FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2005
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:
43,143,297 shares of Common Stock, $.01 par value as of 4/25/2005.
1
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 March 31, 2005 and at December 31, 2004.................................. 4
Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2005 and 2004.................... 5
Condensed Consolidated Statements of Stockholders' Equity for the Three Months Ended March 31,
2005 and 2004..................................................................................................... 6
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2005 and 2004................ 7
Notes to Condensed Consolidated Financial Statements.............................................................. 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........................ 20
Item 3. Quantitative and Qualitative Disclosures About Market Risk................................................... 35
Item 4. Controls and Procedures...................................................................................... 37
PART II. OTHER INFORMATION: 37
Item 1. Legal Proceedings............................................................................................ 37
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.................................................. 37
Item 3. Defaults Upon Senior Securities.............................................................................. 37
Item 4. Submission of Matters to a Vote of Security Holders.......................................................... 37
Item 5. Other Information............................................................................................ 38
Item 6. Exhibits..................................................................................................... 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 March 31, 2005, and the related
condensed consolidated statements of income, stockholders' equity and cash flows
for the three-month periods ended March 31, 2005 and 2004. These interim
financial statements are the responsibility of the Corporation's management.
We conducted our reviews in accordance with the 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 the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheet of CNA Surety Corporation and subsidiaries as of December 31, 2004, and
the related consolidated statements of income, stockholders' equity, and cash
flows for the year then ended (not presented herein); and in our report dated
February 25, 2005, we expressed an unqualified opinion on those consolidated
financial statements. In our opinion, the information set forth in the
accompanying condensed consolidated balance sheet as of December 31, 2004 is
fairly stated, in all material respects, in relation to the consolidated balance
sheet from which it has been derived.
/s/ Deloitte & Touche LLP
Chicago, Illinois
May 2, 2005
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
MARCH 31, DECEMBER 31,
2005 2004
----------------------------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $646,629 and $698,374)................ $ 662,063 $ 728,338
Equity securities, at fair value (cost: $1,115 and $1,084).................................... 1,162 1,198
Short-term investments, at cost (approximates fair value)..................................... 79,723 28,457
Other investments, at fair value (cost: $1,056 and $1,058)................................... 1,056 1,058
------------- ------------
Total invested assets....................................................................... 744,004 759,051
Cash............................................................................................ 7,707 7,336
Deferred policy acquisition costs............................................................... 103,496 102,128
Insurance receivables:
Premiums, including $11,623 and $11,012 from affiliates (net of allowance for doubtful
accounts: $2,056 and $2,153)................................................................ 37,887 32,340
Reinsurance, including $3,261 and $5,364 from affiliates...................................... 97,047 98,874
Intangible assets (net of accumulated amortization: $25,523 and $25,523)...................... 138,785 138,785
Property and equipment, at cost (less accumulated depreciation and amortization: $22,216 and
$21,600).................................................................................... 15,325 15,358
Prepaid reinsurance premiums.................................................................... 12,853 7,955
Accrued investment income....................................................................... 8,266 8,891
Other assets.................................................................................... 2,649 3,776
------------- ------------
Total assets................................................................................ $ 1,168,019 $ 1,174,494
============= ============
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses.................................................... $ 357,350 $ 363,387
Unearned premiums............................................................................. 235,063 226,019
------------- ------------
Total reserves.............................................................................. 592,413 589,406
Debt............................................................................................ 60,513 65,488
Deferred income taxes, net...................................................................... 22,435 27,024
Current income taxes payable.................................................................... 6,320 3,491
Reinsurance and other payables to affiliates.................................................... 159 461
Accrued expenses................................................................................ 12,247 17,090
Other liabilities............................................................................... 21,796 25,163
------------- ------------
Total liabilities........................................................................... $ 715,883 $ 728,123
------------- ------------
Commitments and contingencies (See Notes 4, 5, 6, & 7)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,530 shares issued and
43,127 shares outstanding at March 31, 2005 and 44,423 shares issued and 43,015 shares
outstanding at December 31, 2004.............................................................. 445 444
Additional paid-in capital...................................................................... 257,124 255,996
Retained earnings............................................................................... 199,571 185,496
Accumulated other comprehensive income.......................................................... 10,062 19,551
Treasury stock, at cost......................................................................... (15,066) (15,116)
------------- ------------
Total stockholders' equity.................................................................. 452,136 446,371
------------- ------------
Total liabilities and stockholders' equity.................................................. $ 1,168,019 $ 1,174,494
============= ============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31
--------------------------
2005 2004
--------- -----------
Revenues:
Net earned premium.............................................. $ 80,563 $ 75,197
Net investment income........................................... 7,971 6,977
Net realized investment gains................................... 2,011 2,230
--------- -----------
Total revenues................................................ 90,545 84,404
--------- -----------
Expenses:
Net losses and loss adjustment expenses......................... 21,591 20,631
Net commissions, brokerage and other underwriting expenses...... 48,645 55,312
Interest expense................................................ 774 342
--------- -----------
Total expenses................................................ 71,010 76,285
--------- -----------
Income before income taxes........................................ 19,535 8,119
Income tax expense................................................ 5,460 1,745
--------- -----------
Net income........................................................ $ 14,075 $ 6,374
========= ===========
Earnings per common share......................................... $ 0.33 $ 0.15
========= ===========
Earnings per common share, assuming dilution...................... $ 0.33 $ 0.15
========= ===========
Weighted average shares outstanding............................... 43,076 42,991
========= ===========
Weighted average shares outstanding, assuming dilution............ 43,304 43,055
========= ===========
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, 2003............................................. 42,980 $ 444 $ 255,816
Comprehensive income:
Net income........................................................... -- -- -- $ 6,374
Other comprehensive income:
Change in unrealized gains on securities, after income taxes of
$803, net of reclassification adjustment of $1,549, after income
taxes of $834........................................................ -- -- -- 1,491
---------
Total comprehensive income.......................................... $ 7,865
=========
Issuance of treasury stock to employee stock purchase program.......... 7 -- (22)
Stock options exercised and other...................................... 6 -- 54
------ ------- ----------
Balance, March 31, 2004................................................ 42,993 $ 444 $ 255,848
====== ======= ==========
Balance, December 31, 2004............................................. 43,015 $ 444 $ 255,996
Comprehensive income:
Net income........................................................... -- -- -- $ 14,075
Other comprehensive income:
Change in unrealized gains on securities, after income taxes of
$5,109, net of reclassification adjustment of ($103), after income
taxes of $55 -- -- -- (9,489)
---------
Total comprehensive income.......................................... $ 4,586
=========
Issuance of treasury stock to employee stock purchase program.......... 5 -- (6)
Stock options exercised and other...................................... 107 1 1,134
------ ------- ----------
Balance, March 31, 2005................................................ 43,127 $ 445 $ 257,124
====== ======= ==========
ACCUMULATED
OTHER TREASURY TOTAL
RETAINED COMPREHENSIVE STOCK STOCKHOLDERS'
EARNINGS INCOME AT COST EQUITY
----------- ------------- ----------- -------------
Balance, December 31, 2003............................................. $ 145,786 $ 23,351 $ (15,256) $ 410,141
Comprehensive income:
Net income........................................................... 6,374 -- -- 6,374
Other comprehensive income:
Change in unrealized gains on securities, after income taxes of
$803, net of reclassification adjustment of $1,549, after income
taxes of $834........................................................ -- 1,491 -- 1,491
Issuance of treasury stock to employee stock purchase program.......... -- 78 56
Stock options exercised and other...................................... -- -- 54
----------- --------- ----------- -------------
Balance, March 31, 2004................................................ $ 152,160 $ 24,842 $ (15,178) $ 418,116
=========== ========= =========== =============
Balance, December 31, 2004............................................. $ 185,496 $ 19,551 $ (15,116) $ 446,371
Comprehensive income:
Net income........................................................... 14,075 -- -- 14,075
Other comprehensive income:
Change in unrealized gains on securities, after income taxes of
$5,109, net of reclassification adjustment of ($103), after
income taxes of $55.................................................. -- (9,489) -- (9,489)
Issuance of treasury stock to employee stock purchase program.......... -- 50 44
Stock options exercised and other...................................... -- -- 1,135
----------- --------- ----------- -------------
Balance, March 31, 2005................................................ $ 199,571 $ 10,062 $ (15,066) $ 452,136
=========== ========= =========== =============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
------------------------
2005 2004
---------- ----------
OPERATING ACTIVITIES:
Net income....................................................................... $ 14,075 $ 6,374
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization................................................... 1,138 1,150
Accretion of bond discount, net................................................. 760 668
Net realized investment gains................................................... (2,011) (2,230)
Changes in:
Insurance receivables........................................................... (3,720) 40,080
Reserve for unearned premiums................................................... 9,044 3,152
Reserve for unpaid losses and loss adjustment expenses.......................... (6,037) (1,214)
Deferred policy acquisition costs............................................... (1,368) (1,388)
Deferred income taxes, net...................................................... 519 800
Reinsurance and other payables to affiliates.................................... (302) 596
Prepaid reinsurance premiums.................................................... (4,898) (6,794)
Accrued expenses................................................................ (4,843) (1,034)
Other assets and liabilities.................................................... (175) 2,730
---------- ----------
Net cash provided by operating activities..................................... 2,532 42,890
---------- ----------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases....................................................................... (4,751) (100,359)
Maturities...................................................................... 15,818 9,368
Sales........................................................................... 41,338 26,915
Purchases of equity securities................................................... (41) (100)
Proceeds from the sale of equity securities...................................... 9 101
Changes in short-term investments................................................ (51,266) 24,831
Purchases of property and equipment.............................................. (1,042) (668)
Changes in receivables/payables for securities sold/purchased.................... 92 --
Other, net....................................................................... 1,503 (55)
---------- ----------
Net cash (used in) provided by investing activities........................... 1,660 (39,967)
---------- ----------
FINANCING ACTIVITIES:
Principal payments on debt....................................................... (5,000) (5,000)
Employee stock option exercises and other........................................ 1,129 28
Issuance of treasury stock to employee stock purchase plan....................... 50 78
---------- ----------
Net cash used in financing activities......................................... (3,821) (4,894)
---------- ----------
Increase (decrease) in cash........................................................ 371 (1,971)
Cash at beginning of period........................................................ 7,336 7,965
---------- ----------
Cash at end of period.............................................................. $ 7,707 $ 5,994
========== ==========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest......................................................................... $ 738 $ 334
Income taxes..................................................................... $ 2,112 $ --
The accompanying notes are an integral part of these condensed consolidated
financial statements.
7
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005
(UNAUDITED)
1. SIGNIFICANT ACCOUNTING POLICIES
FORMATION OF CNA SURETY CORPORATION AND MERGER
In December 1996, CNA Financial Corporation ("CNAF") and Capsure agreed to
merge (the "Merger") the surety business of CNAF with Capsure's insurance
subsidiaries, Western Surety Company ("Western Surety"), Surety Bonding Company
of America ("Surety Bonding") and Universal Surety of America ("USA"), into CNA
Surety. CNAF, through its operating subsidiaries, writes multiple lines of
property and casualty insurance, including surety business that is reinsured by
Western Surety. CNAF owns approximately 64% of the outstanding common stock of
CNA Surety. Loews Corporation ("Loews") owns approximately 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"). CIC was acquired by CNAF on May 10,
1995. The combined surety operations of CCC and CIC are referred to herein as
CCC Surety Operations.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of CNA Surety
and all majority-owned subsidiaries.
ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles ("GAAP") requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
BASIS OF PRESENTATION
These unaudited Condensed Consolidated Financial Statements should be read
in conjunction with the Consolidated Financial Statements and Notes thereto
included in the Company's 2004 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 2004 financial statements to conform with the presentation in
the 2005 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.
The computation of earnings per common share is as follows (amounts in
thousands, except for per share data):
8
THREE MONTHS ENDED
MARCH 31,
--------------------------
2005 2004
---------- ----------
Net income.............................................. $ 14,075 $ 6,374
========== ==========
Shares:
Weighted average shares outstanding..................... 43,015 42,980
Weighted average shares of options exercised and
additional stock issuance.......................... 61 11
---------- ----------
Total weighted average shares outstanding............... 43,076 42,991
Effect of dilutive options........................... 228 64
---------- ----------
Total weighted average shares outstanding, assuming
dilution............................................. 43,304 43,055
========== ==========
Earnings per share...................................... $ 0.33 $ 0.15
========== ==========
Earnings per share, assuming dilution................... $ 0.33 $ 0.15
========== ==========
No adjustments were made to reported net income in the computation of
earnings per share. Options to purchase shares of common stock of 0.5 million
for the three months ended March 31, 2005 and 1.0 million for the three months
ended March 31, 2004 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 and earnings 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
MARCH 31,
--------------------------
2005 2004
---------- ----------
Net income................................................ $ 14,075 $ 6,374
Less: Total stock based compensation cost
determined under the fair value method, net of tax...... (168) (70)
---------- ----------
Pro forma net income ..................................... $ 13,907 $ 6,304
========== ==========
Basic and diluted earnings per share, as reported......... $ 0.32 $ 0.15
========== ==========
Basic and diluted earnings per share, pro forma........... $ 0.32 $ 0.15
========== ==========
ACCOUNTING PRONOUNCEMENTS
In December of 2004, the FASB issued SFAS No. 123 (revised 2004),
"Share-Based Payment ("SFAS 123R"), that amends SFAS No. 123 ("SFAS 123"), as
originally issued in May of 1995. SFAS 123R addresses the accounting for
share-based payment transactions in which an enterprise receives employee
services in exchange for (a) equity instruments of the enterprise or (b)
liabilities that are based on the fair value of the enterprise's equity
instruments or that may be settled by the issuance of such equity instruments.
SFAS 123R supercedes APB No. 25, "Accounting for Stock Issued to Employees"
("APB No. 25"). After the effective date of this standard, entities will not be
permitted to use the intrinsic value method specified in APB 25 to measure
compensation expense and generally would be required to measure compensation
expense using a fair-value based method. Public companies are to apply this
standard using either the modified prospective method or the modified
retrospective method. The modified prospective method requires a company to (a)
record compensation expense for all awards it grants after the date it adopts
the standard and (b) record compensation expense for the unvested portion of
previously granted awards that remain outstanding at the date of adoption. The
modified retrospective method requires companies to record compensation expense
to either (a) all prior years for which SFAS 123 was effective (i.e. for all
fiscal years beginning after December 15, 2004) or (b) only to prior interim
periods in the year of initial adoption if the effective date of SFAS 123R does
not coincide with the beginning of the fiscal year. SFAS 123R is effective for
annual periods beginning after June 15, 2005. The SEC issued Staff Accounting
Bulletin ("SAB") No. 107 that provides implementation guidance on the adoption
of SFAS 123R. Adoption of this standard is not expected to have a
9
material impact on the Company's results of operations and/or equity.
2. INVESTMENTS
The estimated fair value and amortized cost or cost of fixed income and
equity securities held by CNA Surety at March 31, 2005 and December 31, 2004, by
investment category, were as follows (dollars in thousands):
GROSS UNREALIZED LOSSES
AMORTIZED GROSS --------------------------- ESTIMATED
COST UNREALIZED LESS THAN 12 MORE THAN 12 FAIR
MARCH 31, 2005 OR COST GAINS MONTHS MONTHS VALUE
----------------------------------------- --------- ---------- ------------ ------------ ---------
Fixed income securities:
U.S. Treasury securities and obligations
of U.S. Government and agencies:
U.S. Treasury......................... $ 17,255 $ 7 $ (162) $ -- $ 17,100
U.S. Agencies......................... 4,574 25 (69) (73) 4,457
Collateralized mortgage obligations... 18,391 538 (179) -- 18,750
Mortgage pass-through securities...... 54,369 155 (468) (314) 53,742
Obligations of states and political
subdivisions............................. 429,437 15,933 (1,205) (640) 443,525
Corporate bonds.......................... 84,258 2,452 (860) (6) 85,844
Non-agency collateralized mortgage
obligations.............................. 2,075 -- (39) -- 2,036
Other asset-backed securities:
Second mortgages/home equity loans.... 20,924 224 (207) -- 20,941
Other................................. 12,346 264 (109) -- 12,501
Redeemable preferred stock............... 3,000 167 -- -- 3,167
--------- ---------- ------------ ------------ ---------
Total fixed income securities......... 646,629 19,765 (3,298) (1,033) 662,063
Equity securities........................ 1,115 47 -- -- 1,162
--------- ---------- ------------ ------------ ---------
Total................................. $ 647,744 $ 19,812 $ (3,298) $ (1,033) $ 663,225
========= ========== ============ ============ =========
GROSS UNREALIZED LOSSES
AMORTIZED GROSS --------------------------- ESTIMATED
COST OR UNREALIZED LESS THAN 12 MORE THAN 12 FAIR
DECEMBER 31, 2004 COST GAINS MONTHS MONTHS VALUE
------------------------------------------ --------- ---------- ------------ ------------ ---------
Fixed income securities:
U.S. Treasury securities and obligations
of U.S. Government and agencies:
U.S. Treasury.......................... $ 55,818 $ 255 $ (39) $ -- $ 56,034
U.S. Agencies.......................... 4,576 39 (9) (49) 4,557
Collateralized mortgage obligations.... 18,260 590 (105) -- 18,745
Mortgage pass-through securities....... 56,696 325 (249) -- 56,772
Obligations of states and political
subdivisions.............................. 431,624 23,467 (387) (87) 454,617
Corporate bonds........................... 94,363 4,735 (27) (2) 99,069
Non-agency collateralized mortgage
obligations............................... 2,078 3 -- -- 2,081
Other asset-backed securities:
Second mortgages/home equity loans..... 20,942 241 (69) -- 21,114
Credit card receivables................ 867 -- -- -- 867
Other.................................. 7,794 391 -- -- 8,185
Redeemable preferred stock................ 5,356 941 -- -- 6,297
--------- ---------- ------------ ------------ ---------
Total fixed income securities.......... 698,374 30,987 (885) (138) 728,338
Equity securities......................... 1,084 114 -- -- 1,198
--------- ---------- ------------ ------------ ---------
Total.................................. $ 699,458 $ 31,101 $ (885) $ (138) $ 729,536
========= ========== ============ ============ =========
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
10
are reported as a component of other comprehensive income, exclusive of
other-than-temporary impairment losses, if any.
Invested assets are exposed to various risks, such as interest rate,
market and credit risks. 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 MARCH 31,
------------------------------------------------
2005 2004
----------------------- ----------------------
WRITTEN EARNED WRITTEN EARNED
----------- -------- ---------- ---------
Direct......................... $ 77,929 $ 65,260 $ 66,070 $ 48,835
Assumed........................ 25,364 28,988 29,809 43,893
Ceded.......................... (18,583) (13,685) (24,325) (17,531)
----------- -------- ---------- ---------
$ 84,710 $ 80,563 $ 71,554 $ 75,197
=========== ======== ========== =========
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 MARCH 31,
-------------------------------------
2005 2004
------------------ ----------------
$ RATIO $ RATIO
---------- ----- -------- -----
Gross losses and loss adjustment expenses.... $ 28,611 30.4% $ 23,336 25.2%
Ceded amounts................................ (7,020) 51.3% (2,705) 15.4%
---------- --------
Net losses and loss adjustment expenses...... $ 21,591 26.8% $ 20,631 27.4%
========== ========
2005 THIRD PARTY REINSURANCE COMPARED TO 2004 THIRD PARTY REINSURANCE
Effective January 1, 2005, CNA Surety entered into a new excess of loss
treaty ("2005 Excess of Loss Treaty") with a group of third party reinsurers on
terms similar to the 2004 Excess of Loss Treaty. Under the 2005 Excess of Loss
Treaty, the Company's net retention per principal remains at $10 million with a
5% co-participation in the $90 million layer of third party reinsurance coverage
above the Company's retention. The significant differences between the 2005
Excess of Loss Treaty and the Company's 2004 Excess of Loss Treaty are as
follows. The annual aggregate coverage increases from $157 million in 2004 to
$185 million in 2005. The base annual premium for the 2005 Excess of Loss Treaty
is $40.7 million compared to the actual cost of the 2004 Excess of Loss Treaty
of $50.6 million (net of expected return premium). The contract again includes
an optional twelve month extended discovery period, for an additional premium (a
percentage of the original premium based on any unexhausted aggregate limit by
layer) which will provide coverage for losses discovered in 2006 on bonds that
were in force during 2005. In addition, the 2005 Excess of Loss Treaty provides
coverage for one commercial principal that had been excluded from the 2004
Excess of Loss Treaty. The Company no longer has exposure to a second commercial
principal that was excluded from the 2004 Excess of Loss Treaty. Only the large
national contractor (described later) that was excluded from the 2004 Excess of
Loss Treaty remains excluded from the 2005 Excess of Loss Treaty.
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.
11
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, 2005 and
expires on December 31, 2005 and is annually renewable thereafter. There was no
amount due to the CNA Surety insurance subsidiaries as of March 31, 2005.
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. The
Quota Share Treaty was renewed on January 1, 2005 and expires on December 31,
2005 and is annually renewable thereafter. 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
25% of net written premiums written on such business. This contemplates an
approximate 4% override commission for fronting fees to CCC and CIC on their
actual direct acquisition costs.
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. The ceding commission paid to CCC and CIC by Western Surety
remained at 28% of net written premiums. Due to lower commissions paid to
producers on the business covered by the Quota Share Treaty, the actual override
commission paid to CCC and CIC for 2004 was approximately 7%.
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 March 31, 2005.
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 required annual premiums. As of March 31, 2005, the Company had
billed and received $54.9 million under the Stop Loss Contract, of which $29.9
million was received in 2004. No amounts were billed or received in 2005.
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. On January 1, 2005, CCC agreed to
12
extend the original discovery period from September 30, 2005 to September 30,
2006, in return for an additional premium of $75,000.
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 and the $3 million excess of $12
million contract with CCC were commuted effective January 1, 2004. As part of
the commutation of the $40 million excess of $60 million contract, the Company
received a commutation payment of $10.9 million from CCC in the first quarter of
2004. 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 was effective from January 1,
2004 to December 31, 2004. The premium for this contract was $3.0 million plus
an additional premium of $6.0 million if a loss is ceded under this contract.
The Company and CCC entered into a new contract covering the large national
contractor effective January 1, 2005 to December 31, 2005 on the same terms as
the 2004 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 was $6.0 million plus an additional premium if a
loss is ceded under this contract. Effective January 1, 2005, the Company and
CCC entered into a new $50 million excess of $100 million contract in force
through December 31, 2005. The premium for this contract is $4.75 million plus
an additional premium of $14.0 million if a loss is ceded under this contract.
As of March 31, 2005 and December 31, 2004, CNA Surety had an insurance
receivable balance from CCC and CIC of $14.9 million and $16.4 million. CNA
Surety had no reinsurance payables to CCC and CIC as of March 31, 2005 and
reinsurance payables of $0.3 million to CCC and CIC as of December 31, 2004.
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, 2006 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
13
discovered after September 30, 2006 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, 2005 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 December 31, 2004, the Company's
exposure was $14.7 million. For bonds written subsequent to December 31, 2004,
the Company's exposure will be limited to 10% of policyholders surplus.
CNAF CREDIT FACILITY
Commencing in 2003, CNAF has provided loans through a credit facility in
order to help the large national contractor meet its liquidity needs and
complete projects which had been bonded by CNA Surety. In December of 2004, the
credit facility was amended to increase the maximum available loans to $106
million from $86 million at December 31, 2003. The amendment also provides that
CNAF may at its sole discretion further increase the amounts available for loans
under the credit facility, up to an aggregate maximum of $126 million. As of
March 31, 2005 and 2004, $112 million and $90 million had been advanced under
the credit facility. Loews, through a participation agreement with CNAF,
provided funds for and owned a participation of $32.9 million and $25.7 million
of the loans outstanding as of March 31, 2005 and 2004, respectively, and has
agreed to a participation of one-third of any additional loans which may be made
above the original $86 million credit facility limit up to the $126 million
maximum available line.
Loans under the credit facility are secured by a pledge of substantially
all of the assets of the contractor and certain of its affiliates. In connection
with the credit facility, CNAF has also guaranteed or provided collateral for
letters of credit which are charged against the maximum available line and, if
drawn upon, would be treated as loans under the credit facility. As of both
March 31, 2005 and December 31, 2004, these guarantees and collateral
obligations aggregated $13 million.
The contractor implemented a restructuring plan intended to reduce costs
and improve cash flow, and appointed a chief restructuring officer to manage
execution of the plan. In the course of addressing various expense, operational
and strategic issues, however, the contractor has decided to substantially
reduce the scope of its original business and to concentrate on those segments
determined to be potentially profitable. As a consequence, operating cash flow,
and in turn the capacity to service debt, has been reduced below previous
levels. Restructuring plans have also been extended to accommodate these
circumstances. In light of these developments, CNAF recorded an impairment
charge of $56 million pretax ($36 million after-tax) for the fourth quarter of
2004, net of the participation by Loews, with respect to amounts loaned under
the credit facility. In addition, CNAF indicated that any draws under the credit
facility beyond $106 million or further changes in the large national
contractor's business plan or projections may necessitate further impairment
charges. CNAF has since agreed to extend the credit facility to $126 million and
has recorded an additional impairment charge of $13.3 million pre-tax ($8.7
million after tax), net of the participation by Loews, for the first quarter of
2005.
The Company intends to continue to provide surety bonds on behalf of the
contractor during the restructuring period, subject to the contractor's initial
and ongoing compliance with the Company'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,
the contractor's failure to achieve its extended restructuring plan or perform
its contractual obligations under the Company's surety bonds could have a
material adverse effect on CNA Surety's results of operations, cash flow and
equity. 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 pretax. However, the
related party reinsurance treaties discussed above would limit the Company's
per principal loss exposure to approximately $60 million.
14
4. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the reserves for unpaid losses and loss adjustment expenses
was as follows (dollars in thousands):
THREE MONTHS ENDED
MARCH 31,
---------------------------
2005 2004
----------- -----------
Reserves at beginning of period:
Gross................................................... $ 363,387 $ 413,539
Ceded reinsurance....................................... 116,831 158,357
----------- -----------
Net reserves at beginning of period................... 246,556 255,182
----------- -----------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period........ 21,591 20,918
Increase (decrease) in provision for insured events
of prior periods..................................... -- (287)
----------- -----------
Total net incurred................................... 21,591 20,631
----------- -----------
Net payments attributable to:
Current period events................................. 162 483
Prior period events................................... 29,795 22,682
----------- -----------
Total net payments................................... 29,957 23,165
----------- -----------
Net reserves at end of period........................... 238,190 252,648
Ceded reinsurance at end of period...................... 119,160 159,677
----------- -----------
Gross reserves at end of period...................... $ 357,350 $ 412,325
=========== ===========
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 ("Enron") 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 March 31, 2005, the Company billed a total of $37.1
million to its reinsurers. All nine reinsurers responsible for payment of the
treaty proceeds either have paid their portions of the claim or have reached
agreement with the Company to commute the entire reinsurance treaty under which
the Enron claim was made. The final two reinsurers agreed to commute the treaty
after March 31, 2005. All parties have executed the commutation agreements and
the Company expects to receive the proceeds from these commutations before May
15, 2005. As such, the Company has not recorded a reduction with respect to
these reinsurance recoverables as of March 31, 2005.
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 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 March 31, 2005 the interest
rate on the junior subordinated debenture was 6.17%
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
15
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 March 31,
2005 was 2.78%.
As of March 31, 2005 and December 31, 2004, the outstanding Revolving
Credit Facility balance was $25.0 million. The Term Loan Facility balance was
reduced by $5.0 million to $5.0 million during the three months ended March 31,
2005 according to scheduled amortization and payment schedules. The Term Loan
facility balance was $10 million at December 31, 2004. Final amortization and
payment of the remaining $5.0 million principal of the Term Loan Facility will
take place on September 30, 2005. No other debt matures in the next five years.
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 March 31, 2005 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 March 31, 2005 and can vary based on CNA
Surety's leverage ratio (debt to total capitalization) from 0.48% to 0.80%. As
of March 31, 2005, the weighted average interest rate was 4.15% on the $30.0
million of outstanding borrowings. As of December 31, 2004, the weighted average
interest rate on the 2002 Credit Facility was 3.28% on the $35.0 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. 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
with all covenants during the quarter ended March 31, 2005.
6. EMPLOYEE BENEFITS
CNA Surety established the CNA Surety Corporation Deferred Compensation
Plan ("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.
On April 25, 2005, the Board of Directors of CNA Surety Corporation
approved the CNA Surety Corporation 2005 Deferred Compensation Plan (the "Plan")
and the CNA Surety Corporation 2005 Deferred Compensation Plan Trust (the
"Trust"). The Plan and Trust were adopted in connection with the enactment of
Section 409A of the Internal Revenue Code of 1986, as amended (the "Code"),
which was implemented under the American Jobs Creation Act of 2004. The Plan and
Trust will be used in lieu of the CNA Surety Corporation Deferred Compensation
Plan (the "Existing Plan") and the CNA Surety Corporation Deferred Compensation
Plan Trust (the "Existing Trust") for all amounts deferred on or after January
1, 2005. Amounts deferred under the Existing Plan prior to January 1, 2005 will
continue to be covered by and paid out in accordance with the terms of the
Existing Plan, the Existing Trust and the elections made by participants under
the Existing Plan.
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. There were no
plan assets for either of the postretirement benefit plans.
16
The plans' combined net periodic postretirement benefit cost for the three
months ended March 31, 2005 and 2004 included the following components (amounts
in thousands):
THREE MONTHS ENDED
MARCH 31,
----------------------
2005 2004
------ ------
Net periodic benefit cost:
Service cost......................... $ 37 $ 42
Interest cost........................ 75 88
Prior service cost................... (41) (37)
Recognized net actuarial loss........ -- 4
------ ------
Net periodic benefit cost............ $ 71 $ 97
====== ======
The Company expects to contribute $0.2 million to the postretirement
benefit plans to pay benefits in 2005. As of March 31, 2005, $0.1 million of
contributions have been made to the postretirement benefit plans.
As of December 31, 2004, the financial statements of the Company reflect
the effects of the Medicare Modernization Act ("MMA") on the Western Surety
retiree medical plan in accordance with FASB Staff Position 106-2. Western
Surety is expected to receive a direct subsidy under MMA which is treated as a
reduction in expected net benefit payments. The estimated effect on annual
benefit cost in 2005 is a reduction in service cost of $38,000, a reduction in
interest cost of $73,000, and an increase in the amortization of unrecognized
gains of $26,000, for a total reduction in annual net periodic postretirement
benefit cost of $137,000.
7. COMMITMENTS AND CONTINGENCIES
The Company is party to various lawsuits arising in the normal course of
business, some seeking material damages. The Company believes the resolution of
these lawsuits will not have a material adverse effect on its financial
condition or its results of operations.
17
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 of this Quarterly Report on Form 10-Q
and the Company's Annual Report on Form 10-K for the year ended December 31,
2004.
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, intangible assets, and
deferred policy acquisition costs. 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 balances 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.
18
RESERVES FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES AND REINSURANCE
CNA Surety accrues liabilities for unpaid losses and loss adjustment
expenses ("LAE") 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.
Reported claims are in various stages of the settlement process. Due to
the nature of surety, which is the relationship among three parties whereby the
surety guarantees the performance of the principal to a third party (the
obligee), the investigation of claims and the establishment of case estimates on
claim files can be a complex process that can occur over a period of time
depending on the type of bond(s) and the facts and circumstances involving the
particular bond(s), the claim(s) and the principal. Case reserves are typically
established after a claim is filed and an investigation and analysis has been
conducted as to the validity of the claim, the principal's response to the claim
and the principal's financial viability. To the extent it is determined that
there are no bona fide defenses to the claim and the principal is unwilling or
financially unable to resolve the claim, a case estimate is established on the
claim file for the amount the Company estimates it will have to pay to honor its
obligations under the provisions of the bond(s).
While the Company intends to establish initial case reserve estimates that
are sufficient to cover the ultimate anticipated loss on a file, some estimates
need to be adjusted during the life cycle of the file as matters continue to
develop. Factors that can necessitate case estimate increases or decreases are
the complexity of the bond(s) and/or underlying contract(s), if additional
and/or unexpected claims are filed, if the financial condition of the principal
or obligee changes or as claims develop and more information is discovered that
was unknown and/or unexpected at the time the initial case reserve estimate was
established. Ultimately, claims are resolved through payment and/or a
determination that, based on the information available, a case reserve is no
longer required.
As of any balance sheet date, not all claims have 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 ("IBNR")
claims. The following table shows the estimated liability as of March 31, 2005
for unpaid claims applicable to reported claims and to IBNR (dollars in
thousands) for each sub-line of business:
GROSS CASE LOSS GROSS IBNR LOSS TOTAL GROSS
AND LAE RESERVES AND LAE RESERVES RESERVES
---------------- ---------------- ------------
Contract..................... $ 46,301 $ 85,840 $ 132,141
Commercial................... 106,460 105,655 212,115
Fidelity and other........... 4,604 8,490 13,094
--------- ----------- ----------
Total........................ $ 157,365 $ 199,985 $ 357,350
========= =========== ==========
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.
The Company's Consolidated Balance Sheet includes estimated liabilities
for unpaid losses and loss adjustment expenses of $357.4 million and $363.4
million and reinsurance receivables related to unpaid losses of $119.2 million
and $116.8 million at March 31, 2005 and December 31, 2004, respectively. 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 and financial condition. Future effects
from changes in these estimates will be recorded 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
19
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 other comprehensive income.
Cash flows from purchases, sales and maturities are reported gross in the
investing activities section of the Condensed Consolidated Statements of Cash
Flows.
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.
INTANGIBLE ASSETS
CNA Surety's Condensed Consolidated Balance Sheet as of March 31, 2005
includes intangible assets 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.
A significant amount of judgment is required in performing intangible
assets 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 intangible assets. The excess of the
recorded amount of intangible assets over the implied value of intangible assets
is recorded as an impairment loss.
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. The Company
periodically tests that deferred acquisition costs are recoverable based on the
expected profitability embedded in the reserve for unearned premium. If the
expected profitability is less than the balance of deferred acquisition costs, a
charge to net income is taken and the deferred acquisition cost balance is
reduced to the amount determined to be recoverable. Anticipated investment
income is considered in the determination of the recoverability of deferred
acquisition costs
20
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 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.
21
COMPARISON OF CNA SURETY RESULTS
FOR THE THREE MONTHS ENDED
MARCH 31, 2005 AND 2004
ANALYSIS OF NET INCOME
Net income for the three months ended March 31, 2005 was $14.1 million,
compared to a net income of $6.4 million for the same period in 2004. This
increase is a result of higher net earned premium, higher net investment income,
and lower underwriting expenses.
The components of net income are discussed in the following sections.
RESULTS OF INSURANCE OPERATIONS
Underwriting components for the Company for the three months ended March
31, 2005 and 2004 are summarized in the following table (dollars in thousands):
THREE MONTHS ENDED
MARCH 31,
2005 2004
----------- -----------
Gross written premiums............................. $ 103,293 $ 95,879
=========== ===========
Net written premiums............................... $ 84,710 $ 71,554
=========== ===========
Net earned premiums................................ $ 80,563 $ 75,197
=========== ===========
Net losses and loss adjustment expenses............ $ 21,591 $ 20,631
=========== ===========
Net commissions, brokerage and other expenses...... $ 48,645 $ 55,312
=========== ===========
Loss ratio......................................... 26.8% 27.4%
Expense ratio...................................... 60.4 73.6
----------- -----------
Combined ratio..................................... 87.2% 101.0%
=========== ===========
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.
The Company assumes significant amounts of premiums primarily from
affiliates. This includes all surety business written or renewed, net of
reinsurance, by CCC and CIC, and their affiliates, after the Merger Date that is
reinsured by Western Surety pursuant to reinsurance and related agreements.
Because of certain regulatory restrictions that limit the Company's ability to
write business on a direct basis, the Company continues to utilize the
underwriting capacity available through these agreements. The Company is in full
control of all aspects of the underwriting and claim management of the assumed
business.
Gross written premiums are summarized in the following table (dollars in
thousands):
THREE MONTHS ENDED
MARCH 31,
2005 2004
----------- -----------
Contract....................................... $ 56,271 $ 49,787
Commercial..................................... 37,213 37,331
Fidelity and other............................. 9,809 8,761
----------- ----------
$ 103,293 $ 95,879
=========== ==========
22
Gross written premiums increased 7.7 percent to $103.3 million, for the
three months ended March 31, 2005 as compared with the same period in 2004.
Contract surety gross written premiums increased 13.0 percent to $56.3 million
due primarily to increased volume. Commercial surety gross written premiums
decreased 0.3 percent to $37.2 million as continued volume growth in small
commercial products was more than offset by declining premiums on large
commercial accounts. Fidelity and other premiums increased by 6.5% primarily due
to the volume growth of related small commercial products.
Net written premiums are summarized in the following table (dollars in
thousands):
THREE MONTHS ENDED MARCH 31,
2005 2004
---------- -----------
Contract............... $ 40,052 $ 33,903
Commercial............. 34,849 29,269
Fidelity and other..... 9,809 8,382
---------- ----------
$ 84,710 $ 71,554
========== ==========
Net written premiums increased 18.4%, or $13.2 million, for the three
months ended March 31, 2005 as compared with the same period in 2004, driven by
the increase in gross written premiums as described above and a decrease in
ceded written premiums. Ceded written premiums decreased $5.7 million for the
three months ended March 31, 2005 as compared with the same period in 2004,
reflecting the reduction in the cost of the Company's 2005 reinsurance program.
EXCESS OF LOSS REINSURANCE
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.
2005 THIRD PARTY REINSURANCE COMPARED TO 2004 THIRD PARTY REINSURANCE
Effective January 1, 2005, CNA Surety entered into a new excess of loss
treaty ("2005 Excess of Loss Treaty") with a group of third party reinsurers on
terms similar to the 2004 Excess of Loss Treaty. Under the 2005 Excess of Loss
Treaty, the Company's net retention per principal remains at $10 million with a
5% co-participation in the $90 million layer of third party reinsurance coverage
above the Company's retention. The significant differences between the 2005
Excess of Loss Treaty and the Company's 2004 Excess of Loss Treaty are as
follows. The annual aggregate coverage increases from $157 million in 2004 to
$185 million in 2005. The base annual premium for the 2005 Excess of Loss Treaty
is $40.7 million compared to the actual cost of the 2004 Excess of Loss Treaty
of $50.6 million (net of expected return premium). The contract again includes
an optional twelve month extended discovery period, for an additional premium (a
percentage of the original premium based on any unexhausted aggregate limit by
layer) which will provide coverage for losses discovered in 2006 on bonds that
were in force during 2005. In addition, the 2005 Excess of Loss Treaty provides
coverage for one commercial principal that had been excluded from the 2004
Excess of Loss Treaty. The Company no longer has exposure to a second commercial
principal that was excluded from the 2004 Excess of Loss Treaty. Only the large
national contractor (described later) that was excluded from the 2004 Excess of
Loss Treaty remains excluded from the 2005 Excess of Loss Treaty.
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
23
services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. This
agreement was renewed on January 1, 2005 and expires on December 31, 2005 and is
annually renewable thereafter. There was no amount due to the CNA Surety
insurance subsidiaries related to this agreement as of March 31, 2005.
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. The
Quota Share Treaty was renewed on January 1, 2005 and expires on December 31,
2005 and is annually renewable thereafter. 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
25% of net written premiums written on such business. This contemplates an
approximate 4% override commission for fronting fees to CCC and CIC on their
actual direct acquisition costs.
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. The ceding commission paid to CCC and CIC by Western Surety
remained at 28% of net written premiums. Due to lower commissions paid to
producers on the business covered by the Quota Share Treaty, the actual override
commission paid to CCC and CIC for 2004 was approximately 7%.
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 March 31, 2005.
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 required annual premiums. As of March 31, 2005, the Company had
billed and received $54.9 million under the Stop Loss Contract, of which $29.9
million was received in 2004. No amounts were billed or received in 2005.
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. On January 1, 2005, CCC agreed to extend the original
discovery period from September 30, 2005 to September 30, 2006, in return for an
additional premium of $75,000.
24
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 and the $3 million excess of $12
million contract with CCC were commuted effective January 1, 2004. As part of
the commutation of the $40 excess of $60 million contract, the Company received
a commutation payment of $10.9 million from CCC in the first quarter of 2004.
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 was effective from January 1, 2004 to December 31, 2004. The premium
for this contract was $3.0 million plus an additional premium of $6.0 million if
a loss is ceded under this contract. The Company and CCC entered into a new
contract covering the large national contractor effective January 1, 2005 to
December 31, 2005 on the same terms as the 2004 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 was $6.0 million plus an additional premium if a
loss is ceded under this contract. Effective January 1, 2005, the Company and
CCC entered into a new $50 million excess of $100 million contract in force
through December 31, 2005. The premium for this contract is $4.75 million plus
an additional premium of $14.0 million if a loss is ceded under this contract.
The Company and CCC are presently discussing a possible restructuring of
the reinsurance arrangements described in the preceding two paragraphs under
which all bonds written for the large national contractor would be reinsured by
CCC under an excess of $60 million treaty and other CNA Surety accounts would be
covered by a separate $50 million excess of $100 million treaty.
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, 2006 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, 2006 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
25
month contract with CCC effective January 1, 2005 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 December 31, 2004, the Company's
exposure was $14.7 million. For bonds written subsequent to December 31, 2004,
the Company's exposure will be limited to 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.
CNAF CREDIT FACILITY
Commencing in 2003, CNAF has provided loans through a credit facility in
order to help the large national contractor meet its liquidity needs and
complete projects which had been bonded by CNA Surety. In December of 2004, the
credit facility was amended to increase the maximum available loans to $106
million from $86 million at December 31, 2003. The amendment also provides that
CNAF may in its sole discretion further increase the amounts available for loans
under the credit facility, up to an aggregate maximum of $126 million. As of
March 31, 2005 and 2004, $112 million and $90 million had been advanced under
the credit facility. Loews, through a participation agreement with CNAF,
provided funds for and owned a participation of $32.9 million and $25.7 million
of the loans outstanding as of March 31, 2005 and 2004, respectively, and has
agreed to a participation of one-third of any additional loans which may be made
above the original $86 million credit facility limit up to the $126 million
maximum available line.
Loans under the credit facility are secured by a pledge of substantially
all of the assets of the contractor and certain of its affiliates. In connection
with the credit facility, CNAF has also guaranteed or provided collateral for
letters of credit which are charged against the maximum available line and, if
drawn upon, would be treated as loans under the credit facility. As of March 31,
2005 and December 31, 2004, these guarantees and collateral obligations
aggregated $13 million.
The contractor implemented a restructuring plan intended to reduce costs
and improve cash flow, and appointed a chief restructuring officer to manage
execution of the plan. In the course of addressing various expense, operational
and strategic issues, however, the contractor has decided to substantially
reduce the scope of its original business and to concentrate on those segments
determined to be potentially profitable. As a consequence, operating cash flow,
and in turn the capacity to service debt, has been reduced below previous
levels. Restructuring plans have also been extended to accommodate these
circumstances. In light of these developments, CNAF recorded an impairment
charge of $56 million pretax ($36 million after-tax) for the fourth quarter of
2004, net of the participation by Loews, with respect to amounts loaned under
the credit facility. In addition, CNAF indicated that any draws under the credit
facility beyond $106 million or further changes in the large national
contractor's business plan or projections may necessitate further impairment
charges. CNAF has since agreed to extend the credit facility to $126 million and
has recorded an additional impairment charge of $13.3 million pre-tax ($8.7
million after tax), net of the participation by Loews, for the first quarter of
2005.
The Company intends to continue to provide surety bonds on behalf of the
contractor during the restructuring period, subject to the contractor's initial
and ongoing compliance with the Company'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,
the contractor's failure to achieve its extended restructuring plan or perform
its contractual obligations under the Company's surety bonds could have a
material adverse effect on CNA Surety's results of operations, cash flow and
equity. If such failures occur, the Company estimates that possible losses, net
of indemnification and subrogation recoveries, but before
26
recoveries under reinsurance contracts, to be approximately $200 million pretax.
However, the related party reinsurance treaties discussed above would limit the
Company's per principal loss exposure to approximately $60 million. After
consideration of the additional premium due in the event of losses under the
reinsurance treaties discussed above, the Company estimates that the financial
statement impact of a failure by this contractor would be approximately $52
million after tax.
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.
NET LOSS RATIO
The net loss ratio was 26.8% for the three months ended March 31, 2005 as
compared with 27.4% for the same period in 2004. The increase in net earned
premium that resulted from the reductions in the cost of the Company's 2005
reinsurance program drove the improvement in the loss ratio. The net loss ratio
for the three months ended March 31, 2005 included no 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 ("Enron") 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 March 31, 2005, the Company billed a total of $37.1
million to its reinsurers. All nine reinsurers responsible for payment of the
treaty proceeds either have paid their portions of the claim or have reached
agreement with the Company to commute the entire reinsurance treaty under which
the Enron claim was made. The final two reinsurers agreed to commute the treaty
after March 31, 2005. All parties have executed the commutation agreements and
the Company expects to receive the proceeds from these commutations before
May 15, 2005. As such, the Company has not recorded a reduction with respect to
these reinsurance recoverables as of March 31, 2005.
EXPENSE RATIO
The expense ratio was 60.4% for the three months ended March 31, 2005 as
compared with 73.6% for the same period in 2004. The improved expense ratio
reflects higher net earned premium and the impacts of cost reduction initiatives
taken in the first quarter of 2004. These items reduced the ratio by 1.0
percentage points and 3.0 percentage points, respectively, in the first quarter
of 2005. The improved expense ratio also reflects the absence of expenses
associated with the initiative to simplify and streamline the Company's field
organization and the increased accrual for policyholder dividends that were
recorded in the first quarter of 2004. These items added 8.8 percentage points
to the expense ratio for 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 total
exposure, before the effects of reinsurance, by 10.7% in 2005 on large
commercial accounts, which are defined as accounts with exposures in excess of
$10 million:
27
NUMBER OF ACCOUNTS TOTAL EXPOSURE (DOLLARS IN MILLIONS)
AS OF AS OF
--------------------------- -------------------------------------------
MARCH 31, DECEMBER 31, MARCH 31, DECEMBER 31, % INCREASE/
COMMERCIAL ACCOUNT EXPOSURE 2005 2004 2005 2004 (DECREASE)
--------------------------- --------- ------------ --------- ------------ ------------
$100 million and larger 2 2 $ 256.2 $ 256.4 (0.1)%
$50 to $100 million 4 7 261.5 468.1 (44.1)%
$25 to $50 million 12 11 426.4 401.0 6.3%
$10 to $25 million 41 39 571.4 572.5 (0.2)%
-- -- --------- --------- -----
Total 59 59 $ 1,515.5 $ 1,698.0 (10.7)%
== == ========= ========= =====
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 bonded backlog of less than $30 million. Bonded
backlog is a measure of the Company's exposure in the event of default before
indemnification, salvage and subrogation recoveries. The Company does have a
number of accounts with higher bonded backlogs. For example, the Company has 12
accounts each with a bonded backlog in excess of $150 million and 15 accounts
each with a bonded backlog of between $100 million and $150 million.
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 AND REALIZED INVESTMENT GAINS/LOSSES
Net investment income was $8.0 million for the three months ended March
31, 2005, as compared with $7.0 million for the same period in 2004 due to an
increase in invested assets. The annualized pretax yield was 4.4% for both the
three months ended March 31, 2005 and 2004. The annualized after-tax yield was
3.7% for both the three months ended March 31, 2005 and 2004. Net realized
investment gains were $2.0 million and $2.2 million for the three months ended
March 31, 2005 and 2004, respectively. The realized investment gain in 2005
resulted primarily from the Company's sale of its interest in DeMontfort, PLC.
The following summarizes net realized investment gains (losses) activity:
THREE MONTHS ENDED
MARCH 31,
------------------
2005 2004
------ ------
Gross realized investment gains.......................... $2,165 $2,234
Gross realized investment losses......................... (154) (4)
------ ------
Net realized investment gains............................ $2,011 $2,230
====== ======
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 126.3% for the three months ended March 31,
2005 as compared with the same period in 2004, due to the addition of $30.9
million of junior subordinated debentures and higher interest rates
28
associated with this long-term debt issued in 2004. Weighted average debt
outstanding was $65.9 million for the three months ended March 31, 2005 as
compared with $50.4 million for the same period in 2004. The weighted
average interest rate for the three months ended March 31, 2005 was 4.5% as
compared with 2.7% for the same period in 2004.
INCOME TAXES
Income tax expense was $5.5 million and $1.7 million for the three months
ended March 31, 2005 and 2004, respectively. The effective income tax rates were
27.9% and 21.5% for the three months ended March 31, 2005 and 2004,
respectively. The increase in the estimated effective tax rates for the three
months ended March 31, 2005 as compared with the same periods in 2004 primarily
relates to the decrease in the relative share of tax-exempt investment income
to total pre-tax 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 March 31, 2005, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $661.1 million of fixed income
securities, $74.0 million of short-term investments, $1.1 million of other
investments and $4.4 million of cash. At December 31, 2004, the carrying value
of the Company's insurance subsidiaries' invested assets was comprised of $722.0
million of fixed income securities, $22.7 million of short-term investments, and
$1.1 million of other investments and $5.6 million of cash.
During the fourth quarter of 2004, the Company reached agreement with the
claimant on a bond regarding certain aspects of the claim resolution. The bond
was originally written by an affiliate and assumed by one of the Company's
insurance subsidiaries pursuant to the Quota Share Treaty. As part of this
agreement, the Company will deposit approximately $34 million with the affiliate
so that a trust can be established by the affiliate to fund future payments
under the bond. This claim was previously fully reserved.
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 March 31, 2005, the parent company's
invested assets consisted of $1.0 million of fixed income securities, $1.2
million of equity securities, $5.3 million of short-term investments and $2.2
million of cash. At December 31, 2004, the parent company's invested assets
consisted of $6.3 million of fixed income securities, $1.2 million of equity
securities, $5.8 million of short-term investments and $1.7 million of cash. At
March 31, 2005 and December 31, 2004 respectively, parent company short-term
investments and cash included $6.7 million and $5.1 million of restricted cash
primarily related to premium receipt collections ultimately due to the Company's
insurance subsidiaries.
The Company's consolidated net cash flow provided by operating activities
was $2.5 million for the three months ended March 31, 2005 compared to net cash
flow provided by operating activities of $42.9 million for the comparable period
in 2004. The decrease in net cash flow provided by operating activities
primarily relates to a $29.9 million reinsurance recoverable receipt in the
first quarter of 2004, and higher loss payments and reduced premium collections
in the first quarter of 2005.
29
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 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 $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 March 31, 2005, the interest rate on the
junior subordinated debentures was 6.17%. 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 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 March 31, 2005 was
2.78%.
As of March 31, 2005 and December 31, 2004, the outstanding Revolving
Credit facility balance was $25.0 million. The Term Loan Facility balance was
reduced by $5.0 million to $5.0 million during the three months ended March 31,
2005 according to scheduled amortization and payment schedules. The Term Loan
Facility balance was $10 million at December 31, 2004. Final amortization and
payment of the remaining $5.0 million principal of the Term Loan Facility will
take place on September 30, 2005. No other debt matures in the next five years.
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, LIBOR, plus the applicable margin. The
margin, including a facility fee and utilization fee on the Revolving Credit
Facility, was 1.30% at March 31, 2005 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 March 31, 2005 and can vary based on CNA
Surety's leverage ratio (debt to total capitalization) from 0.48% to 0.80%. As
of March 31, 2005, the weighted average interest rate was 4.15% on the $30.0
million of outstanding borrowings. As of December 31, 2004, the weighted average
interest rate on the 2002 Credit Facility was 3.28% on the $35.0 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. 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
with all covenants during the quarter ended March 31, 2005.
A summary of the Company's commitments as of March 31, 2005 is presented
in the following table (in millions):
MARCH 31, 2005 2005 2006 2007 2008 2009 THEREAFTER TOTAL
----------------------------- ------ ------ ----- ----- ----- ---------- -------
Debt (a)..................... $ 32.1 $ 1.9 $ 1.9 $ 1.9 $ 1.9 $ 77.5 $ 117.2
Operating leases............. 1.2 1.4 1.1 1.0 1.0 2.7 8.4
Loss and loss adjustment
expense reserves............. 108.0 124.5 45.2 18.2 15.6 45.9 357.4
Other long-term liabilities
(b).......................... 0.8 0.3 0.4 0.4 0.4 5.8 8.1
------ ------ ----- ----- ----- ------ -------
Total........................ $142.1 $128.1 $48.6 $21.5 $18.9 $131.9 $ 491.1
====== ====== ===== ===== ===== ====== =======
30
(a) Reflects expected principal and interest payments.
(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 (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 2005 is based on
statutory surplus and income at and for the year ended December 31, 2004.
Without prior regulatory approval, CNA Surety's insurance subsidiaries may pay
stockholder dividends of $46.8 million in the aggregate in 2005. CNA Surety
received no dividends from its insurance subsidiaries during the first three
months of 2005 or 2004. CNA Surety received $1.5 million in dividends, including
$0.5 million in cash, from its non-insurance subsidiaries during the first three
months of 2005. CNA Surety received no dividends from its non-insurance
subsidiaries during the first three months of 2004.
Combined statutory surplus totaled $264.2 million at March 31, 2005,
resulting in a net written premium to statutory surplus ratio of 1.3 to 1.
Insurance regulations restrict Western Surety's maximum net retention on a
single surety bond to 10 percent of statutory surplus. Under the 2005 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 received $0.7 million from its subsidiaries for the three months ended
March 31, 2005. CNA Surety did not receive any tax sharing payments from its
subsidiaries for the three months ended March 31, 2004
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, 2004 through June 30, 2005, the
underwriting limitations of Western Surety and Surety Bonding are $18.5 million
and $0.6 million, respectively. Through the Surety Quota Share Treaty between
CCC and Western Surety Company, CNA Surety has access to CCC and its affiliates'
U.S. Department of Treasury underwriting limitations. The Surety Quota Share
Treaty had an original term of five years from the Merger Date and was renewed
on October 1, 2002, January 1, 2004 and January 1, 2005 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.
31
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.
FINANCIAL CONDITION
INVESTMENT PORTFOLIO
The estimated fair value and amortized cost or cost of fixed income and
equity securities held by CNA Surety at March 31, 2005 and December 31, 2004, 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
MARCH 31, 2005 COST GAINS MONTHS MONTHS VALUE
------------------------------------------- --------- ---------- ------------ ------------ ---------
Fixed income securities:
U.S. Treasury securities and obligations
of U.S. Government and agencies:
U.S. Treasury........................... $ 17,255 $ 7 $ (162) $ -- $ 17,100
U.S. Agencies........................... 4,574 25 (69) (73) 4,457
Collateralized mortgage obligations..... 18,391 538 (179) -- 18,750
Mortgage pass-through securities........ 54,369 155 (468) (314) 53,742
Obligations of states and political
subdivisions............................... 429,437 15,933 (1,205) (640) 443,525
Corporate bonds............................ 84,258 2,452 (860) (6) 85,844
Non-agency collateralized mortgage
obligations................................ 2,075 -- (39) -- 2,036
Other asset-backed securities:
Second mortgages/home equity loans...... 20,924 224 (207) -- 20,941
Other................................... 12,346 264 (109) -- 12,501
Redeemable preferred stock................. 3,000 167 -- -- 3,167
--------- ---------- ------------ ------------ ---------
Total fixed income securities........... 646,629 19,765 (3,298) (1,033) 662,063
Equity securities.......................... 1,115 47 -- -- 1,162
--------- ---------- ------------ ------------ ---------
Total................................... $ 647,744 $ 19,812 $ (3,298) $ (1.033) $ 663,225
========= ========== ============ ============ =========
GROSS UNREALIZED LOSSES
AMORTIZED GROSS --------------------------- ESTIMATED
COST OR UNREALIZED LESS THAN 12 MORE THAN 12 FAIR
DECEMBER 31, 2004 COST GAINS MONTHS MONTHS VALUE
------------------------------------------- --------- ---------- ------------ ------------ ---------
Fixed income securities:
U.S. Treasury securities and obligations
of U.S. Government and agencies:
U.S. Treasury........................... $ 55,818 $ 255 $ (39) $ -- $ 56,034
U.S. Agencies........................... 4,576 39 (9) (49) 4,557
Collateralized mortgage obligations..... 18,260 590 (105) -- 18,745
Mortgage pass-through securities........ 56,696 325 (249) -- 56,772
Obligations of states and political
subdivisions............................... 431,624 23,467 (387) (87) 454,617
Corporate bonds............................ 94,363 4,735 (27) (2) 99,069
Non-agency collateralized mortgage
obligations................................ 2,078 3 -- -- 2,081
Other asset-backed securities:
Second mortgages/home equity loans...... 20,942 241 (69) -- 21,114
Credit card receivables................. 867 -- -- -- 867
Other................................... 7,794 391 -- -- 8,185
Redeemable preferred stock................. 5,356 941 -- -- 6,297
--------- ---------- ------------ ------------ ---------
Total fixed income securities........... 698,374 30,987 (885) (138) 728,338
Equity securities.......................... 1,084 114 -- -- 1,198
--------- ---------- ------------ ------------ ---------
Total................................... $ 699,458 $ 31,101 $ (885) $ (138) $ 729,536
========= ========== ============ ============ =========
The following table summarizes for fixed maturities in an unrealized loss
position at March 31, 2005 and 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):
32
MARCH 31, 2005 DECEMBER 31, 2004
GROSS GROSS
ESTIMATED UNREALIZED ESTIMATED UNREALIZED
UNREALIZED LOSS AGING FAIR VALUE LOSS FAIR VALUE LOSS
------------------------------------ ---------- ---------- ---------- ----------
Fixed maturity securities:
Investment grade:
0-12 months.................... $ 211,173 $ 3,298 $ 107,401 $ 885
Greater than 12 months......... 24,526 1,033 5,484 138
---------- ---------- ---------- ----------
Total investment grade........... $ 235,699 $ 4,331 $ 112,885 $ 1,023
========== ========== ========== ==========
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 one other
executive officer 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.
As of March 31, 2005, 65 separate securities held by the Company were in
an unrealized loss position. Of these, 41 securities were rated AAA by Standard
and Poor's ("S&P") and Aaa by Moody's Investor Services ("Moody's") and none
were rated below investment grade. Only two securities were in loss positions
that exceeded 5% of their respective book values, with the largest unrealized
loss being approximately 7% of that security's book value. Both of these
securities were rated AAA by S&P and Aaa by Moody's. The Company believes that
all of the unrealized losses have resulted from changes in interest rates and do
not reflect any adverse changes in the credit quality of the issuers. These
facts were part of the Company's consideration of whether any
other-than-temporary impairments existed as of March 31, 2005. No
other-than-temporary impairments were recorded for the three months ended March
31, 2005. No other-than-temporary impairments were recorded for the year ended
December 31, 2004.
IMPACT OF PENDING ACCOUNTING STANDARDS
In December of 2004, the FASB issued SFAS No. 123 (revised 2004),
"Share-Based Payment ("SFAS 123R"), that amends SFAS No. 123 ("SFAS 123"), as
originally issued in May of 1995. SFAS 123R addresses the accounting for
share-based payment transactions in which an enterprise receives employee
services in exchange for (a) equity instruments of the enterprise or (b)
liabilities that are based on the fair value of the enterprise's equity
instruments or that may be settled by the issuance of such equity instruments.
SFAS 123R supercedes APB No. 25, "Accounting for Stock Issued to Employees"
("APB No. 25"). After the effective date of this standard, entities will not be
permitted to use the intrinsic value method specified in APB 25 to measure
compensation expense and generally would be required to measure compensation
expense using a fair-value based method. Public companies are to apply this
standard using either the modified prospective method or the modified
retrospective method. The modified prospective method requires a company to (a)
record compensation expense for all awards it grants after the date it adopts
the standard and (b) record compensation expense for the unvested portion of
previously granted awards that remain outstanding at the date of adoption. The
modified retrospective method requires companies to record compensation expense
to either (a) all prior years for which SFAS 123 was effective (i.e. for all
fiscal years beginning after December 15, 2004) or (b) only to prior interim
periods in the year of initial adoption if the effective date of SFAS 123R does
not coincide with the beginning of the fiscal year. SFAS 123R is effective for
annual periods beginning after June 15, 2005. The SEC issued Staff Accounting
Bulletin ("SAB") No. 107 that provides implementation guidance on the adoption
of SFAS 123R. Adoption of this standard is not expected to have a material
impact on the Company's results of operations and/or equity.
33
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 ability of the Company's contract principals to fulfill their
bonded obligations;
- the effects of corporate bankruptcies on surety bond claims, as well
as on capital markets;
- 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;
- changes in the Company's composition of operating segments;
- 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.
34
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.
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 March 31, 2005. 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.
HYPOTHETICAL
ESTIMATED FAIR PERCENTAGE
HYPOTHETICAL VALUE AFTER INCREASE
FAIR VALUE AT CHANGE IN HYPOTHETICAL (DECREASE) IN
MARCH 31, INTEREST RATE CHANGE IN STOCKHOLDERS'
2005 (bp=BASIS POINTS) INTEREST RATE EQUITY
------------- ----------------- -------------- -------------
(DOLLARS IN THOUSANDS)
U.S. Government and government agencies and authorities...... $ 94,049 200 bp increase $ 83,165 (1.6)%
100 bp increase 88,748 (0.8)
100 bp decrease 98,744 0.7
200 bp decrease 102,976 1.3
States, municipalities and political subdivisions............ 443,525 200 bp increase 390,687 (7.6)
100 bp increase 416,889 (3.8)
100 bp decrease 471,151 4.0
200 bp decrease 500,796 8.2
Corporate bonds and all other................................ 124,489 200 bp increase 110,400 (2.0)
-------------
100 bp increase 115,665 (1.3)
100 bp decrease 127,321 0.4
200 bp decrease 133,691 1.3
Total fixed income securities................................ $ 662,063 200 bp increase 584,252 (11.2)
=============
100 bp increase 621,303 (5.9)
100 bp decrease 697,216 5.1
200 bp decrease 737,462 10.8
35
HYPOTHETICAL
ESTIMATED FAIR PERCENTAGE
HYPOTHETICAL VALUE AFTER INCREASE
FAIR VALUE AT CHANGE IN HYPOTHETICAL (DECREASE) IN
DECEMBER 31, INTEREST RATE CHANGE IN STOCKHOLDERS'
2004 (bp=BASIS POINTS) INTEREST RATE EQUITY
------------- ----------------- -------------- -------------
(DOLLARS IN THOUSANDS)
U.S. Government and government agencies and authorities...... $ 136,108 200 bp increase $ 123,990 (1.8)%
100 bp increase 130,255 (0.9)
100 bp decrease 141,248 0.7
200 bp decrease 145,997 1.4
States, municipalities and political subdivisions............ 454,617 200 bp increase 398,451 (8.2)
100 bp increase 426,163 (4.1)
100 bp decrease 484,149 4.3
200 bp decrease 515,785 8.9
Corporate bonds and all other................................ 137,613 200 bp increase 122,449 (2.2)
-------------
100 bp increase 128,147 (1.4)
100 bp decrease 141,072 0.5
200 bp decrease 148,431 1.6
Total fixed income securities................................ $ 728,338 200 bp increase 644,890 (12.2)
=============
100 bp increase 684,565 (6.4)
100 bp decrease 766,469 5.6
200 bp decrease 810,213 11.9
36
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.
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. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS - None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES - None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Annual Meeting of Shareholders of CNA Surety Corporation held on
April 26, 2005, the Company's shareholders voted on the following
proposals. The numbers of shares issued, outstanding and eligible to vote
as of the record date of March 1, 2005 were 43,114,170. Proxies
representing 41,990,063 shares or approximately 97 percent of the eligible
voting shares were tabulated.
PROPOSAL I
Election of Directors.
Number of Shares/Votes
-------------------------------------
For Authority Withheld
---------- ------------------
Philip H. Britt 41,864,865 125,198
Roy E. Posner 41,277,622 712,441
Adrian M. Tocklin 41,626,936 363,127
James R. Lewis 37,102,783 4,887,280
Lori Komstadius 37,099,653 4,890,410
Robert Tinstman 41,864,555 125,508
John F. Welch 37,101,083 4,888,980
PROPOSAL II
To ratify the Board of Directors' appointment of the Company's independent
auditors, Deloitte & Touche LLP, for fiscal year 2005.
For 41,969,858
Against 17,491
Abstain 2,714
37
ITEM 5. OTHER INFORMATION - None
ITEM 6. EXHIBITS
Exhibit Number
--------------
CNA Surety Corporation 2005 Deferred Compensation Plan...................... (10) 27
CNA Surety Corporation 2005 Deferred Compensation Plan Trust................ (10) 28
Third Amendment to CNA Surety Corporation 2005 Deferred Compensation Plan... (10) 29
Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002........ 31.1
Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002........ 31.2
Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002........ 32.1*
Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002........ 32.2*
* Exhibits 32.1 and 32.2 are being furnished and shall not be deemed "filed" for
the purpose of Section 18 of the Securities Exchange Act of 1934, as amended, or
otherwise subject to the liabilities of that Section. These Exhibits shall not
be incorporated by reference into any registration statement or other document
pursuant to the Securities Act of 1933, as amended.
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: May 2, 2005
39
EXHIBIT INDEX
CNA Surety Corporation 2005 Deferred Compensation Plan...................... (10) 27
CNA Surety Corporation 2005 Deferred Compensation Plan Trust................ (10) 28
Third Amendment to CNA Surety Corporation 2005 Deferred Compensation Plan... (10) 29
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