FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended SEPTEMBER 30, 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:
42,978,052 shares of Common Stock, $.01 par value as of November 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 September 30, 2003 and
at December 31, 2002 (Unaudited)............................................................... 4
Condensed Consolidated Statements of Income for the Three and Nine Months
Ended September 30, 2003 and 2002 (Unaudited).................................................. 5
Condensed Consolidated Statements of Stockholders' Equity for the
Nine Months Ended September 30, 2003 and 2002 (Unaudited)...................................... 6
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2003 and 2002 (Unaudited)........................................................ 7
Notes to Condensed Consolidated Financial Statements
at September 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..................................... 37
Item 4. Controls and Procedures........................................................................ 39
Part II. Other Information:
Item 1. Legal Proceedings.............................................................................. 40
Item 2. Changes in the Rights of the Company's Security Holders........................................ 40
Item 3. Defaults Upon Senior Securities................................................................ 40
Item 4. Submission of Matters to a Vote of Security Holders............................................ 40
Item 5. Other Information.............................................................................. 40
Item 6. Exhibits and Reports on Form 8-K .............................................................. 40
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 September 30, 2003, and the related
condensed consolidated statements of income, stockholders' equity and cash flows
for the three and nine month periods ended September 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
November 3, 2003
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
September 30, December 31,
2003 2002
------------- -------------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $521,400 and $539,364) ......... $ 557,339 $ 570,538
Equity securities, at fair value (cost: $914 and $852) ................................. 910 761
Short-term investments, at cost (approximates fair value) .............................. 60,755 50,669
Other investments, at fair value ....................................................... 1,117 1,257
Cash ................................................................................... 10,329 14,979
------------- -------------
Total invested assets and cash ...................................................... 630,450 638,204
Deferred policy acquisition costs ........................................................ 105,943 96,386
Insurance receivables:
Premiums, including $14,583 and $34,097 from affiliates (net of allowance for
doubtful accounts: $1,575 and $1,365) ............................................... 32,363 45,423
Reinsurance, including $45,138 and $15,401 from affiliates ............................. 153,196 127,776
Intangible assets (net of accumulated amortization: $25,523 and $25,523) ............... 138,785 143,785
Current income taxes recoverable ......................................................... 28,099 --
Property and equipment, at cost (less accumulated
depreciation: $18,052 and $16,047) ..................................................... 16,421 17,260
Prepaid reinsurance premiums ............................................................. 7,606 13,337
Receivable for securities sold ........................................................... 7,121 3
Other assets ............................................................................. 9,270 9,018
------------- -------------
Total assets ...................................................................... $ 1,129,254 $ 1,091,192
============= =============
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses ............................................. $ 384,906 $ 303,433
Unearned premiums ...................................................................... 229,468 216,213
------------- -------------
Total reserves ...................................................................... 614,374 519,646
Debt ..................................................................................... 50,418 60,816
Deferred income taxes, net ............................................................... 30,568 30,727
Current income taxes payable ............................................................. -- 5,123
Reinsurance and other payables to affiliates ............................................. 4,035 23,003
Other liabilities ........................................................................ 36,016 32,738
------------- -------------
Total liabilities ................................................................... $ 735,411 $ 672,053
------------- -------------
Commitments and contingencies (See Note 6)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,398 shares
issued and 42,977 shares outstanding at September 30, 2003 and 44,386
shares issued and 42,947 shares outstanding at December 31, 2002 ....................... $ 444 $ 444
Additional paid-in capital ............................................................... 255,795 255,765
Retained earnings ........................................................................ 129,502 158,515
Accumulated other comprehensive income ................................................... 23,358 19,861
Treasury stock, at cost .................................................................. (15,256) (15,446)
------------- -------------
Total stockholders' equity .......................................................... 393,843 419,139
------------- -------------
Total liabilities and stockholders' equity .......................................... $ 1,129,254 $ 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 Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Revenues:
Net earned premium ................................................. $ 75,544 $ 79,196 $ 219,220 $ 222,159
Net investment income .............................................. 6,429 7,031 19,780 21,258
Net realized investment gains (losses) ............................. 1 (698) 1,829 625
---------- ---------- ---------- ----------
Total revenues .................................................. 81,974 85,529 240,829 244,042
---------- ---------- ---------- ----------
Expenses:
Net losses and loss adjustment expenses ............................ 112,492 35,380 151,333 71,633
Net commissions, brokerage and other underwriting expenses ......... 48,805 46,027 141,041 133,173
Interest expense ................................................... 372 407 1,180 1,310
---------- ---------- ---------- ----------
Total expenses .................................................. 161,669 81,814 293,554 206,116
---------- ---------- ---------- ----------
Income (loss) before income taxes .................................... (79,695) 3,715 (52,725) 37,926
Income tax expense (benefit) ......................................... (30,854) 1,098 (23,712) 11,850
---------- ---------- ---------- ----------
Net income (loss) .................................................... $ (48,841) $ 2,617 $ (29,013) $ 26,076
========== ========== ========== ==========
Earnings per share ................................................... $ (1.14) $ 0.06 $ (0.68) $ 0.61
========== ========== ========== ==========
Earnings per share, assuming dilution ................................ $ (1.14) $ 0.06 $ (0.68) $ 0.61
========== ========== ========== ==========
Weighted average shares outstanding .................................. 42,971 42,945 42,962 42,896
========== ========== ========== ==========
Weighted average shares outstanding, assuming dilution ............... 42,994 43,094 42,985 43,048
========== ========== ========== ==========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
Common
Stock Additional
Shares Common Paid-In Comprehensive Retained
Outstanding Stock Capital Income (Loss) Earnings
----------- ------ ---------- ------------- --------
Balance, December 31, 2001 ......................................... 42,780 $ 442 $ 254,133 $149,128
Comprehensive income:
Net income ....................................................... -- -- -- $ 26,076 26,076
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $1,190 ............. -- -- -- 17,148 --
-------------
Total comprehensive income .................................... $ 43,224
=============
Issuance of treasury stock to employee stock purchase program ...... 10 15
Stock options exercised and other .................................. 157 2 1,617 --
Dividends paid to stockholders ..................................... -- -- -- (19,309)
----------- ------ ---------- --------
Balance, September 30, 2002 ........................................ 42,947 $ 444 $ 255,765 $155,895
=========== ====== ========== ========
Balance, December 31, 2002 ......................................... 42,947 $ 444 $ 255,765 $158,515
Comprehensive income:
Net income (loss) ................................................ -- -- -- $ (29,013) (29,013)
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $(1,846) ........... -- -- -- 3,497 --
-------------
Total comprehensive income (loss) ............................. $ (25,516)
=============
Issuance of treasury stock to employee stock purchase program ...... 18 -- (71)
Stock options exercised and other .................................. 12 -- 101
----------- ------ ---------- --------
Balance, September 30, 2003 ........................................ 42,977 $ 444 $ 255,795 $129,502
=========== ====== ========== ========
Accumulated
Other Treasury Total
Comprehensive Stock Stockholders'
Income (Loss) (at cost) Equity
------------- -------- -------------
Balance, December 31, 2001 ......................................... $ 278 $(15,553) $ 388,428
Comprehensive income:
Net income ....................................................... -- -- 26,076
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $1,190 ............. 17,148 -- 17,148
Total comprehensive income ....................................
Issuance of treasury stock to employee stock purchase program ...... 107 122
Stock options exercised and other .................................. -- -- 1,619
Dividends paid to stockholders ..................................... -- -- (19,309)
------------- -------- -------------
Balance, September 30, 2002 ........................................ $ 17,426 $(15,446) $ 414,084
============= ======== =============
Balance, December 31, 2002 ......................................... $ 19,861 $(15,446) $ 419,139
Comprehensive income:
Net income (loss) ................................................ -- -- (29,013)
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $(1,846) ........... 3,497 -- 3,497
Total comprehensive income (loss) .............................
Issuance of treasury stock to employee stock purchase program ...... 190 119
Stock options exercised and other .................................. -- -- 101
------------- -------- -------------
Balance, September 30, 2003 ....................................... $ 23,358 $(15,256) $ 393,843
============= ======== =============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
Nine Months Ended
September 30,
-----------------------
2003 2002
---------- ----------
OPERATING ACTIVITIES:
Net income (loss) ...................................................................... $ (29,013) $ 26,076
Adjustments to reconcile net income (loss) to net cash provided by operating ...........
activities:
Depreciation and amortization ....................................................... 3,094 2,861
Accretion of bond discount, net ..................................................... 1,429 647
Net realized investment gains ....................................................... (1,829) (625)
Changes in:
Insurance receivables ............................................................... (12,360) 10,906
Reserve for unearned premiums ....................................................... 13,255 19,692
Reserve for unpaid losses and loss adjustment expenses .............................. 81,473 22,123
Deferred policy acquisition costs ................................................... (9,557) (7,345)
Deferred income taxes, net .......................................................... (2,046) 3,027
Reinsurance and other payables to affiliates ........................................ (18,968) 1,838
Prepaid reinsurance premiums ........................................................ 5,731 (4,678)
Current income taxes payable (recoverable) .......................................... (28,217) 299
Other assets and liabilities ........................................................ (381) (1,208)
---------- ----------
Net cash provided by operating activities ......................................... 2,611 73,613
---------- ----------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases ........................................................................... (59,144) (137,937)
Maturities .......................................................................... 24,621 105,938
Sales ............................................................................... 53,321 24,305
Purchases of equity securities ......................................................... (359) (22,572)
Proceeds from the sale of equity securities ............................................ 292 2,649
Changes in short-term investments ...................................................... (10,079) (7,187)
Purchases of property and equipment .................................................... (2,595) (2,675)
Changes in receivables/payables for securities sold/purchased .......................... (3,032) (11,429)
Other, net ............................................................................. (12) (1,733)
---------- ----------
Net cash provided by (used in) investing activities ............................... 3,013 (50,641)
---------- ----------
FINANCING ACTIVITIES:
Principal payments on debt ............................................................. (10,398) (75,379)
Proceeds from long-term debt ........................................................... -- 65,000
Dividends to stockholders .............................................................. -- (12,868)
Employee stock option exercises ........................................................ 5 1,412
Issuance of treasury stock to employee stock purchase plan ............................. 119 122
---------- ----------
Net cash used in financing activities ............................................. (10,274) (21,713)
---------- ----------
Increase (decrease) in cash ............................................................. (4,650) 1,259
Cash at beginning of period .............................................................. 14,979 13,159
---------- ----------
Cash at end of period .................................................................... $ 10,329 $ 14,418
========== ==========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest ............................................................................ $ 942 $ 1,726
Income taxes ........................................................................ $ 6,250 $ 8,000
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
SEPTEMBER 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 provided for
additional disclosure requirements related to guarantees, effective for
financial periods ended after December 15, 2002. Additionally, FIN 45 outlined
provisions for initial recognition and measurement of the liability incurred in
providing a guarantee. These provisions are applied 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
8
impact on the Company's financial position or results of operations.
In January of 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51 ("ARB No. 51")" ("FIN No. 46"). As a general rule,
ownership by the parent, either directly or indirectly, of over fifty percent of
the outstanding voting shares of a subsidiary is a condition pointing toward
preparation of consolidated financial statements of the parent and its
subsidiary. FIN 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 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 has adopted FIN No. 46.
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 loss for the nine months ended September
30, 2003 would have been $29.1 million and the Company's pro forma net income
for the same period in 2002 would have been $26.1 million, respectively. Diluted
net loss per share would have been $0.68 for the nine months ended September 30,
2003 and diluted net income per share would have been $0.61 for the nine months
ended September 30, 2002.
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. Adoption of SFAS No. 149 did not
have a significant impact on the Company's financial position or results of
9
operations.
In May of 2003, the FASB issued SFAS No. 150 entitled "Accounting for
Certain Financial 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 did not 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 September 30, 2003 and December 31, 2002, by
investment category, were as follows (dollars in thousands):
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
September 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 ......................................... $ 16,847 $ 792 $ -- $ 17,639
U.S. Agencies ......................................... 6,553 218 (54) 6,717
Collateralized mortgage obligations ................... 82 2 -- 84
Mortgage pass-through securities ...................... 9,261 448 -- 9,709
Obligations of states and political subdivisions ........... 378,644 24,799 (204) 403,239
Corporate bonds ............................................ 70,173 7,267 (51) 77,389
Non-agency collateralized mortgage obligations ............. 8,490 548 (27) 9,011
Other asset-backed securities:
Second mortgages/home equity loans ....................... 7,480 507 -- 7,987
Credit card receivables .................................. 5,000 72 -- 5,072
Other .................................................... 5,416 300 -- 5,716
Redeemable preferred stock ................................. 13,454 1,322 -- 14,776
-------------- ---------- ---------- --------------
Total fixed income securities ......................... 521,400 36,275 (336) 557,339
Equity securities .......................................... 914 -- (4) 910
-------------- ---------- ---------- --------------
Total ................................................. $ 522,314 $ 36,275 $ (340) $ 558,249
============== ========== ========== ==============
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.
11
CNA Surety classifies its fixed income securities and its equity
securities as available-for-sale, and as 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 September 30,
-------------------------------------------------------
2003 2002
-------------------------------------------------------
Written Earned Written Earned
----------- ----------- ----------- ------------
Direct........................................................ $ 52,623 $ 44,192 $ 38,024 $ 35,891
Assumed....................................................... 41,599 48,980 59,005 52,862
Ceded......................................................... (14,272) (17,628) (10,643) (9,557)
----------- ----------- ----------- ------------
$ 79,950 $ 75,544 $ 86,386 $ 79,196
=========== =========== =========== ============
Nine Months Ended September 30,
-------------------------------------------------------
2003 2002
-------------------------------------------------------
Written Earned Written Earned
----------- ----------- ----------- ------------
Direct........................................................ $ 141,388 $ 119,707 $ 111,317 $ 100,578
Assumed....................................................... 141,951 150,385 163,278 154,365
Ceded......................................................... (45,134) (50,872) (37,421) (32,784)
----------- ----------- ----------- ------------
$ 238,205 $ 219,220 $ 237,174 $ 222,159
=========== =========== =========== ============
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):
Three Months Ended September 30,
-------------------------------------------------------
2003 2002
------------------------- --------------------------
$ Ratio $ Ratio
----------- ----------- ----------- ------------
Gross losses and loss adjustment expenses..................... $ 141,577 152.0% $ 45,733 51.5%
Ceded amounts................................................. (29,085) 165.0% (10,353) 108.3%
----------- -----------
Net losses and loss adjustment expenses....................... $ 112,492 148.9% $ 35,380 44.7%
=========== ===========
Nine Months Ended September 30,
-------------------------------------------------------
2003 2002
------------------------- --------------------------
$ Ratio $ Ratio
----------- ----------- ----------- ------------
Gross losses and loss adjustment expenses..................... $ 213,496 79.0% $ 86,889 34.1%
Ceded amounts................................................. (62,163) 122.2% (15,256) 46.5%
----------- -----------
Net losses and loss adjustment expenses....................... $ 151,333 69.0% $ 71,633 32.2%
=========== ===========
12
Assumed premiums primarily includes all surety business written or
renewed, net of reinsurance, by Continental Casualty Company ("CCC") and The
Continental Insurance Company ("CIC"), and their affiliates, that is reinsured
by Western Surety Company ("Western Surety") pursuant to intercompany
reinsurance and related agreements.
2003 Third Party Reinsurance Compared to 2002 Third Party Reinsurance
Effective January 1, 2003, CNA Surety entered into a new excess of loss
treaty ("2003 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal on new bonds to $15 million with a
5% co-participation in the $45 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $40
million excess of $20 million per principal coverage ("2002 Excess of Loss
Treaty"). The material differences between the new excess of loss reinsurance
program and the Company's 2002 Excess of Loss Treaty are as follows. The annual
aggregate coverage increases from $100 million in 2002 to $110 million in 2003.
The minimum annual premium for the 2003 Excess of Loss Treaty is $38.0 million
compared to $30.0 million of reinsurance 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 $53 million and is currently rated B by Standard and Poor's
("S&P"). The bonded exposure will decline over the term of the bond which
extends until 2007. The other is a foreign industrial enterprise with an
estimated bonded exposure of $31 million. Management estimates that this
enterprise has an equivalent S&P rating of B+. The remaining $31 million of the
bonded exposure is expected to be discharged by June 30, 2004. With respect to
the three contract principals other than the large national contractor
(described below), 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 went into claim in the second quarter of
2003. Although in claim and experiencing financial difficulties, the contractor
continued to perform substantially all of its contractual obligations underlying
the Company's surety bonds. This contractor recently filed for bankruptcy in
late September, 2003. This filing increased the likelihood that the contractor
will be unable to perform all of its contractual obligations. Based upon
currently available information, management believes its net exposure to loss on
this contractor could be up to $15 million. This loss exposure has been
considered in the Company's $49 million net reserve addition in the third
quarter of 2003 for the 2003 accident year.
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, $74.8 million, including accrued
interest, was outstanding at September 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
13
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. 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. As of September 30, 2003 these guarantees amounted to $7.4
million.
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 was 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 were due to expire between May and August of 2003. One of these letters of
credit in the amount of $3.4 million was extended, but on September 30, 2003 was
due to expire on November 1, 2003. Any amounts paid by CNAF to the banks as
reimbursements for draws upon the banks' letters of credit would 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 September 30, 2003 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 will be successful and provide sufficient cash flow for
its operations, the contractor's failure to achieve its restructuring plan or
perform its contractual obligations underlying all of the Company's surety bonds
could have a material adverse effect on CNA Surety's future results of
operations, cash flows and capital resources. If such failures occur, the
Company estimates that possible losses, net of indemnification and subrogation
recoveries, but before recoveries under reinsurance contracts, could be up to
$200 million. However, the related party reinsurance treaties discussed below
should limit the Company's per principal exposure to approximately $60 million.
Related Party Reinsurance
14
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 September 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 September 30, 2003 and December 31, 2002, CNA Surety had an
insurance receivable balance from CCC and CIC of $59.7 million and $49.5
million, respectively. CNA Surety had reinsurance payables to CCC and CIC of
$1.3 million and $24.3 million as of September 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 expense reserves transferred to Western Surety as of
September 30, 1997 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 September 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 September 30, 2003, the Company had an estimated
unpaid loss recoverable balance of approximately $37.0 million under the Stop
Loss Contract of which $28.0 million has been billed.
15
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 paid annual reinsurance premiums of $12.5 million in year one to
CCC. Effective October 1, 2003, the $40 million excess of $60 million contract
was amended to extend the year one quarterly premium rate of $3.125 million and
commutation provision for an additional quarter ending December 31, 2003. The
Company is seeking to obtain replacement coverage with third party reinsurers
effective January 1, 2004. The Company will pay CCC a total of $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.
Effective October 1, 2003, pending state insurance department
regulatory approval, the Company entered into a $3 million excess of $12 million
excess of loss contract with CCC. The reinsurance premium for the coverage
provided by the $3 million excess of $12 million contract is $0.3 million plus,
if applicable, additional premiums based on paid losses. The contract provides
for aggregate coverage of $12 million. This contract expires on December 31,
2004. This contract effectively lowers the Company's net retention on new bonds
for the remainder of 2003 to $12 million plus a 5% co-participation in the $45
million layer of excess reinsurance with third party reinsurers.
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 Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Reserves at beginning of period:
Gross ..................................................................... 277,210 $ 308,746 $ 303,433 $ 315,811
Ceded reinsurance ......................................................... 116,456 148,673 137,301 166,318
---------- ---------- ---------- ----------
Net reserves at beginning of period ..................................... $ 160,754 160,073 166,132 149,493
========== ---------- ---------- ----------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period .......................... 73,531 31,222 112,032 66,566
Increase in provision for insured events of prior periods ............... 38,961 4,158 39,301 5,067
---------- ---------- ---------- ----------
Total net incurred ................................................... 112,492 35,380 151,333 71,633
---------- ---------- ---------- ----------
Net payments attributable to:
Current period events ................................................... 19,753 2,267 19,020 5,340
Prior period events ..................................................... 7,039 18,027 51,991 40,627
---------- ---------- ---------- ----------
Total net payments ................................................... 26,792 20,294 71,011 45,967
---------- ---------- ---------- ----------
Net reserves at end of period ............................................. 246,454 175,159 246,454 175,159
Ceded reinsurance at end of period ........................................ 138,452 162,775 138,452 162,775
---------- ---------- ---------- ----------
Gross reserves at end of period ...................................... $ 384,906 $ 337,934 $ 384,906 $ 337,934
========== ========== ========== ==========
The Company recorded net unfavorable loss reserve development which
resulted in increases in the estimated liability of $39.0 million for the nine
months ended September 30, 2003. This increase primarily relates to accident
years 2002 and 2001 and changes in estimates of potential additional losses
resulting from material adverse claim activity in the third quarter of 2003.
In addition to the net unfavorable loss reserve development in the
third quarter of 2003, the higher net loss ratio in 2003 primarily relates to
net reserve additions in the quarter of approximately $49.0 million for the
current accident year due to material adverse loss severity in the third quarter
of 2003 on the Company's branch commercial and contract business.
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. Four reinsurers responsible for payment of 46%
of the treaty proceeds have paid or have agreed to pay 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 September 30, 2003.
17
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, as amended
September 30, 2003, provides an aggregate of up to $50 million in borrowings
divided between a revolving credit facility (the "Revolving Credit Facility") of
$30 million and a term loan facility (the "Term Loan") of $20 million. The
Revolving Credit Facility matures on September 30, 2005. The Revolving Credit
Facility may be increased from time to time by the amount of amortization under
the Term Loan facility up to an additional $10 million. 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 Term Loan. As a result, the current effective interest rate on the
term loan as of September 30, 2003 was 2.83%.
The Term Loan balance was reduced by $10 million through September 30,
2003 according to the scheduled amortization. Further amortization of the Term
Loan will take place at $10 million per year, in equal semi-annual installments
of $5 million on the following dates:
Date Amortization Outstanding Balance
---- ------------ -------------------
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 --
The interest rate on borrowings under the 2002 Credit Facility may be
fixed, at CNA Surety's option, for a period of one, two, three, or six months
and is based on, among other rates, the London Interbank Offered Rate ("LIBOR"),
plus the applicable margin. The margin, including a facility fee and utilization
fee on the Revolving Credit Facility, was 1.30% at September 30, 2003 and can
vary based on CNA Surety's leverage ratio (debt to total capitalization) from
1.15% to 1.45%. The margin on the Term Loan, was 0.625% at September 30, 2003
and can vary based on CNA Surety's leverage ratio (debt to total capitalization)
from 0.48% to 0.80%. As of September 30, 2003, the weighted average interest
rate was 2.7% on the $50 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. At September 30, 2003 and
December 31, 2002, CNA Surety was in compliance with all restrictive debt
covenants, except for the fixed charge coverage ratio for the period ended
September 30, 2003 for which CNA Surety obtained a waiver from the lenders. The
lenders amended the 2002 Credit Facility to replace the fixed charge coverage
ratio requirement for the next three quarters with a minimum earnings
requirement.
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 September 30, 2003 was $0.4 million.
The consolidated balance sheet reflects total debt of $50.4 million at
September 30, 2003 and $60.8 million at December 31, 2002. The weighted average
interest rate on outstanding borrowings was 2.5% and 2.0% at September 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 September 30, 2003
includes goodwill and identified intangibles of approximately $138.8 million.
The goodwill and intangible balance as of September 30, 2003 reflects a $5
million reduction in goodwill in the third quarter of 2003 resulting from a
change in estimate with respect to pre-acquisition income taxes. 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
21
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.
CNA Surety's Consolidated Balance Sheet includes estimated liabilities for
unpaid losses and loss adjustment expenses of $384.9 million and reinsurance
receivables of $153.2 million at September 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 September 30,
2003 net estimate for unpaid losses and loss adjustment expenses would produce
approximately a $24.6 million charge to pre-tax earnings. Future effects from
changes in these estimates will be recorded as a component of losses incurred in
the period such changes are determined to be needed.
FORMATION OF CNA SURETY AND MERGER
In December 1996, CNA Financial Corporation ("CNAF") and Capsure agreed
to merge (the "Merger") the surety business of CNAF with Capsure's insurance
subsidiaries, Western Surety Company ("Western Surety") and Universal Surety of
America ("USA"), into CNA Surety. CNAF, through its operating subsidiaries,
writes multiple lines of property and casualty insurance, including surety
business that is reinsured by Western Surety. CNAF owns approximately 64% of the
outstanding common stock of CNA Surety. Loews Corporation ("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 (Excellent), with a negative rating outlook
by A.M. Best. An A (Excellent) rating is assigned to those companies which A.M.
Best believes have an excellent ability to meet their ongoing obligations to
policyholders. A (Excellent) rated insurers have been shown to be among the
strongest in ability to meet policyholder and other contractual obligations. The
rating outlook indicates the potential direction of a company's rating for an
intermediate period, generally defined as the next 12 to 36 months. 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
22
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.
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.
23
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 of its 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.
CNA SURETY RESULTS FOR THREE- AND NINE- MONTHS ENDED SEPTEMBER 30, 2003
AND 2002
The components of income for the Company for the three and nine months
ended September 30, 2003 and 2002 are summarized as follows (dollars in
thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Total revenues ................................... $ 81,974 $ 85,529 $ 240,829 $ 244,042
========== ========== ========== ==========
Underwriting income (loss) ....................... $ (85,753) $ (2,211) $ (73,154) $ 17,353
Net investment income ............................ 6,429 7,031 19,780 21,258
Net realized investment gains (losses) ........... 1 (698) 1,829 625
Interest expense ................................. 372 407 1,180 1,310
---------- ---------- ---------- ----------
Income (loss) before income taxes ................ (79,695) 3,715 (52,725) 37,926
Income taxes ..................................... (30,854) 1,098 (23,712) 11,850
---------- ---------- ---------- ----------
Net income (loss) ................................ $ (48,841) $ 2,617 $ (29,013) $ 26,076
========== ========== ========== ==========
Net income (loss) per share ...................... $ (1.14) $ 0.06 $ (0.68) $ 0.61
========== ========== ========== ==========
24
Insurance Underwriting
Underwriting results for the Company for the three and nine months ended
September 30, 2003 and 2002 are summarized in the following table (dollars in
thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- ------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Gross written premiums ........................... $ 94,222 $ 97,029 $ 283,339 $ 274,595
========== ========== ========== ==========
Net written premiums ............................. $ 79,950 $ 86,386 $ 238,205 $ 237,174
========== ========== ========== ==========
Net earned premiums .............................. $ 75,544 $ 79,196 $ 219,220 $ 222,159
Net losses and loss adjustment expenses .......... 112,492 35,380 151,333 71,633
Net commissions, brokerage and other
underwriting expenses ........................ 48,805 46,027 141,041 133,173
---------- ---------- ---------- ----------
Underwriting income (loss) ....................... $ (85,753) $ (2,211) $ (73,154) $ 17,353
========== ========== ========== ==========
Loss ratio ....................................... 148.9% 44.7% 69.0% 32.2%
Expense ratio .................................... 64.6 58.1 64.4 60.0
---------- ---------- ---------- ----------
Combined ratio ................................... 213.5% 102.8% 133.4% 92.2%
========== ========== ---------- ==========
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.
Gross written premiums are shown in the table below (dollars in
thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Contract ......................................... $ 56,863 $ 55,503 $ 157,651 $ 148,773
Commercial ....................................... 29,970 34,630 103,145 104,615
Fidelity and other ............................... 7,389 6,896 22,543 21,207
---------- ---------- ---------- ----------
$ 94,222 $ 97,029 $ 283,339 $ 274,595
========== ========== ========== ==========
Gross written premiums decreased 2.9%, or $2.8 million, for the three
months ended September 30, 2003 over the comparable period in 2002. Contract
surety gross written premiums increased 2.5%, or $1.4 million, as compared to
2002 primarily due to improving rates. Commercial surety in the third quarter of
2003 decreased by $4.7 million, or 13.5%, due to the Company's ongoing efforts
to reduce
25
aggregate exposures to large commercial accounts. In the third 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 $2.1
billion for the first nine months of 2003 represents approximately $9.5 million
in annual premium, assuming an average rate per $1,000 of bond exposure of
$4.52, or 45 basis points. Fidelity and other products increased 7.1%, or $0.5
million, to $7.4 million for the three months ended September 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 3.2%, or $8.7 million, for the nine
months ended September 30, 2003 over the comparable period in 2002. Gross
written premiums for contract surety increased 6.0%, or $8.9 million and
commercial surety decreased 1.4%, or $1.5 million for the nine months ended
September 30, 2003 reflecting trends comparable to those previously discussed
for the third quarter 2003. Fidelity and other products increased 6.3% to $22.5
million for the nine months ended September 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 Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Contract ......................................... $ 50,398 $ 50,527 $ 137,094 $ 131,709
Commercial ....................................... 22,508 29,289 79,591 85,232
Fidelity and other ............................... 7,044 6,570 21,520 20,233
---------- ---------- ---------- ----------
$ 79,950 $ 86,386 $ 238,205 $ 237,174
========== ========== ========== ==========
For the three months ended September 30, 2003, net written premiums
decreased 7.5%, or $6.4 million, to $80.0 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 $3.6
million to $14.3 million for the third 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 decreased 0.3%, or $0.1 million, to $50.4 million. Net written premiums
for commercial surety decreased 23.2%, or $6.8 million, to $22.5 million for the
three months ended September 30, 2003. Fidelity and other products increased
7.2%, or $0.5 million, to $7.0 million for the three months ended September 30,
2003 as compared to the same period in 2002.
For the nine months ended September 30, 2003, net written premiums
increased 0.4% to $238.2 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 $7.7
million to $45.1 million for the nine months ended September 30, 2003. Net
written premiums for contract surety business increased 4.1% to $137.1 million.
Net written premiums for commercial surety decreased 6.6% to $79.6 million for
the first nine months in 2003. Fidelity and other products increased 6.4% to
$21.5 million for the first nine 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
26
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 $53 million and is currently rated B by Standard and Poor's
("S&P"). The bonded exposure will decline over the term of the bond which
extends until 2007. The other is a foreign industrial enterprise with an
estimated bonded exposure of $31 million. Management estimates that this
enterprise has an equivalent S&P rating of B+. The remaining $31 million of the
bonded exposure is expected to be discharged by June 30, 2004. With respect to
the three contract principals other than the large national contractor
(described below), 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 went into claim in the second quarter of
2003. Although in claim and experiencing financial difficulties, the contractor
continued to perform substantially all of its contractual obligations underlying
the Company's surety bonds. This contractor recently filed for bankruptcy in
late September, 2003. This filing increased the likelihood that the contractor
will be unable to perform all of its contractual obligations. Based upon
currently available information, management believes its net exposure to loss on
this contractor could be up to $15 million. This loss exposure has been
considered in the Company's $49 million net reserve addition in the third
quarter of 2003 for the 2003 accident year.
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, $74.8 million, including accrued
interest, was outstanding at September 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.
27
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. 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. As of September 30, 2003 these guarantees amounted to $7.4
million.
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 was 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 were due to expire between May and August of 2003. One of these letters of
credit in the amount of $3.4 million was extended, but on September 30, 2003 was
due to expire on November 1, 2003. Any amounts paid by CNAF to the banks as
reimbursements for draws upon the banks' letters of credit would 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 September 30, 2003 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 will be successful and provide sufficient cash flow for
its operations, the contractor's failure to achieve its restructuring plan or
perform its contractual obligations underlying all of the Company's surety bonds
could have a material adverse effect on CNA Surety's future results of
operations, cash flows and capital resources. If such failures occur, the
Company estimates that possible losses, net of indemnification and subrogation
recoveries, but before recoveries under reinsurance contracts, could be up to
$200 million. However, the related party reinsurance treaties discussed below
should limit the Company's per principal exposure to approximately $60 million.
Related Party Reinsurance
Intercompany reinsurance agreements together with the Services and
Indemnity Agreement that are described below provide for the transfer of the
surety business written by CCC and CIC to Western Surety. All these agreements
originally were entered into on September 30, 1997 (the "Merger Date"): (i)
28
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 September 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 September 30, 2003 and December 31, 2002, CNA Surety had an
insurance receivable balance from CCC and CIC of $59.7 million and $49.5
million, respectively. CNA Surety had reinsurance payables to CCC and CIC of
$1.3 million and $24.3 million as of September 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 expense reserves transferred to Western Surety as of
September 30, 1997 by agreeing to pay Western Surety, within 30 days following
the end of each calendar quarter, the amount of any adverse development on such
reserves, as re-estimated as of the end of such calendar quarter. There was not
any adverse reserve development for the period from September 30, 1997 (date of
inception) through September 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 September 30, 2003, the Company had an estimated
unpaid loss recoverable balance of approximately $37.0 million under the Stop
Loss Contract of which $28.0 million has been billed.
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.
29
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 paid annual reinsurance premiums of $12.5 million in year one to CCC
.. Effective October 1, 2003, the $40 million excess of $60 million contract was
amended to extend the year one quarterly premium rate of $3.125 million and
commutation provision for an additional quarter ending December 31, 2003. The
Company is seeking to obtain replacement coverage with third party reinsurers
effective January 1, 2004. The Company will pay CCC a total of $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.
Effective October 1, 2003, pending state insurance department
regulatory approval the Company entered into a $3 million excess of $12 million
excess of loss contract with CCC. The reinsurance premium for the coverage
provided by the $3 million excess of $12 million contract is $0.3 million plus,
if applicable, additional premiums based on paid losses. The contract provides
for aggregate coverage of $12 million. This contract expires on December 31,
2004. This contract effectively lowers the Company's net retention on new bonds
for the remainder of 2003 to $12 million plus a 5% co-participation in the $45
million layer of excess reinsurance with third party reinsurers.
Underwriting Income
For the quarter ended September 30, 2003, underwriting losses increased
$83.5 million to $85.8 million. For the nine months ended September 30, 2003,
the Company had an underwriting loss of $73.2 million compared to underwriting
income of $17.4 million in the prior period. The increased underwriting loss
reflects material adverse loss severity in the third quarter which resulted in
higher current year provisions for incurred losses and net unfavorable loss
reserve development on prior accident years. Increased claim severity in recent
years has caused the Company to increase its estimates of gross and net incurred
losses. In addition, these severity trends have adversely impacted the cost and
availability of reinsurance as of September 30, 2003 and could impact the future
cost and availability of reinsurance.
30
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 various exposure management initiatives, particularly to reduce its
risks on large commercial accounts. As the following table depicts, the Company
has reduced its exposure, before the effects of reinsurance, by 37% 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
---------------------------- ------------------------------------------
September 30, December 31, September 30, December 31, %
Commercial Account Exposure 2003 2002 2003 2002 Reduction
--------------------------- ------------- ------------ ------------- ------------ ---------
$100 million and larger 8 14 $ 1.3 $ 2.7 49.5%
$50 to $100 million 8 19 0.6 1.2 55.7
$25 to $50 million 17 16 0.6 0.6 -
$10 to $25 million 70 75 1.1 1.2 13.8
--- --- ------- -------
Total 103 124 $ 3.6 $ 5.7 37.4%
=== === ======= =======
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 September 30, 2003 and
2002 were 148.9% and 44.7%, respectively. The loss ratios included $39.0 million
and $4.2 million of net unfavorable loss reserve development for the three
months ended September 30, 2003 and 2002, respectively. The net adverse
development on prior accident years of $39.0 million primarily relates to
accident years 2001 and 2002 and changes in estimates of potential additional
large losses resulting from the material adverse claim activity in the third
quarter of 2003. This change in estimated net losses reflects the recent receipt
of a $5 million payment demand with respect to a $45 million insurance program
bond. The Company estimates its maximum additional net exposure with respect to
this account at $17 million. Net adverse development also includes approximately
$8 million of claims pertaining to self-insured workers' compensation bonds
issued in the 1980's on behalf of companies now in bankruptcy. Excluding the
impact of loss reserve development, the net loss ratios would have been 97.3%
and 39.4% for the three month periods ended September 30, 2003 and September 30,
2002, respectively. For the nine months ended September 30, 2003 and 2002, the
net loss ratios were 69.0% and 32.2%, respectively. The loss ratios included
$39.3 million and $5.1 million of net unfavorable reserve development for the
nine months ended September 30, 2003 and 2002, respectively. Excluding the
impact of loss reserve development, the loss ratios would have been 51.1% and
29.9% for the nine-month periods ended September 30, 2003 and September 30,
2002, respectively.
In addition to the net unfavorable loss reserve development in the
third quarter of 2003, the higher net
31
loss ratio in 2003 primarily relates to net reserve additions in the quarter of
approximately $49.0 million for the current accident year due to material
adverse loss severity in the third quarter of 2003 on the Company's branch
commercial and contract business. The net additions to reserves for the current
accident year primarily relate to two large claims totaling $23 million incurred
in the quarter and changes in estimates of potential additional large losses
resulting from this significant adverse claim activity. Approximately $15
million of net additions relate to a net loss with respect to an insurance
program bond for a now bankrupt large commercial account. The other $8 million
relates to a contract claim. A portion of the remaining change in estimated net
losses for the current accident year relates to a contractor that went into
claim in the second quarter of 2003 for which the Company disclosed a loss
contingency of up to $15 million. These net additions to the 2003 accident year
resulted in a 68.6% net loss ratio on the branch commercial and contract
business for the first nine months of 2003. The Company was 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 nine months of 2002.
This business represents about 43% of the Company's gross premiums for the third
quarter of 2003 compared to 59% for the same period of 2002. This decline
primarily reflects the considerable success achieved in shedding the more
volatile and capital intensive large commercial account business.
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. Four reinsurers responsible for payment of 46%
of the treaty proceeds have paid or have agreed to pay 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 September 30, 2003.
Within the commercial surety segments, the Company has exposures
related to a small number of accounts, which are now in various stages of
bankruptcy proceedings. In addition, certain other accounts have experienced
deterioration in creditworthiness since the Company issued bonds to them. Given
the current economic climate and its impact on these companies, the Company may
experience an increase in claims and, possibly, incur high severity losses. Such
losses would be recognized in the period in which the claims are filed and
determined to be a valid loss under the provisions of the surety bond issued.
Expense Ratio
The expense ratio increased to 64.6% for the three months ended
September 30, 2003 compared to 58.1% for the same period in 2002. For the nine
months ended September 30, 2003, the expense ratio increased to 64.4% from 60.0%
for the same period in 2002. The increase in the expense ratio for the three and
nine months ended September 30, 2003 primarily reflects the impact of higher
reinsurance costs on net earned premiums. Bad debt expense also increased $1.0
million in the third quarter. Net earned premiums
32
declined 4.6% and operating expenses increased 6.0% for the three months ended
September 30, 2003. For the nine months ended September 30, 2003, net earned
premiums declined 1.3% and operating expenses increased at a higher rate of
5.9%.
Investment Income
For the three months ended September 30, 2003, net investment income
was $6.4 million compared to the three months ended September 30, 2002 of $7.0
million. The decrease in investment income primarily reflects the impact of
lower investment yields and greater investment in tax-exempt securities. The
annualized pretax yields were 4.3% and 4.8% for the three months ended September
30, 2003 and 2002, respectively. The annualized after-tax yields for the
Company's portfolio were 3.6% and 3.8% for the three months ended September 30,
2003 and 2002. Net investment income for the nine months ended September 30,
2003 and 2002 was $19.8 million and $21.3 million, respectively. The annualized
pretax yields were 4.5% and 4.9% for the nine months ended September 30, 2003
and 2002. The annualized after-tax yields were 3.7% and 3.8% for the nine months
ended September 30, 2003 and 2002.
Net realized investment gains were minimal for the three months ended
September 30, 2003 compared to net realized investment losses of approximately
$0.7 million for the same period in 2002. Net realized investment gains were
approximately $1.8 million for the nine months ended September 30, 2003 compared
to net realized investment gains of approximately $0.6 for the same period in
2002.
The following summarizes net realized investment gains (losses)
activity:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Gross realized investment gains............................ $ 2 $ 1,882 $ 2,368 $ 4,253
Gross realized investment losses........................... (1) (2,580) (539) (3,628)
---------- ---------- ---------- ----------
Net realized investment gains (losses)..................... $ 1 $ (698) $ 1,829 $ 625
========== ========== ========== ==========
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.
33
Analysis of Other Operations
Interest expense for the three months ended September 30, 2003
decreased 8.6% as compared to the third quarter in 2002. Average debt
outstanding was $55.2 million for the third quarter of 2003 compared to $65.9
million in the third of 2002. The weighted average interest rate for the three
months ended September 30, 2003 was 2.3% compared to 2.1% for the same period in
2002. Interest expense decreased 9.9% for the first nine months of 2003 as
compared to the same period in 2002. Average debt outstanding was $59.0 million
for the first nine months in 2003 compared to $73.8 million in the first nine
months of 2002. The weighted average interest rate for the nine months ended
September 30, 2003 was 2.4% compared to 2.2% for the same period in 2002. The
increases in the 2003 weighted average interest rates are primarily due to the
Company's entrance into an interest rate swap on its $30 million Term Loan. The
current effective interest rate on the term loan after the effect of the
interest rate swap was 2.83% as of September 30, 2003.
Income Taxes
The Company's income tax benefit was $30.9 million for the three months
ended September 30, 2003 compared to income tax expense of $1.1 million for the
same period in 2002. The effective income tax rates were 38.7% and 29.6% for the
three months ended September 30, 2003 and 2002, respectively. For the nine
months ended September 30, 2003, the Company's income tax benefit was $23.7
million compared to income tax expense of $11.9 million for the same period in
2002. The effective income tax rates were 45.0% and 31.2%, respectively. The
changes in the estimated effective tax rate in 2003 primarily relates to taxable
losses and greater investments in tax exempt securities in 2003.
LIQUIDITY AND CAPITAL RESOURCES
It is anticipated that the liquidity requirements of CNA Surety will be
met primarily by funds generated from operations. The principal sources of
operating cash flows are premiums, investment income, and sales and maturities
of investments. CNA Surety also may generate funds from additional borrowings
under the credit facility described below. The primary cash flow uses are
payments for claims, operating expenses, federal income taxes, debt service, as
well as dividends to CNA Surety stockholders. In general, surety operations
generate premium collections from customers in advance of cash outlays for
claims. Premiums are invested until such time as funds are required to pay
claims and claims adjusting expenses.
The Company believes that total invested assets, including cash and
short-term investments, are sufficient in the aggregate and have suitably
scheduled maturities to satisfy all policy claims and other operating
liabilities, including dividend and income tax sharing payments of its insurance
subsidiaries. At September 30, 2003, the carrying value of the Company's
insurance subsidiaries' invested assets was comprised of $551.1 million of fixed
income securities, $29.7 million of short-term investments, $1.1 million of
other investments and $3.1 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,
34
pay operating expenses, including income taxes, and pay dividends to
stockholders. At September 30, 2003, the parent company's invested assets
consisted of $6.2 million of fixed income securities, $0.9 million of equity
securities, $31.1 million of short-term investments and $7.2 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 September 30,
2003 and December 31, 2002, parent company short-term investments and cash
included $15.2 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 provided by operating
activities was $2.6 million for the nine months ended September 30, 2003
compared to net cash flow provided by operating activities of $73.6 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, decreases in
reinsurance and other payables to affiliates and increases in income taxes
recoverable.
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 provides an aggregate of up to $50 million
in borrowings divided between a revolving credit facility (the "Revolving Credit
Facility") of $30 million and a term loan facility (the "Term Loan") of $20
million. The Revolving Credit Facility matures on September 30, 2005. The
Revolving Credit Facility may be increased from time to time by the amount of
amortization under the Term Loan facility up to an additional $10 million. 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 $50 million
as of September 30, 2003, consisting of $30 million under the Revolving Credit
Facility and $20 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
September 30, 2003 was 2.83%.
The Term Loan balance was reduced by $10 million through September 30,
2003 according to the scheduled amortization. Further amortization of the Term
Loan will take place at $10 million per year, in equal semi-annual installments
of $5 million on the following dates:
Date Amortization Outstanding Balance
---- ------------ -------------------
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 --
The interest rate on borrowings under the 2002 Credit Facility may be
fixed, at CNA Surety's option, for a period of one, two, three, or six months
and is based on, among other rates, the London Interbank Offered Rate ("LIBOR"),
plus the applicable margin. The margin, including a facility fee and utilization
fee on the Revolving Credit Facility, was 1.30% at September 30, 2003 and can
vary based on CNA Surety's leverage ratio (debt to total capitalization) from
1.15% to 1.45%. The margin on the Term Loan, was 0.625% at September 30, 2003
and can vary based on CNA Surety's leverage ratio (debt to total
35
capitalization) from 0.48% to 0.80%. As of September 30, 2003, the weighted
average interest rate was 2.7% on the $50 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. At September 30, 2003 and
December 31, 2002, CNA Surety was in compliance with all restrictive debt
covenants, except for the fixed charge coverage ratio for the period ended
September 30, 2003 for which CNA Surety obtained a waiver from the lenders. The
lenders amended the 2002 Credit Facility to replace the fixed charge coverage
ratio requirement for the next three quarters with a minimum earnings before
interest, income taxes, depreciation and amortization requirement.
In 1999 CNA Surety acquired certain assets of Clark Bonding Company,
Inc., a Charlotte, North Carolina, insurance agency and brokerage doing business
as The Bond Exchange for $5.9 million. As part of this acquisition, the Company
incurred an additional $1.9 million of debt in the form of a promissory note.
The promissory note matures on July 27, 2004 and has an interest rate of 5.0%.
The balance of this promissory note at September 30, 2003 was $0.4 million.
As an insurance holding company, CNA Surety is dependent upon dividends
and other permitted payments from its insurance subsidiaries to pay operating
expenses, meet debt service requirements, as well as to pay cash dividends. The
payment of dividends by the insurance subsidiaries is subject to varying degrees
of supervision by the insurance regulatory authorities in South Dakota and
Texas. In South Dakota, where Western Surety and SBCA are domiciled, insurance
companies may only pay dividends from earned surplus excluding surplus arising
from unrealized capital gains or revaluation of assets. In Texas, where USA is
domiciled, an insurance company may only declare or pay dividends to
stockholders from the insurer's earned surplus. The insurance subsidiaries may
pay dividends without obtaining prior regulatory approval only if such dividend
or distribution (together with dividends or distributions made within the
preceding 12-month period) is less than, as of the end of the immediately
preceding year, the greater of (i) 10% of the insurer's surplus to policyholders
or (ii) statutory net income. In South Dakota, net income includes net realized
capital gains in an amount not to exceed 20% of net unrealized capital gains.
All dividends must be reported to the appropriate insurance department prior to
payment.
The dividends that may be paid without prior regulatory approval are
determined by formulas established by the applicable insurance regulations, as
described above. The formulas that determine dividend capacity in the current
year are dependent on, among other items, the prior year's ending statutory
surplus and statutory net income. Dividend capacity for 2003 is based on
statutory surplus and income at and for the year ended December 31, 2002.
Likewise, dividend capacity for 2004 will be based on the statutory earned
surplus at December 31, 2003. 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 $28.5 million and $21.5 million in
dividends from its insurance subsidiaries during the first nine months of 2003
and 2002, respectively.
Combined statutory surplus totaled $161.2 million at September 30,
2003, resulting in a net written premium to statutory surplus ratio of 1.9 to 1.
Approximately $147 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
36
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. Due to the decline in statutory surplus, effective October 1,
2003, pending state insurance department regulatory approval, the Company
entered into a $3 million excess of $12 million surety excess of loss contract
with CCC which lowers the Company's net retention on new bonds for the remainder
of 2003 to $12 million plus a 5% co-participation in the $45 million layer of
excess reinsurance with third party reinsurers. 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 $7.4 million for the nine months ended
September 30, 2003 and $9.9 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.
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.
37
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 September 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
September 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..... $ 34,149 200 bp increase $ 31,042 (0.5)%
100 bp increase 32,614 (0.3)
100 bp decrease 35,628 0.2
200 bp decrease 37,216 0.5
States, municipalities and political subdivisions........... 403,239 200 bp increase 349,618 (8.8)
100 bp increase 375,659 (4.6)
100 bp decrease 431,651 4.7
200 bp decrease 461,384 9.6
Corporate bonds and all other............................... 119,951 200 bp increase 109,079 (1.8)
----------
100 bp increase 114,404 (0.9)
100 bp decrease 125,720 1.0
200 bp decrease 131,825 2.0
Total fixed income securities............................ $ 557,339 200 bp increase 489,739 (11.2)
==========
100 bp increase 522,677 (5.7)
100 bp decrease 592,999 5.9
200 bp decrease 630,525 12.1
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
38
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.
39
CNA SURETY CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings - None.
ITEM 2. Changes in the Rights of the Company's Security Holders - None.
ITEM 3. Defaults Upon Senior Securities - None.
ITEM 4. Submission of Matters to a Vote of Security Holders - None.
ITEM 5. Other Information - None.
ITEM 6. Exhibits and Reports on Form 8-K:
(a) Exhibits: -
10(1) Endorsement No. 1 to the Surety Excess of Loss Reinsurance
Contract by and between Western Surety Company, Universal Surety of
America, Surety Bonding Company of America and Continental Casualty
Company.
10(2) Second Amendment to Credit Agreement between CNA Surety
Corporation and LaSalle Bank National Association.
10(3) Third Amendment to Credit Agreement between CNA Surety
Corporation and LaSalle Bank National Association.
31(1) Certification pursuant to Rule 13a-14(a) of the Securities
Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002-Chief Executive Officer.
31(2) Certification pursuant to Rule 13a-14(a) of the Securities
Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002-Chief Financial Officer.
32(1) Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002-Chief
Executive Officer.
32(2) Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002-Chief
Financial Officer.
(b) Reports on Form 8-K:
August 4, 2003; CNA Surety Corporation Press Release issued on
August 4, 2003.
September 2, 2003; CNA Surety Corporation Press Release issued on
September 2, 2003.
September 30, 2003; CNA Surety Corporation Press Release issued on
September 30, 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/ John F. Welch
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John F. Welch
President and Chief Executive Officer
/s/ John S. Heneghan
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John S. Heneghan
Senior Vice President and Chief Financial Officer
Date: November 13, 2003
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