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, 2004
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 CENTER, 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:
43,000,943 shares of Common Stock, $.01 par value as of October 21, 2004.
CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION:
Item 1. Condensed Consolidated Financial Statements (Unaudited): 3
Report of Independent Registered Public Accounting Firm........................................................... 3
Condensed Consolidated Balance Sheets at September 30, 2004 and at December 31, 2003 ............................. 4
Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2004 and 2003 ...... 5
Condensed Consolidated Statements of Stockholders' Equity for the Nine Months Ended September 30, 2004 and 2003... 6
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003 ............ 7
Notes to Condensed Consolidated Financial Statements.............................................................. 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ........................ 19
Item 3. Quantitative and Qualitative Disclosures About Market Risk.................................................... 36
Item 4. Disclosure Controls and Procedures............................................................................ 38
PART II. OTHER INFORMATION:
Item 1. Legal Proceedings............................................................................................. 38
Item 2. Changes in the Rights of the Company's Security Holders....................................................... 38
Item 3. Defaults Upon Senior Securities............................................................................... 38
Item 4. Submission of Matters to a Vote of Security Holders........................................................... 38
Item 5. Other Information............................................................................................. 38
Item 6. Exhibits and Reports on Form 8-K.............................................................................. 38
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
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, 2004, and the related
condensed consolidated statements of income for the three-month and nine-month
periods ended September 30, 2004 and 2003 and of stockholders' equity and of
cash flows for the nine-month periods ended September 30, 2004 and 2003. These
interim financial statements are the responsibility of the Corporation's
management.
We conducted our reviews in accordance with standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with standards
of the Public Company Accounting Oversight Board (United States), 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 reviews, we are not aware of any material modifications that should
be made to such condensed consolidated interim 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 standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheet of
CNA Surety Corporation and subsidiaries as of December 31, 2003, 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 March 12, 2004,
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, 2003 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
October 28, 2004
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------- ------------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost of $636,287 and $544,201)............... $ 667,528 $ 580,056
Equity securities, at fair value (cost of $3,059 and $992)..................................... 3,152 1,061
Short-term investments, at cost (approximates fair value)...................................... 84,944 63,871
Other investments, at fair value............................................................... 1,069 1,119
------------- ------------
Total invested assets........................................................................ 756,693 646,107
Cash............................................................................................. 8,585 7,965
Deferred policy acquisition costs................................................................ 106,392 104,674
Insurance receivables:
Premiums, including $14,079 and $18,394 from affiliates (net of allowance for doubtful
accounts:
$1,779 and $1,575)............................................................................ 39,037 39,455
Reinsurance, including $5,442 and $52,704 from affiliates...................................... 107,562 177,775
Intangible assets (net of accumulated amortization: $25,523 and $25,523)......................... 138,785 138,785
Current income taxes receivable.................................................................. -- 21,315
Property and equipment, at cost (less accumulated depreciation: $20,958 and $18,944)............. 15,083 16,556
Prepaid reinsurance premiums..................................................................... 10,633 6,432
Accrued investment income........................................................................ 8,168 8,031
Other assets..................................................................................... 3,707 2,028
------------- ------------
Total assets................................................................................. $ 1,194,645 $ 1,169,123
============= ============
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses..................................................... $ 377,400 $ 413,539
Unearned premiums.............................................................................. 236,935 224,068
------------- ------------
Total reserves............................................................................... 614,335 637,607
Debt............................................................................................. 65,671 50,418
Current income taxes payable..................................................................... 7,987 -- --
Deferred income taxes, net....................................................................... 27,448 30,738
Reinsurance and other payables to affiliates..................................................... 141 191
Accrued expenses................................................................................. 16,273 14,854
Other liabilities................................................................................ 27,955 25,174
------------- ------------
Total liabilities............................................................................ $ 759,810 $ 758,982
------------- ------------
Commitments and contingencies (See Notes 4, 6, & 7)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,409 shares issued and
43,001 shares outstanding at September 30, 2004 and 44,401 shares issued and 42,980 shares
outstanding at December 31, 2003............................................................... 444 444
Additional paid-in capital....................................................................... 255,849 255,816
Retained earnings................................................................................ 173,319 145,786
Accumulated other comprehensive income........................................................... 20,339 23,351
Treasury stock, at cost.......................................................................... (15,116) (15,256)
------------- ------------
Total stockholders' equity................................................................... 434,835 410,141
------------- ------------
Total liabilities and stockholders' equity................................................... $ 1,194,645 $ 1,169,123
============= ============
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,
------------------------ --------------------------
2004 2003 2004 2003
----------- ------------ ----------- -----------
Revenues:
Net earned premium.............................................. $ 83,068 $ 77,732 $ 235,418 $ 225,784
Net investment income........................................... 7,688 6,429 22,127 19,780
Net realized investment gains................................... 194 1 2,476 1,829
--------- --------- ----------- -----------
Total revenues................................................ 90,950 84,162 260,021 247,393
--------- --------- ----------- -----------
Expenses:
Net losses and loss adjustment expenses......................... 22,847 112,492 64,685 151,333
Net commissions, brokerage and other underwriting expenses...... 52,245 48,805 156,627 141,041
Interest expense................................................ 664 372 1,512 1,180
--------- --------- ----------- -----------
Total expenses................................................ 75,756 161,669 222,824 293,554
--------- --------- ----------- -----------
Income (loss) before income taxes................................. 15,194 (77,507) 37,197 (46,161)
Income tax expense (benefit)...................................... 4,220 (30,088) 9,664 (21,414)
--------- --------- ----------- -----------
Net income (loss)................................................. $ 10,974 $ (47,419) $ 27,533 $ (24,747)
========= ========= =========== ===========
Earnings (loss) per common share.................................. $ 0.26 $ (1.10) $ 0.64 $ (0.58)
========= ========= =========== ===========
Earnings (loss) per common share, assuming dilution............... $ 0.25 $ (1.10) $ 0.64 $ (0.58)
========= ========= =========== ===========
Weighted average shares outstanding............................... 43,001 42,971 42,995 42,962
========= ========= =========== ===========
Weighted average shares outstanding, assuming dilution............ 43,048 42,994 43,048 42,985
========= ========= =========== ===========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
COMMON
STOCK ADDITIONAL
SHARES COMMON PAID-IN COMPREHENSIVE
OUTSTANDING STOCK CAPITAL INCOME (LOSS)
----------- ------- ----------- --------------
Balance, December 31, 2002............................................ 42,947 $ 444 $ 255,765
Comprehensive income (loss):
Net income (loss)................................................... -- -- -- $ (24,747)
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).................................. $ (21,150)
===========
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
====== ======= ===========
Balance, December 31, 2003............................................ 42,980 $ 444 $ 255,816
Comprehensive income:
Net income.......................................................... -- -- -- $ 27,533
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of $1,662........................... -- -- -- (3,012)
-----------
Total comprehensive income......................................... $ 24,521
===========
Issuance of treasury stock to employee stock purchase program......... 13 -- (34)
Stock options exercised and other..................................... 8 -- 67
------ ------- -----------
Balance, September 30, 2004........................................... 43,001 $ 444 $ 255,849
====== ======= ===========
ACCUMULATED
OTHER TREASURY TOTAL
RETAINED COMPREHENSIVE STOCK STOCKHOLDERS'
EARNINGS INCOME (AT COST) EQUITY
----------- ------------- ----------- ------------
Balance, December 31, 2002.......................................... $ 159,937 $ 19,861 $ (15,446) $ 420,561
Comprehensive income (loss):
Net income (loss)................................................. (24,747) -- -- (24,747)
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of ($1,846)....................... -- 3,497 -- 3,497
Issuance of treasury stock to employee stock purchase program....... 190 119
Stock options exercised and other................................... -- -- -- 101
----------- ----------- ----------- -----------
Balance, September 30, 2003......................................... $ 135,190 $ 23,358 $ (15,256) $ 399,531
=========== =========== =========== ===========
Balance, December 31, 2003.......................................... $ 145,786 $ 23,351 $ (15,256) $ 410,141
Comprehensive income:
Net income........................................................ 27,533 -- -- 27,533
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of $1,662......................... -- (3,012) -- (3,012)
Issuance of treasury stock to employee stock purchase program....... -- -- 140 106
Stock options exercised and other................................... -- -- -- 67
----------- ----------- ----------- -----------
Balance, September 30, 2004......................................... $ 173,319 $ 20,339 $ (15,116) $ 434,835
=========== =========== =========== ===========
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,
-----------------
2004 2003
---- ----
OPERATING ACTIVITIES:
Net income (loss).................................................................. $ 27,533 $ (24,747)
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:
Depreciation and amortization..................................................... 3,416 3,094
Accretion of bond discount, net................................................... 2,170 1,429
Net realized investment gains..................................................... (2,476) (1,829)
Changes in:
Insurance receivables............................................................. 70,632 (18,924)
Reserve for unearned premiums..................................................... 12,866 13,255
Reserve for unpaid losses and loss adjustment expenses............................ (36,138) 81,473
Deferred policy acquisition costs................................................. (1,718) (9,557)
Deferred income taxes, net........................................................ (1,667) (2,046)
Reinsurance and other payables to affiliates...................................... (50) (18,968)
Prepaid reinsurance premiums...................................................... (4,201) 5,731
Current income taxes payable (receivable) ........................................ 29,302 (25,919)
Other assets and liabilities...................................................... 3,847 (381)
--------- ---------
Net cash provided by operating activities....................................... 103,516 2,611
--------- ---------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases......................................................................... (154,014) (59,144)
Maturities........................................................................ 18,156 24,621
Sales............................................................................. 41,962 53,321
Purchases of equity securities..................................................... (680) (359)
Proceeds from the sale of equity securities........................................ 706 292
Changes in short-term investments.................................................. (21,050) (10,079)
Purchases of property and equipment................................................ (2,010) (2,595)
Changes in receivables/payables for securities sold/purchased...................... 142 (3,032)
Other, net......................................................................... (1,287) (12)
--------- ---------
Net cash (used in) provided by investing activities............................. (118,075) 3,013
--------- ---------
FINANCING ACTIVITIES:
Proceeds from long-term debt....................................................... 30,930 (10,398)
Principal payments on debt......................................................... (15,417) --
Debt issuance costs................................................................ (506) --
Employee stock option exercises and other.......................................... 32 5
Issuance of treasury stock to employee stock purchase plan......................... 140 119
--------- ---------
Net cash provided by (used in) financing activities............................. 15,179 (10,274)
--------- ---------
Increase (decrease) in cash.......................................................... 620 (4,650)
Cash at beginning of period.......................................................... 7,965 14,979
--------- ---------
Cash at end of period................................................................ $ 8,585 $ 10,329
========= =========
Supplemental Disclosure of Cash Flow Information:
Cash paid (received) during the period for:
Interest.......................................................................... $ 1,366 $ 942
Income taxes...................................................................... $ (17,968) $ 6,250
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, 2004
(UNAUDITED)
1. SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings
Corporation ("Capsure") agreed to merge (the "Merger") the surety business of
CNAF with Capsure's insurance subsidiaries, Western Surety Company ("Western
Surety"), Surety Bonding Company of America ("Surety Bonding"), and Universal
Surety of America ("USA"), into CNA Surety Corporation. 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
Corporation. Loews Corporation ("Loews") owns approximately 91% 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").
The consolidated financial statements include the accounts of CNA Surety
Corporation and its controlled subsidiaries (collectively, "CNA Surety" or the
"Company").
ESTIMATES
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America ("GAAP") requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
BASIS OF PRESENTATION
These unaudited Condensed Consolidated Financial Statements should be read
in conjunction with the Consolidated Financial Statements and Notes thereto
included in the Company's 2003 Form 10-K. 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 2003 Financial Statements to conform with the presentation in
the 2004 Condensed Consolidated Financial Statements.
EARNINGS PER SHARE
Basic earnings per common share is computed by dividing income available to
common stockholders by the weighted average number of common shares outstanding
for the period. Diluted earnings per common share is computed based on the
weighted average number of shares outstanding plus the dilutive effect of common
stock equivalents which is computed using the treasury stock method.
8
The computation of earnings per common share is as follows (amounts in
thousands, except for per share data):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Net income (loss)....................................... $ 10,974 $ (47,419) $ 27,533 $ (24,747)
========= ========== ========= =========
Shares:
Weighted average shares outstanding..................... 42,995 42,967 42,980 42,947
Weighted average shares of options exercised and
additional stock issuance.......................... 6 4 15 15
--------- --------- --------- ---------
Total weighted average shares outstanding............... 43,001 42,971 42,995 42,962
Effect of dilutive options........................... 47 23 53 23
--------- --------- --------- ---------
Total weighted average shares outstanding, assuming
dilution.............................................. 43,048 42,994 43,048 42,985
========= ========= ========= =========
Earnings (loss) per share............................... $ 0.26 $ (1.10) $ 0.64 $ (0.58)
========= ========== ========= =========
Earnings (loss) per share, assuming dilution............ $ 0.25 $ (1.10) $ 0.64 $ (0.58)
========= ========== ========= =========
No adjustments were made to reported net income (loss) in the computation
of earnings (loss) per share. Options to purchase shares of common stock of 0.9
million for the three and nine months ended September 30, 2004 and 1.2 million
for the three and nine months ended September 30, 2003 were excluded from the
calculation of diluted earnings per share because the exercise price of these
options was greater than the average market price of CNA Surety's common stock.
The Company applies the intrinsic value method per Accounting Principles
Board ("APB") Opinion No. 25 "Accounting for Stock Issued to Employees" ("APB
Opinion No. 25") and related interpretations, in accounting for its plans as
allowed for under the provisions of Statement of Financial Accounting Standards
("SFAS") No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123").
Accordingly, no compensation expense 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. The following table illustrates the effect on net
income (loss) and earnings (loss) per share data if the Company had applied the
fair value recognition provisions of SFAS No. 123 to stock based compensation
under the Company's stock-based compensation plan (amounts in thousands, except
for per share data):
THREE MONTHS ENDED NINE MONTHS ENDED
----------------------------- ------------------------------
SEPTEMBER 30, SEPTEMBER 30,
2004 2003 2004 2003
---------- ---------- ---------- -----------
Net income (loss)........................................ $ 10,974 $ (47,419) $ 27,533 $ (24,747)
Less: Total stock based compensation cost determined
under the fair value method, net of tax................ (159) 59 (390) (118)
---------- ---------- ---------- ----------
Pro forma net income (loss).............................. $ 10,815 $ (47,360) $ 27,143 $ (24,865)
========== =========== ========== ==========
Basic and diluted earnings (loss) per share, as reported. $ 0.26 $ (1.10) $ 0.64 $ (0.58)
========== =========== ========== ==========
Basic and diluted earnings (loss) per share, pro forma... $ 0.25 $ (1.10) $ 0.63 $ (0.58)
========== =========== ========== ==========
ACCOUNTING CHANGES
In January of 2003, the Financial Accounting Standards Board ("FASB")
issued FASB Interpretation ("FIN") No. 46, "Consolidation of Variable Interest
Entities, an interpretation of Accounting Research Bulletin ("ARB") No. 51"
("ARB No. 51") ("FIN No. 46"). In December of 2003, the FASB issued a revision
to FIN No. 46 ("FIN No. 46R"), which superceded FIN No. 46 and further clarified
the application of ARB No. 51. Per ARB No. 51, 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. However, application of the majority voting interest requirement of
ARB No. 51 to certain types of entities may not identify the party with a
controlling financial interest because the controlling financial interest may be
achieved through arrangements that do not involve voting interest. FIN No. 46R
clarifies the applicability of ARB No. 51 to entities in which the equity
investors do not have the characteristics of a controlling financial interest or
do not have sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support. FIN No. 46R requires an
entity to consolidate a variable interest entity ("VIE") in which it is the
primary beneficiary 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
9
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. FIN No.46R is applicable for financial statements issued for reporting
periods that end after March 15, 2004. The adoption of FIN No. 46R did not have
a significant impact on the results of operations or equity of the Company. The
Company is not the primary beneficiary of a VIE. In May of 2004, the Company
privately issued $30 million of preferred securities through a wholly-owned
subsidiary, CNA Surety Capital Trust I ("Issuer Trust"). Under the requirements
of FIN No. 46R, the Issuer Trust is not a consolidated subsidiary.
In December of 2003, the FASB revised SFAS No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits" ("SFAS No. 132") to require
additional disclosures related to pensions and post retirement benefits. While
retaining the existing disclosure requirements for pensions and postretirement
benefits, additional disclosures are required related to pension plan assets,
obligations, contributions and net benefit costs, beginning with fiscal years
ending after December 15, 2003. Additional disclosures pertaining to benefit
payments are required for fiscal years ending after September 30, 2004. The SFAS
No. 132 revisions also include additional disclosure requirements for interim
financial reports, beginning after December 15, 2003. The Company has
implemented the interim disclosure requirements in these financial statements
and will include annual benefit payment disclosures in all subsequent annual
financial statements.
In March of 2004, the Emerging Issues Task Force ("EITF") reached consensus
on the guidance provided in EITF Issue No. 03-1, "The Meaning of
Other-Than-Temporary Impairment and its Application to Certain Investments"
("EITF 03-1") as applicable to debt and equity securities that are within the
scope of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities" and equity securities that are accounted for using the cost method
specified in Accounting Policy Board Opinion No. 18, "The Equity Method of
Accounting for Investments in Common Stock". An investment is impaired if the
fair value of the investment is less than its cost including adjustments for
amortization, accretion, foreign exchange, and hedging. EITF 03-1 outlines that
an impairment would be considered other-than-temporary unless a) the investor
has the ability and intent to hold an investment for a reasonable period of time
sufficient for the recovery of the fair value up to (or beyond) the cost of the
investment and b) evidence indicating that the cost of the investment is
recoverable within a reasonable period of time outweighs evidence to the
contrary. The investor should consider its cash and/or working capital needs to
assess its intent and ability to hold an investment for a reasonable period of
time for the recovery of fair value up to or beyond the cost of the investment.
Although not presumptive, a pattern of selling investments prior to the
forecasted recovery of fair value may call into question the investor's intent.
In addition, the severity and duration of the impairment should also be
considered in determining whether the impairment is other-than-temporary. The
new guidance for determining whether impairment is other-than-temporary was to
be effective for reporting periods beginning after June 15, 2004. In September
of 2004, the FASB issued a FASB Staff Position ("FSP") on EITF Issue 03-1-1,
which delayed the effective date for the measurement and recognition guidance
included in EITF Issue 03-1 related to other-than-temporary impairment until
additional implementation guidance is provided. As a result of the delay, during
the three month period ended September 30, 2004, the Company continued to apply
existing accounting literature for determining when a decline in fair value is
other-than-temporary.
The Company continues to evaluate the impact of this deferred accounting
standard on its process for determining other-than-temporary impairment of
equity and fixed maturity securities, including the potential impacts from any
revisions to the original guidance issued. Adoption of this standard as
originally issued may cause the Company to recognize impairment losses in the
Consolidated Statements of Operations which would not have been recognized under
the current guidance or to recognize such losses in earlier periods, especially
those due to increases in interest rates, and would likely also impact the
recognition of investment income on impaired securities. Such an impact would
likely increase earnings volatility in future periods. However, since
fluctuations in the fair value for available-for-sale securities are already
recorded in Accumulated Other Comprehensive Income, adoption of this standard is
not expected to have a significant impact on equity.
In May of 2004, the FASB revised FASB Staff Position ("FSP") No. 106-1,
"Accounting and Disclosure Requirements Related to the Medicare Prescription
Drug, Improvement and Modernization Act of 2003" and issued FSP No. 106-2,
"Accounting and Disclosure Requirements Related to the Medicare Prescription
Drug, Improvement and Modernization Act of 2003" ("FSP No. 106-2"). FSP 106-2
provides accounting guidance to the employers who sponsor post retirement health
care plans that provide prescription drug benefits; and the prescription drug
benefit provided by the employer is "actuarially equivalent" to Medicare Part D
and hence qualifies for the subsidy under the Medicare amendment act. FSP 106-2
is not expected to have a material impact on CNA Surety's financial position or
results of operations.
10
2. INVESTMENTS
The estimated fair value and amortized cost or cost of fixed income and
equity securities held by CNA Surety at September 30, 2004 and December 31,
2003, by investment category, were as follows (dollars in thousands):
GROSS UNREALIZED LOSSES
AMORTIZED GROSS --------------------------- ESTIMATED
COST OR UNREALIZED LESS THAN 12 MORE THAN 12 FAIR
SEPTEMBER 30, 2004 COST GAINS MONTHS MONTHS VALUE
------------------ ---------- ---------- ------------ ------------ ----------
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury....................................... $ 21,167 $ 385 $ (1) $ -- $ 21,551
U.S. Agencies....................................... 4,579 42 (11) (55) 4,555
Collateralized mortgage obligations................. 18,132 509 (74) -- 18,567
Mortgage pass-through securities.................... 59,001 329 (306) -- 59,024
Obligations of states and political subdivisions....... 387,535 24,370 (268) (69) 411,568
Corporate bonds........................................ 106,503 5,035 (190) (2) 111,346
Non-agency collateralized mortgage obligations......... 4 1 -- -- 5
Other asset-backed securities:
Second mortgages/home equity loans................... 23,174 370 (2) -- 23,542
Credit card receivables.............................. 2,109 4 -- -- 2,113
Other................................................ 8,727 465 -- -- 9,192
Redeemable preferred stock............................. 5,356 709 -- -- 6,065
--------- -------- -------- ------- ---------
Total fixed income securities........................ 636,287 32,219 (852) (126) 667,528
Equity securities...................................... 3,059 93 -- -- 3,152
--------- -------- -------- ------- ---------
Total................................................ $ 639,346 $ 32,312 $ (852) $ (126) $ 670,680
========= ======== ======== ======= =========
GROSS UNREALIZED LOSSES
AMORTIZED GROSS --------------------------- ESTIMATED
COST OR UNREALIZED LESS THAN 12 MORE THAN 12 FAIR
DECEMBER 31, 2003 COST GAINS MONTHS MONTHS VALUE
----------------- ---------- ---------- ------------ ------------ ----------
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury....................................... $ 21,267 $ 497 $ -- $ -- $ 21,764
U.S. Agencies....................................... 4,587 47 (99) -- 4,535
Collateralized mortgage obligations................. 7,770 425 -- -- 8,195
Mortgage pass-through securities.................... 7,607 386 -- -- 7,993
Obligations of states and political subdivisions....... 376,961 25,604 (127) (27) 402,411
Corporate bonds........................................ 96,525 7,322 (45) -- 103,802
Non-agency collateralized mortgage obligations......... 749 -- -- (22) 727
Other asset-backed securities:
Second mortgages/home equity loans................... 5,721 426 -- -- 6,147
Credit card receivables.............................. 5,000 51 -- -- 5,051
Other................................................ 4,619 192 (13) -- 4,798
Redeemable preferred stock............................. 13,395 1,238 -- -- 14,633
--------- -------- ------ ----- ---------
Total fixed income securities........................ 544,201 36,188 (284) (49) 580,056
Equity securities...................................... 992 69 -- -- 1,061
--------- -------- ------ ----- ---------
Total................................................ $ 545,193 $ 36,257 $ (284) $ (49) $ 581,117
========= ======== ====== ===== =========
The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk, with investments
concentrated in high quality fixed income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
CNA Surety classifies its fixed maturity securities and its equity
securities as available-for-sale, and as such, they are carried at fair value.
The amortized cost of fixed maturity securities is adjusted for amortization of
premiums and accretion of discounts to maturity, which is included in net
investment income. Changes in fair value are reported as a component of other
comprehensive income, exclusive of other-than-temporary impairment losses, if
any.
11
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.
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,
---------------------------------------------
2004 2003
-------------------- ---------------------
WRITTEN EARNED WRITTEN EARNED
--------- --------- ---------- ---------
Direct........................................................................... $ 71,225 $ 64,802 $ 52,623 $ 44,192
Assumed.......................................................................... 30,926 35,127 41,599 48,980
Ceded............................................................................ (15,734) (16,861) (12,084) (15,440)
--------- --------- --------- ---------
$ 86,417 $ 83,068 $ 82,138 $ 77,732
========= ========= ========= =========
NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------------------
2004 2003
-------------------- ---------------------
WRITTEN EARNED WRITTEN EARNED
--------- --------- ---------- ---------
Direct.......................................................................... $ 206,625 $ 171,955 $ 141,388 $ 119,707
Assumed......................................................................... 94,469 116,273 141,951 150,385
Ceded........................................................................... (57,011) (52,810) (38,570) (44,308)
--------- --------- --------- ---------
$ 244,083 $ 235,418 $ 244,769 $ 225,784
========= ========= ========= =========
Assumed premiums primarily include all surety business written or renewed,
net of reinsurance, by CCC and CIC, which is reinsured by Western Surety
pursuant to reinsurance and related agreements.
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):
THREE MONTHS ENDED SEPTEMBER 30,
------------------------------------------
2004 2003
-------------------- ------------------
$ RATIO $ RATIO
--------- -------- -------- ------
Gross losses and loss adjustment expenses....................................... $ (6,177) (6.2%) $ 141,577 152.0%
Ceded amounts................................................................... 29,024 172.1% (29,085) 188.4%
---------- -----------
Net losses and loss adjustment expenses......................................... $ 22,847 27.5% $ 112,492 144.7%
========== ===========
NINE MONTHS ENDED SEPTEMBER 30,
------------------------------------------
2004 2003
-------------------- ------------------
$ RATIO $ RATIO
--------- -------- -------- ------
Gross losses and loss adjustment expenses....................................... $ 44,133 15.3% $213,496 79.0%
Ceded amounts................................................................... 20,552 38.9% (62,163) 140.3%
--------- --------
Net losses and loss adjustment expenses......................................... $ 64,685 27.5% $151,333 67.0%
========= ========
During the three months ended September 30, 2004, the Company has reflected
results of an independent actuarial review which indicated that gross reserves
should be reduced by approximately $32 million, with a corresponding reduction
in ceded reserves. This adjustment reflects changes in estimates of incurred-
but-not-reported reserves for large losses and the associated estimate of
reinsurance receivables. Although there is no impact to net losses and loss
adjustment expenses, these actions did result in unusual fluctuations in the
gross and ceded amounts shown above.
2004 THIRD PARTY REINSURANCE COMPARED TO 2003 THIRD PARTY REINSURANCE
Effective January 1, 2004, CNA Surety entered into a new excess of loss
treaty ("2004 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal to $10 million with a 5%
co-participation in the $90 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $45
million excess of $15 million per principal coverage, as well as the $40 million
excess of $60 million per principal and the $3 million excess of $12 million
coverage that had been provided by CCC. The significant differences between the
new excess of loss reinsurance program and the Company's 2003 Excess of Loss
Treaty are as follows. The annual aggregate coverage increases from $110 million
in 2003 to $157 million in 2004. The minimum annual premium for the 2004 excess
of loss treaty is $49.2 million (net of expected return premium) compared to a
total of $42.0 million of reinsurance premiums paid in 2003 (net of expected
return premium) for the $45 million
12
excess of $15 million, the $40 million excess of $60 million and the $3 million
excess of $12 million treaties. The contract also includes an optional
twelve-month extended discovery period, for an additional premium, which will
provide coverage for losses discovered in 2005 on bonds that were in force
during 2004, and somewhat less restrictive special acceptance provisions for
larger contract accounts than those contained in the 2003 Excess of Loss Treaty.
In addition to the one large contract principal (described later as the
"large national contractor" on page 15) and the two commercial principals
excluded (based upon class of business), the Company's reinsurers had excluded
three other contract principals from the 2003 Excess of Loss Treaty, for a total
of six excluded principals. The large national contractor and the two commercial
principals remain excluded from the 2004 Excess of Loss Treaty. Of the two
commercial principals, one is a domestic electric utility with an estimated
bonded exposure of $41 million and is currently rated B- by Standard and Poor's
("S&P"). This rating was increased from CCC+ during the current quarter due to
significant recapitalization efforts by the principal. The bonded exposure will
decline over the term of the bond that extends until 2007. The other is a
foreign industrial enterprise that fulfilled its bonded obligations in the
second quarter of 2004, so the Company no longer has any exposure.
With respect to the three contract principals other than the large national
contractor, two contract principals have completed asset sales and other
reorganization efforts and have been accepted into the 2004 Excess of Loss
Treaty. The Company received claims related to the third contract principal in
2003. The Company believes it is adequately reserved for any exposure related to
this principal. The Company is currently not providing bonds to this contractor,
so inclusion in the 2004 Excess of Loss Treaty was unnecessary.
RELATED PARTY REINSURANCE
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 of 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 was renewed on January 1, 2004 and
expires on December 31, 2004 and is annually renewable thereafter. There was no
amount due to the CNA Surety insurance subsidiaries as of September 30, 2004.
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.
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 no adverse
reserve development for the period from September 30, 1997 (date of inception)
through September 30, 2004.
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. The Quota Share Treaty was again renewed
on January 1, 2004 on substantially the same terms with an expiration date of
December 31, 2004; 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
exceeded 24% in any of the accident years 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
13
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, 2004, the Company had billed and
received $54.9 million under the Stop Loss Contract, of which $29.9 million was
received in 2004.
The Excess of Loss Contract 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 provided $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
provided 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 for new 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 two previous
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.
Effective October 1, 2003, the Company entered into a $3 million excess of
$12 million contract with CCC. The reinsurance premium for the coverage provided
by the $3 million excess of $12 million contract was $0.3 million plus, if
applicable, additional premiums based on paid losses. The contract provided for
aggregate coverage of $12 million. This contract effectively lowered the
Company's net retention per principal 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 contract was to expire on December 31, 2004.
Effective January 1, 2004, the Company obtained replacement coverage from
third party reinsurers as part of the 2004 Excess of Loss Treaty. Accordingly,
the $40 million excess of $60 million contract with CCC was commuted effective
January 1, 2004. As part of this commutation, the Company has received a
commutation payment of $10.9 million from CCC. As of December 31, 2003 the full
amount of the commutation payment had been recognized as a receivable. The
Company and CCC entered into a new $40 million excess of $60 million reinsurance
contract providing coverage exclusively for the one large national contractor
that is excluded from the Company's third party reinsurance. This contract is
effective from January 1, 2004 to December 31, 2004. The premium for this
contract is $3.0 million plus an additional premium if a loss is ceded under
this contract.
The reinsurance premium for the coverage provided by the $50 million excess
of $100 million contract was $6.0 million. This contract expired on December 31,
2003. The Company and CCC entered into a new $50 million excess of $100 million
contract for the period of January 1, 2004 to December 31, 2004. The premium for
this contract is $6.0 million plus an additional premium if a loss is ceded
under this contract.
As of September 30, 2004 and December 31, 2003, CNA Surety had an insurance
receivable balance from CCC and CIC of $19.5 million and $71.1 million. CNA
Surety had no reinsurance payables to CCC and CIC as of September 30, 2004 and
December 31, 2003.
14
LARGE NATIONAL CONTRACTOR
The Company has provided significant surety bond protection guaranteeing
projects undertaken by the large national contract principal that is excluded
from the Company's third party reinsurance. The related party reinsurance
available to the Company for this principal and the credit extended to the
principal by affiliates of the Company are described below.
If the Company should suffer any losses that are discovered prior to
September 30, 2005 arising from bonds issued to the contractor with effective
dates of September 30, 2002 and prior, the Company would retain the first $60
million of losses on bonds written, and CCC would incur 100% of losses above $60
million pursuant to the extended discovery provisions of the two Excess of Loss
treaties that expired on September 30, 2002. Any losses discovered after
September 30, 2005 on bonds with effective dates prior to September 30, 2002
would be covered up to $150 million pursuant to the $50 million excess of $100
million contract with CCC described above and a twelve month contract with CCC
effective January 1, 2004 that provides $40 million excess of $60 million
reinsurance coverage exclusively for the national contractor.
For bonds that the Company has written after September 30, 2003, in
addition to the coverage provided by excess of loss reinsurance treaties
described above ($40 million excess of $60 million and $50 million excess of
$100 million) the Company and CCC have entered into facultative reinsurance in
connection with larger bonds. The Company's exposure on bonds written from
October 1, 2002 through October 31, 2003 was limited to $20 million per bond.
For bonds written between November 1, 2003 and March 31, 2004, the Company's
exposure was $14.7 million. For bonds written subsequent to March 31, 2004, the
Company's exposure will be limited to the lesser of $20 million or 10% of
policyholders surplus.
The Company has had discussions with its insurance regulatory authorities
regarding the level of bonds provided for this principal and will continue to
keep the insurance regulators informed of its ongoing exposure to this account.
CNAF CREDIT FACILITY
In December of 2002 and January of 2003, CNAF provided loans in an
aggregate amount of approximately $45 million to the national contractor. The
loans were provided by CNAF to help the contractor meet its liquidity needs. The
loans are evidenced by demand notes and until replaced by the credit facility
described below, accrue interest at 10%. In March of 2003, CNAF entered into a
credit facility with the contractor under which CNAF has agreed to provide up to
$86 million of loans to the contractor and certain of its subsidiaries,
including the refinancing of the already advanced $45 million of credit
described above. The credit facility matures in March of 2006. CNAF has been
granted a security interest in substantially all of the assets of the contractor
to secure borrowings under the new credit facility. Loews and CNAF have entered
into a participation agreement, pursuant to which Loews has purchased a
one-third participation share in CNAF's position in the credit facility, on a
dollar-for-dollar basis, up to a maximum of $25 million, plus accrued interest.
Although Loews does not have rights against the contractor directly under the
participation agreement, it shares recoveries and fees under the facility on a
proportional basis with CNAF.
In March of 2003, CNAF purchased the contractor's outstanding bank debt for
$16.4 million. The contractor purchased the bank debt and retired it, with $11.4
million of the purchase price being funded under the new credit facility and $5
million from money loaned to the contractor by its shareholders. Under its
purchase agreement with the banks, CNAF is also required to reimburse the banks
for any draws upon outstanding letters of credit issued by the banks for the
contractor's benefit. Letters of credit in the amount of $3 million are due to
expire in August 2005. CNAF has also provided collateral for letters of credit
issued by another bank for the contractor's benefit in the aggregate amount of
$8 million. Any CNAF reimbursements for draws upon the banks' letters of credit
will become obligations of the contractor to CNAF as draws upon the credit
facility. As of September 30, 2004, CNAF had credit exposure of $61.1 million
under the credit facility, net of participation by Loews, in the amount of $24.1
million, for total outstanding of $85.2 million.
As of March 31, 2004, the credit facility was amended to provide for
calculating the amount available for borrowing without regard to approximately
$1.1 million representing accrued interest on a bridge loan provided by CNAF
that became a borrowing under the facility; the elimination of the reduction in
CNAF's commitment upon receipt by the contractor of certain claim proceeds; and
an increase in the monthly compensation limits for the contractor's principals.
In connection with the amendment, the principals and an affiliate contributed $5
million in the aggregate to the contractor's capital by forgiving certain of the
contractor's indebtedness.
15
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. 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 the Company
believes that the contractor's restructuring efforts will be successful and
provide sufficient cash flow for its operations and for repayment of its
borrowings, the contractor's failure to achieve its restructuring plan could
have a material adverse effect on CNA Surety's results of operations, cash flow
and capital. If such failures occur, the Company estimates that possible losses,
net of indemnification and subrogation recoveries, but before recoveries under
reinsurance contracts, to be approximately $200 million. However, the related
party reinsurance treaties discussed above would limit the Company's per
principal exposure to approximately $60 million.
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,
------------------------------ ------------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
Reserves at beginning of period:
Gross................................................... $ 412,367 $ 277,210 $ 413,539 $ 303,433
Ceded reinsurance....................................... 160,419 116,456 158,357 137,301
----------- ----------- ----------- -----------
Net reserves at beginning of period................... 251,948 160,754 255,182 166,132
----------- ----------- ----------- -----------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period........ 22,843 73,531 65,252 112,032
Increase (decrease) in provision for insured events
of prior periods..................................... 4 38,961 (567) 39,301
----------- ----------- ----------- -----------
Total net incurred................................... 22,847 112,492 64,685 151,333
----------- ----------- ----------- -----------
Net payments attributable to:
Current period events................................. 1,320 19,753 2,814 19,020
Prior period events................................... 23,012 7,039 66,590 51,991
----------- ----------- ----------- -----------
Total net payments................................... 24,332 26,792 69,404 71,011
----------- ----------- ----------- -----------
Net reserves at end of period........................... 250,463 246,454 250,463 246,454
Ceded reinsurance at end of period...................... 126,937 138,452 126,937 138,452
----------- ----------- ----------- -----------
Gross reserves at end of period...................... $ 377,400 $ 384,906 $ 377,400 $ 384,906
=========== =========== =========== ===========
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. 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. As of October 28, 2004, the Company has billed a total of $37.1
million to its reinsurers. Six reinsurers responsible for payment of 61% of the
treaty proceeds either have paid their portions of the claim or have reached
agreement with the Company and paid the Company to commute the entire
reinsurance treaty under which the Enron claim was made. Pursuant to the treaty,
the Company demanded and began arbitration proceedings against all the
reinsurers that have not paid or commuted their treaties. 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 not
recorded a reduction with respect to these reinsurance recoverables as of
September 30, 2004.
5. DEBT
In May of 2004, the Company, through a wholly-owned trust, privately issued
$30 million of preferred securities through two pooled transactions. These
securities bear interest at a rate of the London Interbank Offered Rate
("LIBOR") plus 337.5 basis points with a 30-year term and are redeemable after
five years. The securities were issued by CNA Surety Capital Trust I (the
"Issuer Trust"). The sole asset of the Issuer Trust consists of a $30.9 million
junior subordinated debenture issued by the Company to the Issuer Trust. The
Company has also guaranteed the dividend payments and redemption of the
preferred securities issued by the Issuer Trust. The maximum amount of
undiscounted future payments the Company could make under the guarantee is $75.0
million, consisting of annual dividend payments of $1.5 million over 30 years
and the redemption value of $30.0 million. Because payment under the
16
guarantee would only be required if the Company does not fulfill its obligations
under the debentures held by the Issuer Trust, the Company has not recorded any
additional liabilities related to this guarantee.
The subordinated debenture bears interest at a rate of LIBOR plus 337.5
basis points and matures in April of 2034. As of September 30, 2004 the interest
rate on the junior subordinated debenture was 5.0863%
On September 30, 2002, the Company refinanced $65.0 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 $50.0 million in borrowings divided between
a revolving credit facility (the "Revolving Credit Facility") of $30.0 million
and a term loan facility (the "Term Loan Facility") of $20.0 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 $10.0 million. Such increase is
subject to consent by each bank participating in the Revolving Credit Facility,
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 Facility which fixed the previously floating interest rate. As
a result, the current effective interest rate on the term loan as of September
30, 2004 was 2.77%.
In June of 2004, the Company reduced the outstanding Revolving Credit
Facility by $10.0 million using a portion of the proceeds from the Issuer Trust
discussed above. In September of 2004, the Company increased the outstanding
Revolving Credit Facility by $5.0 million. The Term Loan Facility balance was
reduced by $20.0 million through September 30, 2004 according to scheduled
amortization and payment schedules. Further amortization and payment of the Term
Loan Facility will take place at $10.0 million per year, in equal semi-annual
installments of $5.0 million on the following dates:
DATE AMORTIZATION OUTSTANDING BALANCE
---- ------------ -------------------
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, 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, 2004 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 Facility was 0.625% at September 30, 2004 and can vary based on
CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to 0.80%.
As of September 30, 2004, the weighted average interest rate was 3.283% on the
$35.0 million of outstanding borrowings. As of December 31, 2003, the weighted
average interest rate on the 2002 Credit Facility was 2.4% on the $50.0 million
of outstanding borrowings.
The 2002 Credit Facility contains, among other conditions, limitations on
CNA Surety with respect to the incurrence of additional indebtedness and
maintenance of a rating of at least "A" by A.M. Best Co. 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. Due to the net loss reported
for the third quarter of 2003, the Company was in violation of the minimum fixed
charge coverage test. The lenders granted the Company a waiver for this
violation and amended the 2002 Credit Facility to replace the fixed charge
coverage ratio requirement for the next three quarters with a minimum earnings
requirement. At March 31, 2004, the Company was in violation of this minimum
earnings requirement and received a waiver for this requirement in the second
quarter of 2004. The Company is in compliance during the quarter ended September
30, 2004.
6. EMPLOYEE BENEFITS
CNA Surety sponsors a tax deferred savings plan ("401(k) plan") covering
substantially all of its employees. Prior to December 31, 1999, the Company
matched 70% of the participating employee's contribution up to 6% of eligible
compensation (4.2% maximum matching). Effective January 1, 2000, the Company
match was increased to 100% of the participating employees' contribution up to
3% of eligible compensation and 50% of the participating employees' contribution
between 3% and 6% of eligible compensation (4.5% maximum matching). Effective
January 1, 2004, the Company implemented an additional basic contribution for
eligible 401(k) plan participants of 3% (if under age 45) or 5% (if 45 or older)
of eligible compensation. In addition, the Company may also make an annual
discretionary performance contribution to the 401(k) plan, subject to the
approval of the Company's Board of Directors. The discretionary performance
contribution may be restricted by plan and regulatory limitations.
17
CNA Surety established the CNA Surety Corporation Deferred Compensation
Plan ("the Plan"), effective April 1, 2000. The Company established and
maintains the Plan as an unfunded, nonqualified deferred compensation plan for a
select group of management or highly compensated employees. The purpose of the
Plan is to permit designated employees of the Company and participating
affiliates to accumulate additional retirement income through a nonqualified
deferred compensation plan that enables them to defer compensation to which they
will become entitled in the future.
Western Surety sponsors two postretirement benefit plans covering certain
employees. One plan provides medical benefits, and the other plan provides sick
leave termination payments. The postretirement health care plan is contributory
and the sick leave plan is non-contributory. Western Surety uses a December 31
measurement date for both of its postretirement benefit plans.
The plans' combined net periodic postretirement benefit cost for the three
and nine months ended September 30, 2004 and 2003 included the following
components (amounts in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
2004 2003 2004 2003
------- ------- ------- -------
Net periodic benefit cost:
Service cost............................................. $ 38 $ 64 $ 112 $ 146
Interest cost............................................ 84 110 254 253
Prior service cost....................................... (40) (50) (121) (115)
Recognized net actuarial (gain) (1) (3) (3) (6)
------ ------ ------ ------
Net periodic benefit cost................................ $ 81 $ 121 $ 242 $ 278
====== ====== ====== ======
The Company expects to contribute $0.2 million to the postretirement
benefit plans to pay benefits in 2004. As of September 30, 2004, $0.1 million of
contributions have been made to the postretirement benefit plans.
7. COMMITMENTS AND CONTINGENCIES
At September 30, 2004, the estimated future minimum payments under
operating leases were as follows: 2004 -- $0.4 million; 2005 -- $1.5 million;
2006 -- $1.4 million; 2007 -- $1.1 million; 2008 -- $1.0 million; and thereafter
-- $3.7 million.
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.
8. SUBSEQUENT EVENT
On October 27, 2004, the Company announced that it had tentatively agreed
to sell all of its financial interest in United Kingdom ("UK") based DeMontfort
Group, Ltd. to HCC Insurance Holdings, Inc. The agreement covers CNA Surety's
34% ownership in the common shares and certain preferred shares and indebtedness
of the DeMontfort Group. The transaction is subject to execution of a definitive
agreement and receipt of UK regulatory approvals. The Company expects to realize
a gain on this transaction that may be material to the financial results in the
quarter in which such sale is recorded, however the decision to sell the
investment is not otherwise expected to have a material impact on the Company's
ongoing operations or financial position.
18
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 and
its subsidiaries' (collectively, "CNA Surety" or the "Company") operating
results, liquidity and capital resources, and financial condition. This
discussion should be read in conjunction with the Condensed Consolidated
Financial Statements in Item 1 of Part 1 and the Company's Annual Report on Form
10-K for the year ended December 31, 2003.
INTRODUCTION
Management believes that the following areas represent the most significant
risks and uncertainties impacting the operating performance and financial
condition of the Company. The financial impacts of these issues would affect
gross and net written premium, incurred losses and reserves for unpaid losses.
Each of these issues is discussed in greater detail later in this section.
AVAILABILITY AND COST OF REINSURANCE
Reinsurance coverage is an important component of the Company's capital
structure. Reinsurance allows the Company to meet certain regulatory
restrictions that would otherwise limit the size of bonds that the Company
writes and limit the market segments in which the Company could compete. In
addition, reinsurance reduces the potential volatility of earnings and protects
the Company's capital by limiting the amount of loss associated with any one
bond principal. Due to increased loss frequency and severity for both the
Company and within the surety industry in general that began emerging in 1999,
the Company, beginning in 2002, paid substantially higher reinsurance premiums
and was required to retain higher amounts of its per principal exposure. Through
aggressive exposure reduction efforts and continued underwriting discipline, the
Company has been able to purchase additional limits and more expansive
reinsurance protection for 2003 and 2004 as compared to 2002.
EXPOSURE TO LOSS ON PRINCIPALS EXCLUDED FROM REINSURANCE PROGRAMS
Beginning in 2002, the Company's reinsurers excluded certain accounts (for
which the Company had continuing exposure from bonds written in prior years)
from the reinsurance programs. For these accounts, the Company would retain up
to $60 million of loss. Due to the improved financial condition of some of these
accounts and the Company's efforts to have these accounts covered, two of these
accounts are again covered under the Company's 2004 reinsurance program.
However, the Company's reinsurance program for 2004 excludes three principals.
Of these excluded principals, one is a domestic electric utility and one is a
large national contractor. As of September 30, 2004, Management estimates that
the Company's net exposure to these accounts would be $41 million and $60
million, respectively. The other is a foreign industrial enterprise that
fulfilled its bonded obligations in the second quarter of 2004, so the Company
no longer has any exposure. The foreign industrial enterprise and the electric
utility are discussed on page 26, and the large national contractor is discussed
in detail on page 27. As of September 30, 2004, no material loss event has
occurred with respect to these three principals.
FINANCIAL STRENGTH RATINGS
Surety bond principals and obligees often refer to the financial strength
ratings assigned by A.M. Best Co. ("A.M. Best"), Standard and Poor's ("S&P") and
other similar companies when they are choosing a surety company. Because the
Company uses the underwriting capacity of Continental Casualty Company and its
subsidiaries (collectively, "CCC") to serve larger accounts, the insurer
financial strength rating of both the Company and CCC factor into customers'
decisions. After reporting a significant operating loss in the third quarter of
2003, the Company's A.M. Best rating was lowered from A+ to A with a negative
outlook. CCC also reported a significant operating loss in the third quarter of
2003, but A.M. Best affirmed CCC's rating of A with a negative outlook.
Management believes that the current ratings are sufficient for the Company to
conduct all aspects of its business. Management also believes that a one level
reduction in ratings would have only a minimal impact on operations. A further
decrease beyond one level would likely have a material adverse impact on the
Company's ability to write business. Management believes that the likelihood of
further ratings downgrades has been reduced by ongoing efforts to reduce large
exposures, lower per principal retentions under the 2004 reinsurance program,
the reduction in number of un-reinsured principals, and enhanced surplus and
capital positions.
19
ECONOMIC CONDITIONS
The Company's results are impacted by general corporate credit conditions,
as well as by the condition of the public construction segment of the economy.
Corporate credit default rates have improved from recent historically high
levels and the amount of new public construction spending appears to be strong.
An improvement in overall corporate default rates could be expected to have a
favorable impact on the Company's loss costs. Strong public construction
spending could be expected to benefit the Company's written premium production
and loss costs. Changes in these factors could have a material impact on
financial condition and results of operations. Management believes that the
diversification of the Company's book of business, with approximately 40% of
current written premium from products that are less sensitive to economic
conditions, mitigates the impact of these economic factors.
BOND PREMIUM RATES
The premium rates that the Company charges for its bonds have a direct
impact on the amount of revenue generated and on the ratio of incurred losses to
earned premium. Over the last several years, the Company has charged higher
rates for its bonds, particularly in the large commercial and contract segments.
These two segments demonstrated the greater rate need due to the emergence of
increased loss frequency and severity as noted above. While the Company will
continue to aggressively pursue rate increases where indicated, current
competitive factors are pointing to a decreased ability to achieve the level of
rate increases that have been obtained over the past several years.
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 reserves for unpaid losses and loss
adjustment expenses and reinsurance, investments, deferred policy acquisition
costs, and goodwill and other intangible assets. 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.
RESERVES FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES AND REINSURANCE
CNA Surety accrues liabilities for unpaid losses and loss adjustment
expenses under its surety and property and casualty insurance contracts based
upon estimates of the ultimate amounts payable under the contracts related to
losses occurring on or before the balance sheet date. As of any balance sheet
date, all claims have not yet been reported and some claims may not be reported
for many years. As a result, the liability for unpaid losses includes
significant estimates for incurred-but-not-reported claims. Additionally,
reported claims are in various stages of the settlement process. Each claim is
settled individually based upon its merits, and certain claim liabilities may
take years to settle, especially if legal action is involved.
The Company uses a variety of techniques to establish the liabilities for
unpaid claims recorded at the balance sheet date. While techniques may vary,
each employs significant judgments and assumptions. Techniques may involve
detailed statistical analysis of past claim reporting, settlement activity,
salvage and subrogation activity, claim frequency and severity data when
sufficient information exists to lend statistical credibility to the analysis.
The analysis may be based upon internal loss experience or industry experience.
Techniques may vary depending on the type of claim being estimated. Liabilities
may also reflect implicit or explicit assumptions regarding the potential
effects of future economic and social inflation, judicial decisions, law
changes, and recent trends in such factors.
Receivables recorded with respect to insurance losses ceded to reinsurers
under reinsurance contracts are estimated in a manner similar to liabilities for
insurance losses and, therefore, are also subject to uncertainty. In addition to
the factors cited above, estimates of reinsurance recoveries may prove
uncollectible if the reinsurer is unable to perform under the contract.
Reinsurance contracts do not relieve the ceding company of its obligations to
indemnify its own policyholders.
CNA Surety's Condensed Consolidated Balance Sheet includes estimated
liabilities for unpaid losses and loss adjustment expenses of $377.4 million and
reinsurance receivables related to losses of $126.9 million as of September 30,
2004. While many factors impact these estimates, Management believes that past
changes in the Company's business mix and reinsurance program along with
increased corporate default rates were the primary drivers of the need to
substantially increase reserve levels in 2003. Beginning in the late
20
1990's, the Company began writing more bonds for large corporate clients.
Shortly thereafter, corporate default rates increased dramatically. These
exposures proved to be more volatile than the Company's more traditional
contract and small commercial surety products, and began resulting in a higher
frequency of severe losses. As a result, the Company's reinsurers significantly
increased rates, reduced the amount of coverage available to the Company and
excluded certain accounts from the reinsurance program. For 2002, the Company's
per principal retention increased from $5 million to $20 million. Although the
Company reduced its per principal retention to $15 million for 2003, these
higher retentions, at a time of continuing higher frequency of severe losses,
further increased the volatility of results.
Since 2001, the Company has been aggressively reducing its exposures to
large corporate clients. Management believes that these efforts, along with
continued underwriting discipline in its traditional contract and small
commercial products, have been key to further reducing the Company's per
principal retention for most accounts to $10 million for the 2004 reinsurance
program. Management anticipates that these steps will reduce the volatility of
the Company's results.
Due to the inherent uncertainties in the process of establishing the
liabilities for unpaid losses and loss adjustment expenses, the actual ultimate
claims amounts will differ from the currently recorded amounts. This difference
could have a material effect on reported earnings. For example, a 10% increase
in the September 30, 2004 net estimate for unpaid losses and loss adjustment
expenses would produce a charge to pre-tax earnings of approximately $25.0
million. 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.
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 classifies 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 that approximates fair value.
Invested assets are exposed to various risks, such as interest rate risk, market
risk and credit risk. Due to the level of risk associated with 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.
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 Condensed Consolidated Balance Sheet as of September 30, 2004
includes goodwill and identified intangibles of approximately $138.8 million.
These amounts represent goodwill and identified intangibles arising from the
acquisition of Capsure Holdings Corp. ("Capsure"). Prior to 2002, goodwill from
this and other acquisitions was 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.
21
A significant amount of judgment is required in performing goodwill
impairment tests. Such tests are performed annually on October 1, or more
frequently if events or changes indicate that the estimated fair value of CNA
Surety's reporting units might be impaired. 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.
FORMATION OF CNA SURETY AND MERGER
In December of 1996, CNA Financial Corporation ("CNAF") and Capsure
Holdings Corporation ("Capsure") agreed to merge (the "Merger") the surety
business of CNAF with Capsure's insurance subsidiaries, Western Surety Company
("Western Surety"), Surety Bonding Company of America ("Surety Bonding"), and
Universal Surety of America ("USA"), into CNA Surety Corporation. 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 91% 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").
BUSINESS
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 34,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety,
Surety Bonding, and USA. The insurance subsidiaries write, on a direct basis or
as business assumed from CCC and CIC, small fidelity and non-contract surety
bonds, referred to as commercial bonds; small, medium and large contract bonds;
and errors and omissions ("E&O") liability insurance. Western Surety is a
licensed insurer in all 50 states, the District of Columbia and Puerto Rico. USA
is licensed in 44 states and the District of Columbia. Surety Bonding is
licensed in 28 states and the District of Columbia.
The Company's corporate objective is to be the leading provider of surety
and surety-related products in the United States and to be the surety of choice
for its customers and independent agents and brokers.
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) with a negative rating outlook by A.M. Best. A.M. Best's
letter ratings range from A++ (Superior) to F (In Liquidation) with A++ being
highest.
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.
RESULTS OF OPERATIONS
FINANCIAL MEASURES
The Management's Discussion and Analysis of Financial Condition and Results
of Operations ("MD&A") discusses certain accounting principles generally
accepted in the United States of America ("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
22
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 that 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 results to monitor its insurance
operations' results without the impact of certain factors, including net
investment income, net realized investment gains (losses) and interest expense.
Management excludes these factors in order to analyze the direct relationship
between net earned premiums and the related net loss and loss adjustment
expenses along with net commissions, brokerage and other underwriting expenses.
Operating ratios are calculated using insurance results and are widely used
by the insurance industry and regulators such as state departments of insurance
and the National Association of Insurance Commissioners for financial regulation
and as a basis of comparison among companies. The ratios discussed in the
Company's MD&A are calculated using GAAP financial results and include the net
loss and loss adjustment expense ratio ("loss ratio") as well as the net
commissions, brokerage and other underwriting expense ratio ("expense ratio")
and combined ratio. The loss ratio is the percentage of net incurred losses and
loss 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
analysis of various factors including unrealized gains and losses on securities,
portfolio duration and exposure to interest rates, and 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 GAAP and 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 the operating performance and the impact to
net income as a whole. Management also believes that investors may find these
widely used financial measures described above useful in interpreting the
underlying trends and performance, as well as to provide visibility into the
significant components of net income.
23
COMPARISON OF CNA SURETY RESULTS FOR THE THREE AND NINE MONTHS ENDED
SEPTEMBER 30, 2004 AND 2003
ANALYSIS OF NET INCOME
Net income for the three months ended September 30, 2004 was $11.0 million,
as compared to a net loss of $47.4 million for the same period in 2003. This
increase is a result of higher net earned premium, higher net investment income,
and the absence of material adverse claim developments which occurred during the
third quarter of 2003.
Net income for the nine months ended September 30, 2004 was $27.5 million,
as compared to a net loss of $24.7 million for the same period in 2003. This
increase reflects the absence of material adverse loss development which
occurred during the third quarter of 2003, higher net earned premium, and higher
net investment income, partially offset by higher underwriting expenses incurred
in the first quarter of 2004 related to an accrual for policyholder dividends
primarily related to premiums earned in 2002 and prior, and severance costs
related to the re-organization of the Company's field office structure.
The components of net income are discussed in the following sections.
RESULTS OF INSURANCE OPERATIONS
Underwriting components for the Company for the three and nine months ended
September 30, 2004 and 2003 are summarized in the following table (dollars in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2004 2003 2004 2003
---------- ---------- ---------- ----------
Gross written premiums..................................... $ 102,151 $ 94,222 $ 301,094 $ 283,339
========== ========== ========== ==========
Net written premiums....................................... $ 86,417 $ 82,138 $ 244,083 $ 244,769
========== ========== ========== ==========
Net earned premiums........................................ $ 83,068 $ 77,732 $ 235,418 $ 225,784
========== ========== ========== ==========
Net losses and loss adjustment expenses.................... $ 22,847 $ 112,492 $ 64,685 $ 151,333
========== ========== ========== ==========
Net commissions, brokerage and other expenses.............. $ 52,245 $ 48,805 $ 156,627 $ 141,041
========== ========== ========== ==========
Loss ratio................................................. 27.5% 144.7% 27.5% 67.0%
Expense ratio.............................................. 62.9 62.8 66.5 62.5
---------- ---------- ---------- ----------
Combined ratio............................................. 90.4% 207.5% 94.0% 129.5%
========== ========== ========== ==========
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 summarized in the following table (dollars in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2004 2003 2004 2003
---------- ---------- ---------- ----------
Contract................................................... $ 61,610 $ 56,863 $ 172,807 $ 157,651
Commercial................................................. 32,548 29,970 103,877 103,145
Fidelity and other......................................... 7,993 7,389 24,410 22,543
---------- ---------- ---------- ----------
$ 102,151 $ 94,222 $ 301,094 $ 283,339
========== ========== ========== ==========
Gross written premiums increased 8.4%, or $7.9 million, for the three
months ended September 30, 2004 as compared with the same period in 2003. This
increase was primarily driven by a 8.6%, or $2.6 million, increase in gross
written premiums for Commercial surety due to continued strong volume growth in
small commercial products and a 8.3%, or $4.7 million, increase in gross written
premiums for Contract surety due to improved rates.
24
Gross written premiums increased 6.3%, or $17.8 million, for the nine
months ended September 30, 2004 as compared with the same period in 2003. This
increase was primarily driven by a 9.6%, or $15.1 million, increase in Contract
surety as compared with the same period in 2003, due to improving rates.
Commercial surety increased 0.7 percent, or $0.7 million, as a result of strong
volume growth in small commercial products, offset by the Company's ongoing
efforts to reduce aggregate exposures to large commercial accounts. The
estimated impact of the Company's exposure reduction efforts to date represents
approximately a $27 million reduction in annual premium, assuming an average
rate per $1,000 of bond exposure of $3.46, or 35 basis points, and approximately
$7.7 billion of bond exposure.
Net written premiums are summarized in the following table (dollars in
thousands):
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
2004 2003 2004 2003
------------- ---------- ------------ -------------
Contract................................................... $ 45,775 $ 51,492 $ 130,384 $ 140,376
Commercial................................................. 33,015 23,602 90,375 82,873
Fidelity and other......................................... 7,627 7,044 23,324 21,520
---------- ---------- ---------- ----------
$ 86,417 $ 82,138 $ 244,083 $ 244,769
========== ========== ========== ==========
Net written premiums increased 5.2%, or $4.3 million, for the three months
ended September 30, 2004 as compared with the same period in 2003, driven by the
increase in gross written premiums as described above, partially offset by
increased ceded written premiums. Ceded written premiums increased $3.6 million
for the three months ended September 30, 2004 as compared with the same period
in 2003, reflecting the Company's decision to purchase additional reinsurance
protection. Net written premiums increased 24.4%, or $5.8 million, for
Commercial surety and 8.3%, or $0.6 million, for Fidelity and other products for
the three months ended September 30, 2004 as compared with the same period in
2003. Net written premiums for Contract surety decreased 4.0%, or $2.1 million,
for the three months ended September 30, 2004 as compared with the same period
in 2003.
For the nine months ended September 30, 2004, net written premiums
decreased 0.3%, or $0.7 million, as compared with the same period in 2003,
reflecting the Company's decision to purchase additional reinsurance protection
as well as the timing of reinsurance premium payments. Net written premiums
decreased 4.6%, or $6.3 million, for Contract surety for the nine months ended
September 30, 2004 as compared with the same period in 2003. Net written
premiums increased 4.6%, or $3.9 million, for Commercial surety and 8.3%, or
$1.8 million, for Fidelity and other products for the nine months ended
September 30, 2004 as compared with the same period in 2003.
EXCESS OF LOSS REINSURANCE
Beginning in 1999, the Company has experienced an increase in claim
severity and frequency in the most recent accident years. CNA Surety is paying
higher costs for reinsurance as a result of this loss experience.
The Company's reinsurance program is predominantly comprised of excess of
loss reinsurance contracts that limit the Company's retention on a per principal
basis. The Company's reinsurance coverage is provided by third party reinsurers
and related parties.
2004 THIRD PARTY REINSURANCE COMPARED TO 2003 THIRD PARTY REINSURANCE
Effective January 1, 2004, CNA Surety entered into a new excess of loss
treaty ("2004 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal to $10 million with a 5%
co-participation in the $90 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $45
million excess of $15 million per principal coverage, as well as the $40 million
excess of $60 million per principal and the $3 million excess of $12 million
coverage that had been provided by CCC. The significant differences between the
new excess of loss reinsurance program and the Company's 2003 Excess of Loss
Treaty are as follows. The annual aggregate coverage increases from $110 million
in 2003 to $157 million in 2004. The minimum annual premium for the 2004 excess
of loss treaty is $49.2 million (net of expected return premium) compared to a
total of $42.0 million of reinsurance premiums paid in 2003 (net of expected
return premium) for the $45 million excess of $15 million, the $40 million
excess of $60 million and the $3 million excess of $12 million treaties. The
contract also includes an optional twelve-month extended discovery period, for
an additional premium, which will provide coverage for losses discovered in 2005
on bonds that were in force during 2004, and somewhat less restrictive special
acceptance provisions for larger contract accounts than those contained in the
2003 Excess of Loss Treaty.
25
In addition to the one large contract principal (described later as the
large national contractor on Page 27) and the two commercial principals excluded
(based upon class of business), the Company's reinsurers had excluded three
other contract principals from the 2003 Excess of Loss Treaty, for a total of
six excluded principals. The large national contractor and the two commercial
principals remain excluded from the 2004 Excess of Loss Treaty. Of the two
commercial principals, one is a domestic electric utility with an estimated
bonded exposure of $41 million and is currently rated B- by Standard and Poor's
("S&P"). This rating was increased from CCC+ during the current quarter due to
significant recapitalization efforts by the principal. The bonded exposure will
decline over the term of the bond that extends until 2007. The other is a
foreign industrial enterprise that fulfilled its bonded obligations in the
second quarter of 2004, so the Company no longer has any exposure.
With respect to the three contract principals other than the large national
contractor, two contract principals have completed asset sales and other
reorganization efforts and have been accepted into the 2004 Excess of Loss
Treaty. The Company received claims related to the third contract principal in
2003. The Company believes it is adequately reserved for any exposure related to
this principal. The Company is currently not providing bonds to this contractor,
so inclusion in the 2004 Excess of Loss Treaty was unnecessary.
RELATED PARTY REINSURANCE
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 of 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 was renewed on January 1, 2004 and
expires on December 31, 2004 and is annually renewable thereafter. There was no
amount due to the CNA Surety insurance subsidiaries related to this agreement as
of September 30, 2004.
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.
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 no adverse
reserve development for the period from September 30, 1997 (date of inception)
through September 30, 2004.
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. The Quota Share Treaty was again renewed
on January 1, 2004 on substantially the same terms with an expiration date of
December 31, 2004; 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
exceeded 24% in any of the accident years 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
26
required annual premiums. As of September 30, 2004, the Company had billed and
received $54.9 million under the Stop Loss Contract, of which $29.9 million was
received in 2004.
The Excess of Loss Contract 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 provided $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
provided 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 for new 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 two previous
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.
Effective October 1, 2003, the Company entered into a $3 million excess of
$12 million contract with CCC. The reinsurance premium for the coverage provided
by the $3 million excess of $12 million contract was $0.3 million plus, if
applicable, additional premiums based on paid losses. The contract provided for
aggregate coverage of $12 million. This contract effectively lowered the
Company's net retention per principal 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 contract was to expire on December 31, 2004.
Effective January 1, 2004, the Company obtained replacement coverage from third
party reinsurers as part of the 2004 Excess of Loss Treaty.
Effective January 1, 2004, the Company obtained replacement coverage from
third party reinsurers as part of the 2004 Excess of Loss Treaty. Accordingly,
the $40 million excess of $60 million contract with CCC was commuted effective
January 1, 2004. As part of this commutation, the Company has received a
commutation payment of $10.9 million from CCC. As of December 31, 2003 the full
amount of the commutation payment had been recognized as a receivable. The
Company and CCC entered into a new $40 million excess of $60 million reinsurance
contract providing coverage exclusively for the one large national contractor
that is excluded from the Company's third party reinsurance. This contract is
effective from January 1, 2004 to December 31, 2004. The premium for this
contract is $3.0 million plus an additional premium if a loss is ceded under
this contract.
The reinsurance premium for the coverage provided by the $50 million excess
of $100 million contract was $6.0 million. This contract expired on December 31,
2003. The Company and CCC entered into a new $50 million excess of $100 million
contract for the period of January 1, 2004 to December 31, 2004. The premium for
this contract is $6.0 million plus an additional premium if a loss is ceded
under this contract.
LARGE NATIONAL CONTRACTOR
The Company has provided significant surety bond protection guaranteeing
projects undertaken by the large national contract principal that is excluded
from the Company's third party insurance. The related party reinsurance
available to the Company for this principal and the credit extended to the
principal by affiliates of the Company are described below.
If the Company should suffer any losses that are discovered prior to
September 30, 2005 arising from bonds issued to the contractor with effective
dates of September 30, 2002 and prior, the Company would retain the first $60
million of losses on bonds written, and CCC would incur 100% of losses above $60
million pursuant to the extended discovery provisions of the two Excess of Loss
treaties that expired on September 30, 2002. Any losses discovered after
September 30, 2005 on bonds with effective dates prior
27
to September 30, 2002 would be covered up to $150 million pursuant to the $50
million excess of $100 million contract with CCC described above and a twelve
month contract with CCC effective January 1, 2004 that provides $40 million
excess of $60 million reinsurance coverage exclusively for the national
contractor.
For bonds that the Company has written after September 30, 2003, in
addition to the coverage provided by excess of loss reinsurance treaties
described above ($40 million excess of $60 million and $50 million excess of
$100 million) the Company and CCC have entered into facultative reinsurance in
connection with larger bonds. The Company's exposure on bonds written from
October 1, 2002 through October 31, 2003 was limited to $20 million per bond.
For bonds written between November 1, 2003 and March 31, 2004, the Company's
exposure was $14.7 million. For bonds written subsequent to March 31, 2004, the
Company's exposure will be limited to the lesser of $20 million or 10% of
policyholders surplus.
The Company believes the run-off protection provided by the extended
discovery provisions of the expired agreements, the current protection provided
by the $40 million excess of $60 million and the $50 million excess of $100
million treaties, and the facultative reinsurance provided for larger bonds
written after September 30, 2002, should limit the Company's exposure for bonds
written on behalf of the national contractor to $60 million.
The Company has had discussions with its insurance regulatory authorities
regarding the level of bonds provided for this principal and will continue to
keep the insurance regulators informed of its ongoing exposure to this account.
CNAF CREDIT FACILITY
In December of 2002 and January of 2003, CNAF provided loans in an
aggregate amount of approximately $45 million to the national contractor. The
loans were provided by CNAF to help the contractor meet its liquidity needs. The
loans are evidenced by demand notes and until replaced by the credit facility
described below, accrue interest at 10%. In March 2003, CNAF entered into a
credit facility with the contractor under which CNAF has agreed to provide up to
$86 million of loans to the contractor and certain of its subsidiaries,
including the refinancing of the already advanced $45 million of credit
described above. The credit facility matures in March of 2006. CNAF has been
granted a security interest in substantially all of the assets of the contractor
to secure borrowings under the new credit facility. Loews, parent of CNAF, and
CNAF have entered into a participation agreement, pursuant to which Loews has
purchased a one-third participation share in CNAF's position in the credit
facility, on a dollar-for-dollar basis, up to a maximum of $25 million, plus
accrued interest. Although Loews does not have rights against the contractor
directly under the participation agreement, it shares recoveries and fees under
the facility on a proportional basis with CNAF.
In March of 2003, CNAF purchased the contractor's outstanding bank debt for
$16.4 million. The contractor purchased the bank debt and retired it, with $11.4
million of the purchase price being funded under the new credit facility and $5
million from money loaned to the contractor by its shareholders. Under its
purchase agreement with the banks, CNAF is also required to reimburse the banks
for any draws upon outstanding letters of credit issued by the banks for the
contractor's benefit. Letters of credit in the amount of $3 million are due to
expire in August of 2005. CNAF has also provided collateral for letters of
credit issued by another bank for the contractor's benefit in the aggregate
amount of $8 million. Any CNAF reimbursements for draws upon the banks' letters
of credit will become obligations of the contractor to CNAF as draws upon the
credit facility. As of September 30, 2004, CNAF had credit exposure of $61.1
million under the credit facility, net of participation by Loews, in the amount
of $24.1 million, for a total outstanding of $85.2 million.
As of March 31, 2004, the credit facility was amended to provide for
calculating the amount available for borrowing without regard to approximately
$1.1 million representing accrued interest on a bridge loan provided by CNAF
that became a borrowing under the facility; the elimination of the reduction in
CNAF's commitment upon receipt by the contractor of certain claim proceeds; and
an increase in the monthly compensation limits for the contractor's principals.
In connection with the amendment, the principals and an affiliate contributed $5
million in the aggregate to the contractor's capital by forgiving certain of the
contractor's indebtedness.
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. 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 the Company
believes that the contractor's restructuring efforts will be successful and
provide sufficient cash flow for its operations and for repayment of its
borrowings, the contractor's failure to achieve its restructuring plan could
have a material adverse effect on CNA Surety's future results of operations,
cash flow and capital. If such failures occur, the Company estimates that
possible losses, net of indemnification and subrogation recoveries, but before
recoveries
28
under reinsurance contracts, to be approximately $200 million. However, the
related party reinsurance treaties discussed above should limit the Company's
per principal exposure to approximately $60 million.
NET LOSS RATIO
The net loss ratio was 27.5% for the three months ended September 30, 2004
as compared with 144.7% for the same period in 2003 due to the absence of
adverse loss development which occurred during the third quarter of 2003. This
third quarter 2003 development included net adverse development on prior
accident years of $39.0 million (primarily relating to accident years 2001 and
2002), and net reserve additions in the quarter of approximately $49.0 million
for the current accident year due to material adverse loss severity on the
Company's branch commercial and contract business. The net loss ratio for the
three months ended September 30, 2004 included no loss development related to
prior years.
The net loss ratio was 27.5% for the nine months ended September 30, 2004
as compared with 67.0% for the same period in 2003. The decrease in the loss
ratio reflects the absence of adverse loss development which occurred during the
third quarter of 2003. The net loss ratio for the nine months ended September
30, 2004 included $0.6 million of net favorable loss development related to
prior years.
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. 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. As of October 28, 2004, the Company has billed a total of $37.1
million to its reinsurers. Six reinsurers responsible for payment of 61% of the
treaty proceeds either have paid their portions of the claim or have reached
agreement with the Company and have paid the Company to commute the entire
reinsurance treaty under which the Enron claim was made. Pursuant to the treaty,
the Company demanded and began arbitration proceedings against 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 not recorded a reduction with respect to
these reinsurance recoverables as of September 30, 2004.
EXPENSE RATIO
The expense ratio was 62.9% for the three months ended September 30, 2004
as compared with 62.8% for the same period in 2003. The expense ratio was 66.5%
for the nine months ended September 30, 2004 as compared with 62.5% for the same
period in 2003. The expense ratio for the first nine months of 2004 was
adversely impacted by the increase of the accrual for policyholder dividends and
costs related to the initiative to simplify and streamline the field
organization recorded in the first quarter of 2004.
EXPOSURE MANAGEMENT
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 continues
with various exposure management initiatives, particularly to reduce its risks
on large commercial accounts. "Exposure" is defined as the face amount of the
bond. As the following table depicts, the Company has reduced its exposure,
before the effects of reinsurance, by 36.7% in 2004 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 2004 2003 2004 2003 REDUCTION
--------------------------- --------------- ------------ ------------- ------------ ---------
$100 million and larger 2 7 $ 0.3 $ 0.9 66.6%
$50 to $100 million 7 8 0.5 0.6 16.7%
$25 to $50 million 13 13 0.4 0.5 20.0%
$10 to $25 million 45 66 0.7 1.0 30.0%
-- -- ------ -----
Total 67 94 $ 1.9 $ 3.0 36.7%
== == ====== =====
29
The company expects to continue to reduce its risks on large commercial
accounts, but the rate of this reduction is expected to slow.
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.
INVESTMENT INCOME
Net investment income was $7.7 million for the three months ended September
30, 2004, as compared with $6.4 million for the same period in 2003 due to an
increase in invested assets. The annualized pretax yields were 4.4% and 4.3% for
the three months ended September 30, 2004 and 2003, respectively. The annualized
after-tax yields were 3.6% and 3.6% for the three months ended September 30,
2004 and 2003. Net realized investment gains were $0.2 million for the three
months ended September 30, 2004. There were minimal net realized investment
gains in the third quarter of 2003.
Net investment income was $22.1 million for the nine months ended September
30, 2004 as compared with $19.8 million for the same period in 2003. The
increase reflects the impact of higher overall invested assets. The annualized
pretax yields were 4.4% and 4.5% for the nine months ended September 30, 2004
and 2003. The annualized after-tax yield was 3.7% and 3.7% for the nine months
ended September 30, 2004 and 2003, respectively. Net realized investment gains
were $2.5 million for the nine months ended September 30, 2004 as compared with
$1.8 million for the same period in 2003.
The following summarizes net realized investment gains (losses) activity:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- ---------------------------
2004 2003 2004 2003
----- -------- -------- --------
Gross realized investment gains......................... $ 194 $ 2 $ 2,481 $ 2,368
Gross realized investment losses........................ - (1) (5) (539)
----- -------- -------- --------
Net realized investment gains........................... $ 194 $ 1 $ 2,476 $ 1,829
===== ======== ======== ========
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.
ANALYSIS OF OTHER OPERATIONS
Interest expense increased by 78.5% for the three months ended September
30, 2004 as compared with the same period in 2003, due to the addition of $30.9
million of junior subordinated debentures discussed on page 31. Average debt
outstanding was $66.1 million for the three months ended September 30, 2004 as
compared with $55.2 million for the same period in 2003. The weighted average
interest rate for the three months ended September 30, 2004 was 3.8% as compared
with 2.3% for the same period in 2003.
Interest expense increased by 28.1% for the nine months ended September 30,
2004 as compared with the same period in 2003. Average debt outstanding was
$59.2 million for the nine months ended September 30, 2004 compared to $59.0
million in the same period in 2003. The weighted average interest rate for the
nine months ended September 30, 2004 was 3.3% as compared with 2.4% for the same
period in 2003.
30
INCOME TAXES
Income tax expense was $4.2 million for the three months ended September
30, 2004 compared to an income tax benefit of $30.1 million for the same period
in 2003. The effective income tax rates were 27.8% and 38.8% for the three
months ended September 30, 2004 and 2003, respectively. For the nine months
ended September 30, 2004, the Company's income tax expense was $9.7 million
compared to an income tax benefit of $21.4 million for the same period in 2003.
The effective income tax rates were 26.0% and 46.4%, respectively. The decreases
in the estimated effective tax rates for the three and nine months ended
September 30, 2004 as compared with the same periods in 2003 primarily relate to
increases in tax-exempt investment income as a proportion of taxable income.
LIQUIDITY AND CAPITAL RESOURCES
It is anticipated that the liquidity requirements of CNA Surety will be met
primarily with funds generated from its insurance operations. The principal
sources of consolidated 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, and debt service. 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, 2004, the carrying value of the Company's
insurance subsidiaries' invested assets was comprised of $661.4 million of fixed
income securities, $2.2 million of equities, $48.29 million of short-term
investments, $1.1 million of other investments and $5.3 million of cash. At
December 31, 2003, the carrying value of the Company's insurance subsidiaries'
invested assets was comprised of $573.7 million of fixed income securities,
$49.8 million of short-term investments, and $1.1 million of other investments
and $2.0 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 and pay operating
expenses, including income taxes. At September 30, 2004, the parent company's
invested assets consisted of $6.1 million of fixed income securities, $1.0
million of equity securities, $36.7 million of short-term investments and $3.3
million of cash. At December 31, 2003, the parent company's invested assets
consisted of $6.3 million of fixed income securities, $1.1 million of equity
securities, $14.1 million of short-term investments and $6.0 million of cash. At
September 30, 2004 and December 31, 2003 respectively, parent company short-term
investments and cash included $33.2 million and $7.3 million 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 $44.2 million for the three months ended September 30, 2004 compared to net
cash flow provided by operating activities of $23.2 million for the comparable
period in 2003.
The Company's consolidated net cash flow provided by operating activities
was $103.5 million for the nine months ended September 30, 2004 compared to net
cash flow used by operating activities of $2.6 million for the comparable period
in 2003. The increase in net cash flow provided by operating activities
primarily relates to a reduction of insurance receivables and income tax refunds
received in the current quarter ($18.0 million).
In May of 2004, the Company, through a wholly-owned trust, privately issued
$30.0 million of preferred securities through two pooled transactions. These
securities bear interest at a rate of LIBOR plus 337.5 basis points with a
30-year term and are redeemable after five years. The securities were issued by
CNA Surety Capital Trust I (the "Issuer Trust"). The assets of the Issuer Trust
consist of $30.9 million of junior subordinated debentures issued by the Company
to the Issuer Trust. The subordinated debentures bear interest at a rate of
LIBOR plus 337.5 basis points and mature in April of 2034. As of September 30,
2004 the interest rate on the junior subordinated debentures was 5.0863%. The
proceeds from the debt issuance were used to reduce the outstanding balance of
the Revolving Credit Facility by $10.0 million and to increase the statutory
surplus of the Company's insurance subsidiaries by $20.0 million.
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 $50.0 million in borrowings divided between
a revolving credit facility (the "Revolving Credit Facility") of $30.0 million
and a
31
term loan facility (the "Term Loan Facility") of $20.0 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 $10.0 million. Such increase is subject to consent
by each bank participating in the Revolving Credit Facility, 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 Facility which fixed the previously floating interest rate. As
a result, the effective interest rate on the term loan as of September 30, 2004
was 2.77%.
In June of 2004, the Company reduced the outstanding Revolving Credit
Facility by $10.0 million. In September of 2004, the Company increased the
outstanding Revolving Credit Facility by $5.0 million. The Term Loan Facility
balance was reduced by $20 million through September 30, 2004 according to the
scheduled amortization and payment schedules. Further amortization and payment
of the Term Loan Facility will take place at $10.0 million per year, in equal
semi-annual installments of $5.0 million on the following dates:
DATE AMORTIZATION OUTSTANDING BALANCE
---- ------------ --------------------
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 nine 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, 2004 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 Facility was 0.625% at September 30,
2004 and can vary based on CNA Surety's leverage ratio (debt to total
capitalization) from 0.48% to 0.80%. As of September 30, 2004, the weighted
average interest rate was 3.28% on the $35.0 million of outstanding borrowings.
As of December 31, 2003, the weighted average interest rate on the 2002 Credit
Facility was 2.4% on the $50.0 million of outstanding borrowings.
The 2002 Credit Facility contains, among other conditions, limitations on
CNA Surety with respect to the incurrence of additional indebtedness and
maintenance of a rating of at least "A" by A.M. Best 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. Due to the net loss reported
for the third quarter of 2003, the Company was in violation of the minimum fixed
charge coverage test. The lenders granted the Company a waiver for this
violation and amended the 2002 Credit Facility to replace the fixed charge
coverage ratio requirement for the next three quarters with a minimum earnings
requirement. At March 31, 2004, the Company was in violation of this minimum
earnings requirement and received a waiver for this requirement in the second
quarter of 2004. The Company is in compliance during the quarter ended September
30, 2004.
A summary of the Company's commitments as of September 30, 2004 is
presented in the following table (in millions):
THERE-
SEPTEMBER 30, 2004 2004 2005 2006 2007 2008 AFTER TOTAL
------------------ ------ ------- ------ ------ ----- ------ -------
Debt (a)............................................. $ 0.2 $ 35.0 $ -- $ -- $ -- $ 30.5 $ 65.7
Operating leases..................................... 0.4 1.5 1.4 1.1 1.0 3.7 9.1
Other long-term liabilities (b)...................... 0.4 1.7 0.4 0.4 0.5 5.7 9.1
------ ------- ------ ------ ----- ------ -------
Total................................................ $ 0.8 $ 38.2 $ 1.8 $ 1.5 $ 1.5 $ 40.1 $ 83.9
====== ======= ====== ====== ===== ====== =======
(a) Does not include original issue discount of $0.5 million.
(b) Reflects post-employment obligations to former executives and unfunded
post-retirement benefit plans.
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 Surety Bonding 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
32
(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 2004 is based on
statutory surplus and income at and for the year ended December 31, 2003.
Without prior regulatory approval, CNA Surety's insurance subsidiaries may pay
stockholder dividends of $19.0 million in the aggregate in 2004. CNA Surety did
not receive a dividend from its insurance subsidiaries during the first nine
months of 2004 and received a dividend of $28 million during the first nine
months of 2003.
Combined statutory surplus totaled $235.3 million at September 30, 2004,
resulting in a net written premium to statutory surplus ratio of 1.4 to 1.
Insurance regulations restrict Western Surety's maximum net retention on a
single surety bond to 10 percent of statutory surplus. Under the 2004 Excess of
Loss Treaty, the Company's net retention on new bonds would generally be $10
million plus a 5% co-participation in the $90 million layer of excess
reinsurance above the Company's retention and this regulation would require
minimum statutory surplus of $145.0 million at Western Surety. This surplus
constraint may limit the amount of future dividends Western Surety could
otherwise pay to CNA Surety.
In accordance with the provisions of intercompany tax sharing agreements
between CNA Surety and its subsidiaries, the tax of each subsidiary shall be
determined based upon each subsidiary's separate return liability. Intercompany
tax payments are made at such times when estimated tax payments would be
required by (or refunds received from) the Internal Revenue Service ("IRS"). CNA
Surety distributed tax payments of $12.5 million to and received $7.4 million
from its subsidiaries for the nine months ended September 30, 2004 and 2003,
respectively.
Western Surety and Surety Bonding each qualify as an acceptable surety for
federal and other public works project bonds pursuant to U.S. Department of
Treasury regulations. U.S. Treasury underwriting limitations are based on an
insurer's statutory surplus. Effective July 1, 2003 through June 30, 2004, the
underwriting limitations of Western Surety and Surety Bonding were $21.9 million
and $0.5 million. Effective July 1, 2004 through June 30, 2005, the underwriting
limitations of Western Surety and Surety Bonding are $18.5 million and $0.6
million. 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, 2004 through June 30, 2005, the
underwriting limitations of CCC and its affiliates totaled $591.1 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.
33
FINANCIAL CONDITION
INVESTMENT PORTFOLIO
The estimated fair value and amortized cost or cost of fixed income and
equity securities held by CNA Surety at September 30, 2004 and December 31,
2003, by investment category were as follows (dollars in thousands):
GROSS UNREALIZED LOSSES
AMORTIZED GROSS --------------------------- ESTIMATED
COST OR UNREALIZED LESS THAN 12 MORE THAN 12 FAIR
SEPTEMBER 30, 2004 COST GAINS MONTHS MONTHS VALUE
------------------ ------------ ---------- ------------ ------------ ----------
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury....................................... $ 21,167 $ 385 $ (1) $ -- $ 21,551
U.S. Agencies....................................... 4,579 42 (11) (55) 4,555
Collateralized mortgage obligations................. 18,132 509 (74) -- 18,567
Mortgage pass-through securities.................... 59,001 329 (306) -- 59,024
Obligations of states and political subdivisions....... 387,535 24,370 (268) (69) 411,568
Corporate bonds........................................ 106,503 5,035 (190) (2) 111,346
Non-agency collateralized mortgage obligations......... 4 1 -- -- 5
Other asset-backed securities:
Second mortgages/home equity loans................... 23,174 370 (2) -- 23,542
Credit card receivables.............................. 2,109 4 -- -- 2,113
Other................................................ 8,727 465 -- -- 9,192
Redeemable preferred stock............................. 5,356 709 -- -- 6,065
--------- -------- -------- ------- ---------
Total fixed income securities........................ 636,287 32,219 (852) (126) 667,528
Equity securities...................................... 3,059 93 -- -- 3,152
--------- -------- -------- ------- ---------
Total................................................ $ 639,346 $ 32,312 $ (852) $ (126) $ 670,680
========= ======== ======== ======= =========
GROSS UNREALIZED LOSSES
AMORTIZED GROSS --------------------------- ESTIMATED
COST OR UNREALIZED LESS THAN 12 MORE THAN 12 FAIR
DECEMBER 31, 2003 COST GAINS MONTHS MONTHS VALUE
----------------- ---------- ---------- ------------ ------------ ---------
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury......................................... $ 21,267 $ 497 $ -- $ -- $ 21,764
U.S. Agencies......................................... 4,587 47 (99) -- 4,535
Collateralized mortgage obligations................... 7,770 425 -- -- 8,195
Mortgage pass-through securities...................... 7,607 386 -- -- 7,993
Obligations of states and political subdivisions......... 376,961 25,604 (127) (27) 402,411
Corporate bonds.......................................... 96,525 7,322 (45) -- 103,802
Non-agency collateralized mortgage obligations........... 749 -- -- (22) 727
Other asset-backed securities:
Second mortgages/home equity loans..................... 5,721 426 -- -- 6,147
Credit card receivables................................ 5,000 51 -- -- 5,051
Other.................................................. 4,619 192 (13) -- 4,798
Redeemable preferred stock............................... 13,395 1,238 -- -- 14,633
--------- -------- ------ ----- ----------
Total fixed income securities.......................... 544,201 36,188 (284) (49) 580,056
Equity securities........................................ 992 69 -- -- 1,061
--------- -------- ------ ----- ----------
Total.................................................. $ 545,193 $ 36,257 $ (284) $ (49) $ 581,117
========= ======== ====== ===== ==========
34
The following table summarizes for fixed maturities in an unrealized loss
position at September 30, 2004, the aggregate fair value and gross unrealized
loss by length of time those securities have been continuously in an unrealized
loss position (dollars in thousands):
SEPTEMBER 30, 2004
GROSS
ESTIMATED UNREALIZED
UNREALIZED LOSS AGING FAIR VALUE LOSS
--------------------- ----------- -----------
Fixed maturity securities:
Investment grade:
0-12 months.................................................................. $ 89,380 $ 852
Greater than 12 months....................................................... 5,510 126
---------- --------
Total investment grade........................................................ $ 94,890 $ 978
---------- --------
A significant judgment in the valuation of investments is the determination
of when an other-than-temporary decline in value has occurred. The Company
follows a consistent and systematic process for impairing securities that
sustain other-than-temporary declines in value. The Company has established a
watch list that is reviewed by the Chief Financial Officer and two other
executive officers on at least a quarterly basis. The watch list includes
individual securities that fall below certain thresholds or that exhibit
evidence of impairment indicators including, but not limited to, a significant
adverse change in the financial condition and near term prospects of the
investment or a significant adverse change in legal factors, the business
climate or credit ratings.
When a security is placed on the watch list, it is monitored for further
market value changes and additional news related to the issuer's financial
condition. The focus is on objective evidence that may influence the evaluation
of impairment factors.
The decision to record an impairment loss incorporates both quantitative
criteria and qualitative information. The Company considers a number of factors
including, but not limited to: (a) the length of time and the extent to which
the market value has been less than book value, (b) the financial condition and
near term prospects of the issuer, (c) the intent and ability of the Company to
retain its investment for a period of time sufficient to allow for any
anticipated recovery in value, (d) whether the debtor is current on interest and
principal payments and (e) general market conditions and industry or sector
specific factors.
For securities for which an impairment loss has been recorded, the security
is written down to fair value and the resulting losses are recognized in
realized gains/losses in the Consolidated Statements of Operations.
For the three and nine months ended September 30, 2004 and for the year
ended December 31, 2003, the Company had no other-than-temporary impairments.
FORWARD-LOOKING STATEMENTS
This report includes a number of statements, which relate to anticipated
future events (forward-looking statements) rather than actual present conditions
or historical events. Forward-looking statements generally include words such as
"believes," "expects," "intends," "anticipates," "estimates," and similar
expressions. Forward-looking statements in this report include expected
developments in the Company's insurance business, including losses and loss
reserves; the impact of routine ongoing insurance reserve reviews being
conducted by the Company; the routine state regulatory examinations of the
Company's primary insurance company subsidiaries, and the Company's responses to
the results of those reviews and examinations; the Company's expectations
concerning its revenues, earnings, expenses and investment activities; expected
cost savings and other results from the Company's expense reduction and
restructuring activities; and the Company's proposed actions in response to
trends in its business.
Forward-looking statements, by their nature, are subject to a variety of
inherent risks and uncertainties that could cause actual results to differ
materially from the results projected. Many of these risks and uncertainties
cannot be controlled by the Company. Some examples of these risks and
uncertainties are:
- general economic and business conditions;
- changes in financial markets such as fluctuations in interest rates,
long-term periods of low interest rates, credit conditions and
currency, commodity and stock prices;
- the effects of corporate bankruptcies, such as Enron and WorldCom, on
surety bond claims, as well as on capital markets;
35
- changes in foreign or domestic political, social and economic
conditions;
- regulatory initiatives and compliance with governmental regulations,
judicial decisions, including interpretation of policy provisions,
decisions regarding coverage, trends in litigation and the outcome of
any litigation involving the Company, and rulings and changes in tax
laws and regulations;
- regulatory limitations, impositions and restrictions upon the Company,
including the effects of assessments and other surcharges for guaranty
funds and other mandatory pooling arrangements;
- the impact of competitive products, policies and pricing and the
competitive environment in which the Company operates, including
changes in the Company's books of business;
- product and policy availability and demand and market responses,
including the level of ability to obtain rate increases and decline or
non-renew underpriced accounts, to achieve premium targets and
profitability and to realize growth and retention estimates;
- development of claims and the impact on loss reserves, including
changes in claim settlement practices;
- the performance of reinsurance companies under reinsurance contracts
with the Company;
- results of financing efforts, including the availability of bank
credit facilities;
- the sufficiency of the Company's loss reserves and the possibility of
future increases in reserves;
- the risks and uncertainties associated with the Company's loss
reserves; and,
- the possibility of further changes in the Company's ratings by ratings
agencies, including the inability to access certain markets or
distribution channels and the required collateralization of future
payment obligations as a result of such changes, and changes in rating
agency policies and practices;
Any forward-looking statements made in this report are made by the Company
as of the date of this report. The Company does not have any obligation to
update or revise any forward-looking statement contained in this report, even if
the Company's expectations or any related events, conditions or circumstances
change.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES 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.
36
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, 2004. 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 tables.
ESTIMATED HYPOTHETICAL
HYPOTHETICAL FAIR VALUE PERCENTAGE
CHANGE IN AFTER INCREASE
FAIR VALUE AT INTEREST RATE HYPOTHETICAL (DECREASE) IN
SEPTEMBER 30, (BP=BASIS CHANGE IN STOCKHOLDERS'
(DOLLARS IN THOUSANDS) 2004 POINTS) INTEREST RATE EQUITY
---------------------- -------------- ---------------- ------------- -------------
Fixed Income Securities:
U.S. Government and government agencies and
authorities....................................... $ 103,697 200 bp increase $ 91,925 (1.8)%
100 bp increase 97,920 (0.9)
100 bp decrease 108,821 0.8
200 bp decrease 113,427 1.5
States, municipalities and political subdivisions.. 411,568 200 bp increase 361,362 (7.5)
100 bp increase 386,132 (3.8)
100 bp decrease 437,654 3.9
200 bp decrease 465,301 8.0
Corporate bonds and all other...................... 152,263 200 bp increase 138,536 (2.1)
--------------
100 bp increase 145,078 (1.1)
100 bp decrease 159,851 1.1
200 bp decrease 168,223 2.4
Total fixed income securities.................... $ 667,528 200 bp increase 591,823 (11.3)
==============
100 bp increase 629,130 (5.7)
100 bp decrease 706,326 5.8
200 bp decrease 746,951 11.9
ESTIMATED HYPOTHETICAL
HYPOTHETICAL FAIR VALUE PERCENTAGE
CHANGE IN AFTER INCREASE
FAIR VALUE AT INTEREST RATE HYPOTHETICAL (DECREASE) IN
DECEMBER 31, (BP=BASIS CHANGE IN STOCKHOLDERS'
(DOLLARS IN THOUSANDS) 2003 POINTS) INTEREST RATE EQUITY
---------------------- -------------- --------------- ------------- -------------
Fixed Income Securities:
U.S. Government and government agencies and
authorities...................................... $ 42,487 200 bp increase $ 37,563 (0.8)%
100 bp increase 40,119 (0.4)
100 bp decrease 44,471 0.3
200 bp decrease 46,343 0.6
States, municipalities and political subdivisions. 402,411 200 bp increase 349,291 (8.4)
100 bp increase 375,189 (4.3)
100 bp decrease 430,247 4.4
200 bp decrease 459,412 9.0
Corporate bonds and all other..................... 135,158 200 bp increase 124,301 (1.7)
--------------
100 bp increase 129,346 (0.9)
100 bp decrease 140,486 0.8
200 bp decrease 146,629 1.8
Total fixed income securities................... $ 580,056 200 bp increase 511,155 (10.9)
==============
100 bp increase 544,654 (5.6)
100 bp decrease 615,204 5.6
200 bp decrease 652,384 11.5
37
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains a system of disclosure controls and procedures which
are designed to ensure that information required to be disclosed by the Company
in reports that it files or submits to the Securities and Exchange Commission
under the Securities and Exchange Act of 1934, including this report, is
recorded, processed, summarized and reported on a timely basis. These disclosure
controls and procedures include controls and procedures designed to ensure that
information required to be disclosed under the Exchange Act is accumulated and
communicated to the Company's Management on a timely basis to allow decisions
regarding required disclosure.
The Company's principal executive officer and its principal financial
officer undertook an evaluation of the Company's disclosure controls and
procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d - 15(e)) as of
the end of the period covered by this report and concluded that the Company's
controls and procedures were effective.
There were no changes in the Company's internal control over financial
reporting that occurred during the Company's last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
CNA SURETY CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS - Information on the Company's legal proceedings is
set forth in Notes 4 and 7 of the Condensed Consolidated Financial
Statements included under Part 1, Item 1.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS - 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: -
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 2, 2004; CNA Surety Corporation Press Release issued on August 2,
2004.
August 10, 2004; CNA Surety Corporation Press Release issued on August 10,
2004.
38
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
---------------------------------------
John F. Welch
President and Chief Executive Officer
/s/ John F. Corcoran
----------------------------------------
John F. Corcoran
Vice President and Chief Financial Officer
Date: November 1, 2004
39
EXHIBIT INDEX
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.
40