its insurance
operations' results without the impact of certain factors, including net
investment income, net realized investment gains (losses) and interest expense.
Management excludes these factors in order to analyze the direct relationship
between net earned premiums and the related net loss and loss adjustment
expenses along with net commissions, brokerage and other underwriting expenses.
Operating ratios are calculated using insurance results and are widely used
by the insurance industry and regulators such as state departments of insurance
and the National Association of Insurance Commissioners for financial regulation
and as a basis of comparison among companies. The ratios discussed in the
Company's MD&A are calculated using GAAP financial results and include the net
loss and loss adjustment expense ratio ("loss ratio") as well as the net
commissions, brokerage and other underwriting expense ratio ("expense ratio")
and combined ratio. The loss ratio is the percentage of net incurred claim and
claim adjustment expenses to net earned premiums. The expense ratio is the
percentage of net commissions, brokerage and other underwriting expenses,
including the amortization of deferred acquisition costs, to net earned
premiums. The combined ratio is the sum of the loss and expense ratios.
The Company's investment portfolio is monitored by management through
analyses of various factors including unrealized gains and losses on securities,
portfolio duration and exposure to interest rate, market and credit risk. Based
on such analyses, the Company may impair an investment security in accordance
with its policy, or sell a security. Such activities will produce net realized
investment gains and losses.
While management uses various non-GAAP financial measures to monitor
various aspects of the Company's performance, net income is the most directly
comparable GAAP measure and represents a more comprehensive measure of operating
performance. Management believes that its process of evaluating performance
through the use of these non-GAAP financial measures provides a basis for
enhanced understanding the operating performance and the impact to net income as
a whole. Management also believes that investors may find these widely used
non-GAAP financial measures described above useful in interpreting the
underlying trends and performance, as well as to provide visibility into the
significant components of net income.
23
CNA SURETY RESULTS FOR THREE- AND SIX- MONTHS ENDED JUNE 30, 2003 AND 2002
The components of income for the Company for the three and six months ended
June 30, 2003 and 2002 are summarized as follows (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Total revenues................................ $ 82,408 $ 84,464 $ 158,855 $ 158,513
========== ========== ========== ==========
Underwriting income........................... $ 6,483 $ 10,542 $ 12,599 $ 19,564
Net investment income......................... 6,652 7,121 13,351 14,227
Net realized investment gains................. 1,098 1,601 1,828 1,323
Interest expense.............................. 455 445 808 903
---------- ---------- ---------- ----------
Income before income taxes.................... 13,778 18,819 26,970 34,211
Income taxes.................................. 3,517 5,917 7,142 10,752
---------- ---------- ---------- ----------
Net income.................................... $ 10,261 $ 12,902 $ 19,828 $ 23,459
========== ========== ========== ==========
Net income per share.......................... $ 0.24 $ 0.30 $ 0.46 $ 0.55
========== ========== ========== ==========
Insurance Underwriting
Underwriting results for the Company for the three and six months ended
June 30, 2003 and 2002 are summarized in the following table (dollars in
thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Gross written premiums........................ $ 97,446 $ 95,452 $ 189,117 $ 177,566
========== ========== ========== ==========
Net written premiums.......................... $ 81,109 $ 86,395 $ 158,255 $ 150,788
========== ========== ========== ==========
Net earned premiums........................... $ 74,658 $ 75,742 $ 143,676 $ 142,963
Net losses and loss adjustment expenses....... 20,235 19,606 38,841 36,253
Net commissions, brokerage and other
underwriting expenses......................... 47,940 45,594 92,236 87,146
---------- ---------- ---------- ----------
Underwriting income........................... $ 6,483 $ 10,542 $ 12,599 $ 19,564
========== ========== ========== ==========
Loss ratio.................................... 27.1% 25.9% 27.0% 25.4%
Expense ratio................................. 64.2 60.2 64.2 60.9
---------- ---------- ---------- ----------
Combined ratio................................ 91.3% 86.1% 91.2% 86.3%
========== ========== ========== ==========
Premiums Written
CNA Surety primarily markets contract and commercial surety bonds. Contract
surety bonds generally secure a contractor's performance and/or payment
obligation with respect to a construction project. Contract surety bonds are
generally required by federal, state and local governments for public works
projects. The most common types include bid, performance and payment bonds.
Commercial surety bonds include all surety bonds other than contract and cover
obligations typically required by law or regulation. The commercial surety
market includes numerous types of bonds categorized as court judicial, court
fiduciary, public official, license and permit and many miscellaneous bonds that
include guarantees of financial performance. The Company also writes fidelity
bonds that cover losses arising from employee dishonesty and other insurance
products.
24
Gross written premiums are shown in the table below (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Contract...................................... $ 59,165 $ 53,890 $ 100,788 $ 93,270
Commercial.................................... 31,160 34,897 73,175 69,985
Fidelity and other............................ 7,121 6,665 15,154 14,311
---------- ---------- ---------- ----------
$ 97,446 $ 95,452 $ 189,117 $ 177,566
========== ========== ========== ==========
Gross written premiums increased 2.1%, or $2.0 million, for the three
months ended June 30, 2003 over the comparable period in 2002. Contract surety
gross written premiums increased 9.8%, or $5.3 million, as compared to 2002
primarily due to improving rates. Commercial surety in the second quarter of
2003 decreased by $3.7 million, or 10.7%, due to the Company's ongoing efforts
to reduce aggregate exposures to large commercial accounts. In the second
quarter of 2003, the Company experienced continued volume growth of small
commercial products along with improving rates on large commercial and contract
bonds. The estimated impact of the Company's large commercial account exposure
reduction of $1.7 billion for the first six months of 2003 represents
approximately $8 million in annual premium, assuming an average rate per $1,000
of bond exposure of $4.51, or 45 basis points. Fidelity and other products
increased 6.8%, or $0.5 million, to $7.1 million for the three months ended June
30, 2003 as compared to the same period in 2002 due primarily to volume growth
in fidelity and E&O products.
Gross written premiums increased 6.5%, or $11.6 million, for the six months
ended June 30, 2003 over the comparable period in 2002. Gross written premiums
for contract surety and commercial surety increased 8.1%, or $7.5 million, and
4.6%, or $3.2 million, respectively for the six months ended June 30, 2003
reflecting trends comparable to the quarter. Fidelity and other products
increased 5.9% to $15.2 million for the six months ended June 30, 2003 as
compared to the same period in 2002 due primarily to volume growth in fidelity
and E&O products.
Net written premiums are shown in the table below (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Contract...................................... $ 51,657 $ 49,947 $ 86,696 $ 81,182
Commercial.................................... 22,654 30,094 57,083 55,943
Fidelity and other............................ 6,798 6,354 14,476 13,663
---------- ---------- ---------- ----------
$ 81,109 $ 86,395 $ 158,255 $ 150,788
========== ========== ========== ==========
For the three months ended June 30, 2003, net written premiums decreased
6.1%, or $5.3 million, to $81.1 million as compared to the same period in 2002,
reflecting higher reinsurance costs partially offset by the aforementioned gross
production changes. Ceded written premiums increased $7.3 million to $16.3
million for the second quarter of 2003 compared to the same period of last year
primarily due to changes in the Company's reinsurance programs as more fully
described below. Net written premiums for contract surety business increased
3.4%, or $1.7 million, to $51.7 million. Net written premiums for commercial
surety decreased 24.7%, or $7.4 million, to $22.7 million for the three months
ended June 30, 2003. Fidelity and other products increased 7.0%, or $0.4
million, to $6.8 million for the three months ended June 30, 2003 as compared to
the same period in 2002.
25
For the six months ended June 30, 2003, net written premiums increased 5.0%
to $158.3 million as compared to the same period in 2002, reflecting the
aforementioned gross production changes partially offset by effects of higher
reinsurance costs. Ceded written premiums increased $4.1 million to $30.9
million for the six months ended June 30, 2003. Net written premiums for
contract surety business increased 6.8% to $86.7 million. Net written premiums
for commercial surety increased 2.0% to $57.1 million for the first six months
in 2003. Fidelity and other products increased 6.0% to $14.5 million for the
first six months in 2003 as compared to the same period in 2002.
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
also excluded three other contract principals from the 2003 Excess of Loss
Treaty for a total of six excluded principals. Of the two commercial principals,
one is a domestic electric utility with an estimated bonded exposure of $54
million and is currently rated B by Standard and Poor's ("S&P"). The other is a
foreign industrial concern with an estimated bonded exposure in excess of the
Company's $60 million net retention per principal under the applicable
reinsurance contracts. Management estimates that this concern has an equivalent
S&P rating of B+. With respect to the three contract principals other than the
large national contractor, two principals have substantially completed asset
sales, debt reductions and other reorganization efforts. Each of these four
principals continues to perform their contractual obligations underlying the
Company's surety bonds.
The third contract principal is in claim and the claim adjustment process
is in its early stages. Based upon currently available information, management
believes that the reasonably possible net loss ranges from zero to $15.0
million, or equivalent to the Company's current per principal net retention
under the 2003 Excess of Loss Treaty.
26
In March 2003, CNA Financial Corporation ("CNAF") entered into a credit
agreement with the large national contractor, which undertakes projects for the
construction of government and private facilities, to provide loans to the
contractor in a maximum aggregate amount of $86.4 million (the "Credit
Facility"). Of the $86.4 million capacity, $62.1 million, including accrued
interest, was outstanding at June 30, 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.
In addition, in June of 2003, CNAF and one of its subsidiaries provided
repayment guarantees to certain creditors of the contractor and a subsidiary of
the contractor amounting to $8.7 million. Such guarantees were provided in order
to allow the contractor to receive financial accommodations from a creditor and
in order to comply with certain regulatory requirements. Under the terms of the
guarantees, any payments made by CNAF, or any of its subsidiaries, would be
considered a draw under the Credit Facility.
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 Corporation ("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, exist that reduce CNA
Surety's exposure to loss. While CNA Surety believes that the contractor's
restructuring efforts are expected to 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
27
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 June 30, 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 June 30, 2003 and December 31, 2002, CNA Surety had an insurance receivable
balance from CCC and CIC of $65.6 million and $49.5 million, respectively. CNA
Surety had reinsurance payables to CCC and CIC of $5.9 million and $24.3 million
as of June 30, 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 June 30, 2003.
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
28
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 June 30, 2003, the Company had an estimated
unpaid loss recoverable balance of approximately $13.3 million under the Stop
Loss Contract.
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.
Underwriting Income
Underwriting income decreased 38.5% to $6.5 million for the three months
ended June 30, 2003 compared to $10.5 million for the same period in 2002.
Underwriting income decreased 35.6% to $12.6 million for the six months ended
June 30, 2003 compared to 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
29
large commercial accounts. As the following table depicts, the Company has
reduced its exposure, before the effects of reinsurance, by 30% 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
----------------------- ------------------------------------
June 30, December 31, June 30, December 31, %
Commercial Account Exposure 2003 2002 2003 2002 Reduction
---------------------------- --------- ------------ -------- ------------ ---------
$100 million and larger 8 14 $ 1.4 $ 2.7 46.6%
$ 50 to $ 100 million 13 19 0.9 1.2 32.0
$ 25 to $ 50 million 18 16 0.6 0.6 -
$ 10 to $ 25 million 70 75 1.1 1.2 11.6
--- --- -------- -------
Total 109 124 $ 4.0 $ 5.7 30.1%
=== === ======== =======
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.
Net Loss Ratio
The net loss ratios for the three months ended June 30, 2003 and 2002 were
27.1% and 25.9%, respectively. The loss ratios included $0.3 million and $0.9
million of net unfavorable loss reserve development for the three months ended
June 30, 2003 and 2002, respectively. Excluding the impact of loss reserve
development, the net loss ratios would have been 26.7% and 24.7% for the period
ended June 30, 2003 and June 30, 2002, respectively. For the six months ended
June 30, 2003 and 2002, the net loss ratios were 27.0% and 25.4%, respectively.
The loss ratios included $0.3 million and $0.9 million of net unfavorable
reserve development for the six months ended June 30, 2003 and 2002,
respectively. Excluding the impact of loss reserve development, the loss ratios
would have been 26.8% and 24.8% for the six-month periods ended June 30, 2003
and June 30, 2002, respectively. 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 the first six months of 2002. This business represents about 52% 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
30
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 paid their
portions of the claim. Two other reinsurers have sent the Company letters
expressing reservations about the claim. One reinsurer has denied coverage.
Pursuant to the treaty, the Company has sent a notice demanding arbitration to
all the reinsurers that have not paid. 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 June 30, 2003.
The company received claims on self insured workers compensation bonds
furnished on behalf of three companies that have either recently filed for
bankruptcy or have affiliates that filed for bankruptcy. The bonds were written
in the 1970s and 1980s. The Company is in the process of investigating the total
bond exposures involved, the underlying workers' claims that may be asserted
against each bond, the ability of the principals to meet their contractual
obligations underlying the Company's surety bonds and available reinsurance
coverage. The Company currently has insufficient information to fully complete
its claim evaluations, but the initial analysis indicates that the gross amount
of exposure consists of approximately $46 million in bonds. Based upon currently
available information, management believes that the ultimate claims made under
these bonds will be less than the total face amount of the bonds and that
required claim payments would occur over a number of years. The resolution of
these matters could have a material adverse impact on the future results of
operations and financial position of the Company.
Expense Ratio
The expense ratio increased to 64.2% for the three months ended June 30,
2003 compared to 60.2% for the same period in 2002. For the six months ended
June 30, 2003, the expense ratio increased to 64.2% from 60.9% for the same
period in 2002. The increase in the expense ratio for the three and six months
ended June 30, 2003 primarily reflects the impact of higher reinsurance costs on
net earned premiums. Net earned premiums declined 1.4% and operating expenses
increased 5.2% for the three months ended June 30, 2003. For the six months
ended June 30, 2003, net earned premiums increased 0.5% and operating expenses
increased at a higher rate of 5.8%.
Investment Income
For the three months ended June 30, 2003, net investment income was $6.7
million compared to the three months ended June 30, 2002 of $7.1 million. The
decrease in investment income primarily reflects the impact of lower investment
yields and higher investment in tax-exempt securities. The annualized pretax
yields were 4.6% and 5.0% for the three months ended June 30, 2003 and 2002,
respectively. The annualized after-tax yields for the Company's portfolio were
3.8% and 3.9% for the three months ended June 30, 2003 and 2002. Net investment
income for the six months ended June 30, 2003 and 2002 was $13.4 million and
$14.2 million, respectively. The annualized pretax yields were 4.6% and 5.0% for
the six months ended June 30, 2003 and 2002. The annualized after-tax yields
were 3.8% for both the six months ended June 30, 2003 and 2002.
Net realized investment gains were approximately $1.1 million for the three
months ended June 30, 2003 compared to net realized investment gains of
approximately $1.6 million for the same period in 2002. Net realized investment
gains were approximately $1.8 million for the six months ended June 30, 2003
compared to net realized investment gains of approximately $1.3 for the same
period in 2002.
31
The following summarizes net realized investment gains (losses) activity:
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Gross realized investment gains.................... $ 1,105 $ 2,028 $ 2,366 $ 2,371
Gross realized investment losses................... (7) (427) (538) (1,048)
---------- ---------- ---------- ----------
Net realized investment gains...................... $ 1,098 $ 1,601 $ 1,828 $ 1,323
========== ========== ========== ==========
The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality fixed income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
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 3 of this
Form 10-Q.
Analysis of Other Operations
Interest expense for the three months ended June 30, 2003 increased 2.3% as
compared to the second quarter in 2002 Average debt outstanding was $60.8
million for the second quarter of 2003 compared to $76.2 million in the 2002.
The weighted average interest rate for the three months ended June 30, 2003 was
2.4% compared to 2.1% for the same period in 2002. Interest expense decreased
10.5% for the first six months of 2003 as compared to the same period in 2002.
Average debt outstanding was $60.8 million for the first six months in 2003
compared to $76.2 million in the first six months of 2002. The weighted average
interest rate for the six months ended June 30, 2003 was 2.4% compared to 2.2%
for the same period in 2002.
Income Taxes
Income tax expense was $3.5 million and $5.9 million and the effective
income tax rates were 25.5% and 31.4% for the three months ended June 30, 2003
and 2002, respectively. For the six months ended June 30, 2003 and 2002, income
tax expense was $7.1 million and $10.8 million and the effective income tax
rates were 26.5% and 31.4%, respectively. The decrease in the estimated
effective tax rate in 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
32
income, and sales and maturities of investments. CNA Surety also may generate
funds from additional borrowings under the credit facility described below. The
primary cash flow uses are payments for claims, operating expenses, federal
income taxes, debt service, 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 June 30, 2003, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $547.2 million of fixed income
securities, $45.2 million of short-term investments, $1.1 million of other
investments and $1.4 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 June 30,
2003, the parent company's invested assets consisted of $6.3 million of fixed
income securities, $1.0 million of equity securities, $13.3 million of
short-term investments and $6.4 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 June 30, 2003 and December 31, 2002,
parent company short-term investments and cash included $7.7 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
$20.6 million for the six months ended June 30, 2003 compared to net cash flow
provided by operating activities of $37.0 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, and decreases in reinsurance and other
payables to affiliates.
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 $55 million as
of June 30, 2003, consisting of $30 million under the Revolving Credit Facility
and $25 million under the Term Loan Facility. Effective January 30, 2003, the
Company entered into an interest rate swap on the $30 million Term Loan. As a
result, the current effective interest rate on the term loan as of June 30, 2003
was 2.58%.
33
The Term Loan balance was reduced by $5 million on June 30, 2003 according
to the scheduled amortization. Further 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
---- ------------ -------------------
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 June 30, 2003 and can vary based
on CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to
0.80%. As of June 30, 2003, the weighted average interest rate was 2.2% on the
$55 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 June 30, 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 June 30, 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.
The dividends that may be paid without prior regulatory approval are
determined by formulas
34
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 received $10.0 million and $12.0 million in
dividends from its insurance subsidiaries during the first six months of 2003
and 2002, respectively. A dividend of $10.0 million was received by CNA Surety
from its insurance subsidiaries on July 24, 2003.
Combined statutory surplus totaled $240.5 million at June 30, 2003,
resulting in a net written premium to statutory surplus ratio of 1.3 to 1.
Approximately $226 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 received tax sharing
payments from its subsidiaries of $6.2 million for the six months ended June 30,
2003 and $3.5 million for the same period in 2002.
Western Surety and SBCA 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. The underwriting limitations of Western Surety, SBCA and USA,
based on each insurer's statutory surplus, were $20.7 million, $0.5 million and
$1.3 million, respectively, for the twelve month period ended June 30, 2003.
Effective July 1, 2003 through June 30, 2004, the underwriting limitations of
Western Surety and SBCA are $21.9 million and $0.5 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, 2003 through June 30, 2004, the
underwriting limitations of CCC and its affiliates total $569.6 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.
35
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCUSSIONS ABOUT MARKET RISK
CNA Surety's investment portfolio is subject to economic losses due to
adverse changes in the fair value of its financial instruments, or market risk.
Interest rate risk represents the largest market risk factor affecting the
Company's consolidated financial condition due to its significant level of
investments in fixed income securities. Increases and decreases in prevailing
interest rates generally translate into decreases and increases in the fair
value of the Company's fixed income portfolio. The fair value of these interest
rate sensitive instruments may also be affected by the credit worthiness of the
issuer, prepayment options, relative value of alternative investments, the
liquidity of the instrument, income tax considerations and general market
conditions. The Company manages its exposure to interest rate risk primarily
through an asset/liability matching strategy. The Company's exposure to interest
rate risk is mitigated by the relative short-term nature of its insurance and
other liabilities. The targeted effective duration of the Company's investment
portfolio is approximately 5 years, consistent with the expected duration of its
insurance and other liabilities.
The tables below summarize the estimated effects of certain hypothetical
increases and decreases in interest rates. It is assumed that the changes occur
immediately and uniformly across each investment category. The hypothetical
changes in market interest rates selected reflect the Company's expectations of
the reasonably possible best or worst case scenarios over a one-year period. The
hypothetical fair values are based upon the same prepayment assumptions that
were utilized in computing fair values as of June 30, 2003. Significant
variations in market interest rates could produce changes in the timing of
repayments due to prepayment options available. The fair value of such
instruments could be affected and therefore actual results might differ from
those reflected in the following table.
Hypothetical
Estimated Fair Percentage
Hypothetical Value after Increase
Fair Value at Change in Hypothetical (Decrease) in
June 30, Interest Rate Change in Stockholders'
(dollars in thousands) 2003 (bp=basis points) Interest Rate Equity
------------- ----------------- -------------- ---------------
Fixed Income Securities:
U.S. Government and government agencies and authorities.... $ 38,714 200 bp increase $ 35,333 (0.5)%
100 bp increase 37,101 (0.2)
100 bp decrease 40,267 0.2
200 bp decrease 41,964 0.5
States, municipalities and political subdivisions.......... 390,395 200 bp increase 337,154 (7.7)
100 bp increase 363,053 (4.0)
100 bp decrease 418,571 4.1
200 bp decrease 448,250 8.4
Corporate bonds and all other.............................. 124,384 200 bp increase 114,474 (1.4)
---------- 100 bp increase 119,436 (0.7)
100 bp decrease 129,230 0.7
200 bp decrease 134,152 1.4
Total fixed income securities........................... $ 553,493 200 bp increase 486,961 (9.7)
========== 100 bp increase 519,590 (4.9)
100 bp decrease 588,068 5.0
200 bp decrease 624,366 10.3
36
Hypothetical
Estimated Fair Percentage
Hypothetical Value after Increase
Fair Value at Change in Hypothetical (Decrease) in
December 31, Interest Rate Change in Stockholders'
(dollars in thousands) 2002 (bp=basis points) Interest Rate Equity
------------- ----------------- -------------- -------------
Fixed Income Securities:
U.S. Government and government agencies and authorities.... $ 69,240 200 bp increase $ 61,233 (1.2)%
100 bp increase 65,075 (0.6)
100 bp decrease 72,300 0.5
200 bp decrease 75,547 1.0
States, municipalities and political subdivisions.......... 367,934 200 bp increase 335,430 (5.0)
100 bp increase 350,594 (2.7)
100 bp decrease 386,612 2.9
200 bp decrease 406,784 6.0
Corporate bonds and all other.............................. 133,364 200 bp increase 126,858 (1.0)
---------- 100 bp increase 130,128 (0.5)
100 bp decrease 137,148 0.6
200 bp decrease 140,893 1.2
Total fixed income securities........................... $ 570,538 200 bp increase 523,521 (7.3)
========== 100 bp increase 545,797 (3.8)
100 bp decrease 596,060 4.0
200 bp decrease 623,224 8.2
37
ITEM 4. 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.
38
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 -
At the Annual Meeting of Shareholders of CNA Surety Corporation held on
May 13, 2003, the Company's shareholders voted on the following
proposals. The numbers of shares issued, outstanding and eligible to
vote as of the record date of March 17, 2003 were 42,958,957. Proxies
representing 41,155,282 shares or approximately 96 percent of the
eligible voting shares were tabulated.
PROPOSAL I
Election of Directors.
Number of Shares/Votes
----------------------
For Authority Withheld
--- ------------------
Philip H. Britt 41,096,833 58,449
James R. Lewis 40,324,191 831,091
Roy E. Posner 39,462,795 1,692,487
Adrian M. Tocklin 39,461,202 1,694,080
Mark C. Vonnahme 40,213,036 942,246
PROPOSAL II
To ratify the Board of Directors' appointment of the Company's
independent auditors, Deloitte & Touche LLP for fiscal year 2003.
For 41,044,900
Against 6,716
Abstain 103,666
ITEM 5. Other Information - None.
ITEM 6. Exhibits and Reports on Form 8-K:
(a) Exhibits: -
10(1) Employment Agreement dated as of June 30, 2003 by and
between CNA Surety Corporation and John F. Welch.
31(1) Certification pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002-Chief
Executive Officer.
31(2) Certification pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002-Chief
Financial Officer.
32(1) Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002-Chief Executive Officer.
39
CNA SURETY CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION (continued)
32(2) Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002-Chief Financial Officer
(b) Reports on Form 8-K:
May 6, 2003; CNA Surety Corporation Press Release issued on May
5, 2003.
June 17, 2003; CNA Surety Corporation Press Release issued on
June 17, 2003.
40
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
Senior Vice President and Chief Financial Officer
Date: August 12, 2003
41