FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 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:
43,260,693 shares of Common Stock, $.01 par value as of 10/24/2005.
CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION:
Item 1. Condensed Consolidated Financial Statements (Unaudited):
Report of Independent Registered Public Accounting Firm............ 3
Condensed Consolidated Balance Sheets at September 30, 2005 and at
December 31, 2004............................................... 4
Condensed Consolidated Statements of Income for the Three and Nine
Months Ended September 30, 2005 and 2004........................ 5
Condensed Consolidated Statements of Stockholders' Equity for the
Three and Nine Months Ended September 30, 2005 and 2004......... 6
Condensed Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 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.......................................... 17
Item 3. Quantitative and Qualitative Disclosures About Market Risk.... 32
Item 4. Controls and Procedures....................................... 33
PART II. OTHER INFORMATION:
Item 1. Legal Proceedings............................................. 33
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds... 33
Item 3. Defaults Upon Senior Securities............................... 33
Item 4. Submission of Matters to a Vote of Security Holders........... 33
Item 5. Other Information............................................. 33
Item 6. Exhibits...................................................... 34
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois
We have reviewed the accompanying condensed consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of September 30, 2005, and the related
condensed consolidated statements of income and stockholders' equity for the
three-month and nine-month periods ended September 30, 2005 and 2004 and the
related condensed consolidated statements of cash flows for the nine-month
periods ended September 30, 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
October 31, 2005
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31
2005 2004
------------- -----------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $696,150 and $698,374)... $ 711,899 $ 728,338
Equity securities, at fair value (cost: $1,144 and $1,084)....................... 1,249 1,198
Short-term investments, at cost (approximates fair value)........................ 91,626 28,457
Other investments, at fair value (cost: $1,020 and $1,058)....................... 1,020 1,058
---------- ----------
Total invested assets............................................................ 805,794 759,051
Cash................................................................................ 7,793 7,336
Deferred policy acquisition costs................................................... 106,742 102,128
Insurance receivables:
Premiums, including $13,041 and $11,012 from affiliates (net of allowance for
doubtful accounts: $1,752 and $2,153)......................................... 44,222 32,340
Reinsurance, including $3,105 and $5,364 from affiliates......................... 74,696 98,874
Deposit with affiliated ceding company.............................................. 32,332 --
Intangible assets (net of accumulated amortization: $25,523 and $25,523)............ 138,785 138,785
Current income taxes receivable..................................................... 1,393 --
Property and equipment, at cost (less accumulated depreciation and amortization:
$23,878 and $21,600)............................................................. 17,622 15,358
Prepaid reinsurance premiums........................................................ 8,404 7,955
Accrued investment income........................................................... 8,773 8,891
Other assets........................................................................ 3,498 3,776
---------- ----------
Total assets..................................................................... $1,250,054 $1,174,494
========== ==========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses....................................... $ 405,947 $ 363,387
Unearned premiums................................................................ 252,120 226,019
---------- ----------
Total reserves................................................................... 658,067 589,406
Debt................................................................................ 60,564 65,488
Deferred income taxes, net.......................................................... 21,159 27,024
Current income taxes payable........................................................ -- 3,491
Reinsurance and other payables to affiliates........................................ 8,994 461
Accrued expenses.................................................................... 13,784 17,090
Other liabilities................................................................... 25,799 25,163
---------- ----------
Total liabilities................................................................ $ 788,367 $ 728,123
---------- ----------
Commitments and contingencies (See Notes 4, 5, 6, & 7)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,659 shares
issued and 43,259 shares outstanding at September 30, 2005 and 44,423 shares
issued and 43,015 shares outstanding at December 31, 2004........................ 447 444
Additional paid-in capital.......................................................... 258,545 255,996
Retained earnings................................................................... 207,419 185,496
Accumulated other comprehensive income.............................................. 10,305 19,551
Treasury stock, at cost............................................................. (15,029) (15,116)
---------- ----------
Total stockholders' equity....................................................... 461,687 446,371
---------- ----------
Total liabilities and stockholders' equity....................................... $1,250,054 $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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------ -------------------
2005 2004 2005 2004
------- ------- -------- --------
Revenues:
Net earned premium........................................... $91,061 $83,068 $256,881 $235,418
Net investment income........................................ 8,681 7,688 24,706 22,127
Net realized investment gains................................ 108 194 2,124 2,476
------- ------- -------- --------
Total revenues............................................ 99,850 90,950 283,711 260,021
------- ------- -------- --------
Expenses:
Net losses and loss adjustment expenses...................... 19,976 22,847 104,330 64,685
Net commissions, brokerage and other underwriting expenses... 51,891 52,245 150,593 156,627
Interest expense............................................. 938 664 2,552 1,512
------- ------- -------- --------
Total expenses............................................ 72,805 75,756 257,475 222,824
------- ------- -------- --------
Income before income taxes...................................... 27,045 15,194 26,236 37,197
Income tax expense.............................................. 7,262 4,220 4,313 9,664
------- ------- -------- --------
Net income...................................................... $19,783 $10,974 $ 21,923 $ 27,533
======= ======= ======== ========
Earnings per common share....................................... $ 0.46 $ 0.26 $ 0.51 $ 0.64
======= ======= ======== ========
Earnings per common share, assuming dilution.................... $ 0.46 $ 0.25 $ 0.51 $ 0.64
======= ======= ======== ========
Weighted average shares outstanding............................. 43,168 43,001 43,174 42,995
======= ======= ======== ========
Weighted average shares outstanding, assuming dilution.......... 43,385 43,048 43,394 43,048
======= ======= ======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
COMMON
STOCK ADDITIONAL
SHARES COMMON PAID-IN COMPREHENSIVE
OUTSTANDING STOCK CAPITAL INCOME (LOSS)
----------- ------ ---------- -------------
Balance, December 31, 2003........................ 42,980 $444 $255,816
Comprehensive income:
Net income..................................... -- -- -- $27,533
Other comprehensive income:
Change in unrealized gains on securities, after
income tax benefit of $1,621 (net of
reclassification adjustment of $1,662, after
income tax expense of $895)................. -- -- -- (3,012)
-------
Total comprehensive income..................... $24,521
=======
Issuance of treasury stock to employee stock
purchase program............................... 13 -- (34)
Stock options exercised and other................. 8 -- 67
------ ---- --------
Balance, September 30, 2004....................... 43,001 $444 $255,849
====== ==== ========
Balance, December 31, 2004........................ 43,015 $444 $255,996
Comprehensive income:
Net income..................................... -- -- -- $21,923
Other comprehensive income:
Change in unrealized gains on securities,
after income tax benefit of $4,978 (net of
reclassification adjustment of $1,113, after
income tax expense of $599)................. -- -- -- (9,246)
-------
Total comprehensive income..................... $12,677
=======
Issuance of treasury stock to employee stock
purchase program............................... 8 -- (5)
Stock options exercised and other................. 236 3 2,554
------ ---- --------
Balance, September 30, 2005....................... 43,259 $447 $258,545
====== ==== ========
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..................................... 27,533 -- -- 27,533
Other comprehensive income:
Change in unrealized gains on securities, after
income tax benefit of $1,621 (net of
reclassification adjustment of $1,662, after
income tax expense of $895)................. -- (3,012) -- (3,012)
Issuance of treasury stock to employee stock
purchase program............................... -- -- 140 106
Stock options exercised and other................. -- -- -- 67
-------- ------- -------- --------
Balance, September 30, 2004....................... $173,319 $20,339 $(15,116) $434,835
======== ======= ======== ========
Balance, December 31, 2004........................ $185,496 $19,551 $(15,116) $446,371
Comprehensive income:
Net income..................................... 21,923 -- -- 21,923
Other comprehensive income:
Change in unrealized gains on securities, after
income tax benefit of $4,978 (net of
reclassification adjustment of $1,113, after
income tax expense of $599)................. -- (9,246) -- (9,246)
Issuance of treasury stock to employee stock
purchase program............................... -- 87 82
Stock options exercised and other................. -- -- 2,557
-------- ------- -------- --------
Balance, September 30, 2005....................... $207,419 $10,305 $(15,029) $461,687
======== ======= ======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
2005 2004
---------- ---------
OPERATING ACTIVITIES:
Net income .......................................... $ 21,923 $ 27,533
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization .................... 3,372 3,416
Accretion of bond discount, net .................. 2,068 2,170
Net realized investment gains .................... (2,124) (2,476)
Changes in:
Insurance receivables ............................ 12,296 70,632
Reserve for unearned premiums .................... 26,101 12,866
Reserve for unpaid losses and loss adjustment
expenses ...................................... 42,560 (36,138)
Deposit with affiliated ceding company ........... (32,332) --
Deferred policy acquisition costs ................ (4,614) (1,718)
Deferred income taxes, net ....................... (886) (1,667)
Reinsurance and other payables to affiliates ..... 8,533 (50)
Prepaid reinsurance premiums ..................... (449) (4,201)
Accrued expenses ................................. (3,306) 29,302
Other assets and liabilities ..................... (4,959) 3,847
--------- ---------
Net cash provided by operating activities ..... 68,183 103,516
--------- ---------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases ........................................... (119,603) (154,014)
Maturities .......................................... 30,071 18,156
Sales ............................................... 90,979 41,962
Purchases of equity securities ...................... (694) (680)
Proceeds from the sale of equity securities ......... 709 706
Changes in short-term investments ................... (62,985) (21,050)
Purchases of property and equipment, net ............ (5,233) (2,010)
Changes in receivables/payables for securities
sold/purchased ................................... (6) 142
Other, net .......................................... 1,522 (1,287)
--------- ---------
Net cash used in investing activities ............ (65,240) (118,075)
--------- ---------
FINANCING ACTIVITIES:
Proceeds from long-term debt ........................ -- 30,930
Principal payments on debt .......................... (5,000) (15,417)
Debt issuance costs ................................. (125) (506)
Employee stock option exercises and other ........... 2,552 32
Issuance of treasury stock to employee stock purchase
plan ............................................. 87 140
--------- ---------
Net cash (used in) provided by financing
activities .................................... (2,486) 15,179
--------- ---------
Increase in cash ....................................... 457 620
Cash at beginning of period ............................ 7,336 7,965
--------- ---------
Cash at end of period .................................. $ 7,793 $ 8,585
========= =========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest ............................................ $ 2,180 $ 1,366
Income taxes ........................................ 10,077 $ (17,968)
The accompanying notes are an integral part of these condensed consolidated
financial statements.
7
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 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 63% 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.
8
The computation of earnings per common share is as follows (amounts in
thousands, except for per share data):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2005 2004 2005 2004
------- ------- ------- -------
Net income ........................................ $19,783 $10,974 $21,923 $27,533
======= ======= ======= =======
Shares:
Weighted average shares outstanding ............... 43,140 42,995 43,015 42,980
Weighted average shares of options exercised and
additional stock issuance ................... 28 6 159 15
------- ------- ------- -------
Total weighted average shares outstanding ......... 43,168 43,001 43,174 42,995
Effect of dilutive options ..................... 217 47 220 53
------- ------- ------- -------
Total weighted average shares outstanding, assuming
dilution ....................................... 43,385 43,048 43,394 43,048
======= ======= ======= =======
Earnings per share ................................ $ 0.46 $ 0.26 $ 0.51 $ 0.64
======= ======= ======= =======
Earnings per share, assuming dilution ............. $ 0.46 $ 0.25 $ 0.51 $ 0.64
======= ======= ======= =======
No adjustments were made to reported net income in the computation of
earnings per share. Options to purchase shares of common stock of 0.4 million
for the three and nine months ended September 30, 2005 and 0.9 million for the
three and nine months ended September 30, 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2005 2004 2005 2004
------- ------- ------- -------
Net income ......................................... $19,783 $10,974 $21,923 $27,533
Less: Total stock based compensation cost determined
under the fair value method, net of tax ......... (94) (159) (491) (390)
------- ------- ------- -------
Pro forma net income ............................... $19,689 $10,815 $21,432 $27,143
======= ======= ======= =======
Basic and diluted earnings per share, as reported .. $ 0.46 $ 0.26 $ 0.51 $ 0.64
======= ======= ======= =======
Basic earnings per share, pro forma ................ $ 0.46 $ 0.25 $ 0.50 $ 0.63
======= ======= ======= =======
Diluted earnings per share, pro forma .............. $ 0.45 $ 0.25 $ 0.49 $ 0.63
======= ======= ======= =======
ACCOUNTING PRONOUNCEMENTS
In December of 2004, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 123 (revised 2004), "Share-Based Payment ("SFAS 123R"), that
amends SFAS No. 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 Opinion 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.
9
2. INVESTMENTS
The estimated fair value and amortized cost or cost of fixed income and
equity securities held by CNA Surety at September 30, 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
SEPTEMBER 30, 2005 COST GAINS MONTHS MONTHS VALUE
------------------ --------- ---------- ------------ ------------ ---------
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury................................... $ 15,650 $ 38 $ (131) $ (10) $ 15,547
U.S. Agencies................................... 14,120 26 (125) (61) 13,960
Collateralized mortgage obligations............. 18,661 449 (99) -- 19,011
Mortgage pass-through securities................ 48,736 110 (430) (352) 48,064
Obligations of states and political subdivisions... 465,506 16,461 (1,176) (358) 480,433
Corporate bonds.................................... 75,602 2,244 (656) (18) 77,172
Non-agency collateralized mortgage obligations..... 22,203 -- (459) -- 21,744
Other asset-backed securities:
Second mortgages/home equity loans.............. 25,924 133 (122) -- 25,935
Other........................................... 6,748 167 (70) -- 6,845
Redeemable preferred stock......................... 3,000 188 -- -- 3,188
-------- ------- ------- ----- --------
Total fixed income securities................... 696,150 19,816 (3,268) (799) 711,899
Equity securities.................................. 1,144 105 -- -- 1,249
-------- ------- ------- ----- --------
Total........................................... $697,294 $19,921 $(3,268) $(799) $713,148
======== ======= ======= ===== ========
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.
10
CNA Surety classifies its fixed income securities and its equity securities
as available-for-sale, and as such, they are carried at fair value. The
amortized cost of fixed income securities is adjusted for amortization of
premiums and accretion of discounts to maturity, which is included in net
investment income. Changes in fair value are reported as a component of other
comprehensive income, exclusive of other-than-temporary impairment losses, if
any.
As of September 30, 2005, 70 separate securities held by the Company were
in an unrealized loss position. Of these, 46 securities were rated "AAA" by
Standard and Poor's ("S&P") and "Aaa" by Moody's Investor Services ("Moody's").
One security was rated below investment grade by Moody's and investment grade by
S&P. Only two securities were in loss positions that exceeded 5% of their
respective book values, with the largest unrealized loss being approximately 6%
of that security's book value. The Company believes that virtually all of the
unrealized losses have resulted from changes in interest rates. No
other-than-temporary impairments were recorded for the nine months ended
September 30, 2005. No other-than-temporary impairments were recorded for the
year ended December 31, 2004.
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 SEPTEMBER 30,
-----------------------------------------
2005 2004
------------------- -------------------
WRITTEN EARNED WRITTEN EARNED
-------- -------- -------- --------
Direct .............. $ 83,428 $ 76,128 $ 71,225 $ 64,802
Assumed ............. 30,054 28,490 30,926 35,127
Ceded ............... (10,451) (13,557) (15,734) (16,861)
-------- -------- -------- --------
$103,031 $ 91,061 $ 86,417 $ 83,068
======== ======== ======== ========
NINE MONTHS ENDED SEPTEMBER 30,
-----------------------------------------
2005 2004
------------------- -------------------
WRITTEN EARNED WRITTEN EARNED
-------- -------- -------- --------
Direct .............. $242,912 $211,590 $206,625 $171,955
Assumed ............. 80,407 85,628 94,469 116,273
Ceded ............... (40,787) (40,337) (57,011) (52,810)
-------- -------- -------- --------
$282,532 $256,881 $244,083 $235,418
======== ======== ======== ========
Assumed premiums primarily include all surety business written or renewed,
net of reinsurance, by CCC and CIC, which is reinsured by Western Surety
pursuant to reinsurance and related agreements.
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):
THREE MONTHS ENDED SEPTEMBER 30,
-----------------------------------
2005 2004
--------------- ----------------
$ RATIO $ RATIO
------- ----- ------- ------
Gross losses and loss adjustment expenses .. $ 9,883 9.4% $(6,177) (6.2%)
Ceded amounts .............................. 10,093 (74.4%) 29,024 (172.1%)
------- -------
Net losses and loss adjustment expenses .... $19,976 21.9% $22,847 27.5%
======= =======
NINE MONTHS ENDED SEPTEMBER 30,
-----------------------------------
2005 2004
---------------- ----------------
$ RATIO $ RATIO
-------- ----- ------- ------
Gross losses and loss adjustment expenses .. $106,682 35.9% $44,133 15.3%
Ceded amounts .............................. (2,352) 5.8% 20,552 (38.9%)
-------- -------
Net losses and loss adjustment expenses .... $104,330 40.6% $64,685 27.5%
======== =======
11
During the three months ended September 30, 2005 and 2004, the Company
recorded results based on independent actuarial reviews performed during the
respective quarters which indicated that gross reserves should be reduced by
approximately $15 million and $32 million, respectively, with a corresponding
reduction in ceded reserves. This adjustment reflects changes in estimates of
incurred-but-not-reported reserves. These actions resulted in the unusual
relationships in the gross and ceded amounts shown above.
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 deposited $32.7 million with the affiliate in the third
quarter of 2005 to enable the affiliate to establish a trust to fund future
payments under the bond. Such deposit is included on the balance sheet as
"Deposit with affiliated ceding company". This claim was previously fully
reserved.
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. 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.
The Services and Indemnity Agreement provides the Company's insurance
subsidiaries 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.
Through a surety quota share treaty ("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.
For the Quota Share Treaty in effect during 2004, the ceding commission
paid to CCC and CIC by Western Surety was 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 September 30, 2005.
Through a stop loss contract entered into at the Merger Date (the "Stop
Loss Contract"), the Company's insurance subsidiaries were protected 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 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. As of September 30,
2005, the Company had billed and received $54.9 million
12
under the Stop Loss Contract. As a result of reevaluation and reduction of the
net loss ratios for the accident years subject to the Stop Loss Contract, the
Company has established a reinsurance payable to CCC of $9.0 million under this
contract at September 30, 2005.
The Company and CCC previously participated in a $40 million excess of $60
million reinsurance contract effective from January 1, 2004 to December 31, 2004
providing coverage exclusively for the one large national contractor that is
excluded from the Company's third party reinsurance. 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. In the second quarter of 2005, this
contract was amended to provide unlimited coverage in excess of the $60 million
retention, to increase the premium to $7.0 million, and to eliminate the
additional premium provision. This treaty provides coverage for the life of
bonds either in force or written during the term of the treaty which is from
January 1, 2005 to December 31, 2005. As of September 30, 2005, no losses have
been ceded under this contract.
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 was $4.75 million plus an additional premium
of $14.0 million if a loss is ceded under this contract. In the second quarter
of 2005, this contract was amended to exclude coverage for the large national
contractor, to reduce the premium to $3.0 million, and to reduce the additional
premium to $7.0 million. As of September 30, 2005, no losses have been ceded
under this contract.
As of September 30, 2005 and December 31, 2004, CNA Surety had an insurance
receivable balance from CCC and CIC of $16.1 million and $16.4 million. CNA
Surety had reinsurance payables to CCC and CIC as of September 30, 2005 and
December 31, 2004 of $9.0 million and $0.3 million.
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. As previously described, during the
second quarter of 2005, the Company and CCC executed amendments to the
reinsurance treaties that provide reinsurance protection for losses associated
with the large national contractor. Coverage for all losses in excess of an
aggregate $60 million is now provided under one treaty. Credit extended to the
principal by affiliates of the Company are described below.
CNAF CREDIT FACILITY
Commencing in 2003, CNAF 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 September
30, 2005 and 2004, $132 million (including accrued interest) and $85 million
(including accrued interest) had been advanced under the credit facility. Loews,
through a participation agreement with CNAF, provided funds for and owned a
participation of $39.6 million and $24.1 million of the loans outstanding as of
September 30, 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 September
30, 2005 and December 31, 2004, these guarantees and collateral obligations were
$11 million and $13 million, respectively.
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 pre-tax for the fourth quarter of 2004, net of the
participation by
13
Loews, with respect to amounts loaned under the credit facility and future
impairment charges with respect to amounts loaned under the credit facility in
2005 of $13 million pre-tax during the first quarter. Any future draws under the
credit facility, if agreed to by CNAF pursuant to the additional credit facility
amendment, or further changes in the large national contractor's business plan
or projections may necessitate further impairment charges.
Representatives from the Company and CNAF met with senior management of the
national contractor in June of 2005 to review their actual cash flow through
that date, as well as expected future cash flow. As a result of the discussions
with the contractor and after consideration of the contractor's overall
performance to date under the restructuring plan, CNAF made a decision not to
provide additional liquidity to the national contractor beyond amounts currently
available under the existing facility. In addition, during the second quarter of
2005, CNAF recorded an additional impairment charge of $21 million pre-tax.
ESTABLISHMENT OF SURETY LOSS RESERVE
The June 2005 discussions with the large national contractor revealed
significant deterioration of the contractor's operations and cash flow. This
deterioration was concentrated in an operating division of the contractor that
had previously been placed into run off. As a result of these developments, the
Company determined that the large national contractor will likely be unable to
meet its obligations that are covered under the surety bonds. Accordingly, in
the second quarter of 2005, the Company established a $40 million loss reserve
based on an initial estimate of probable surety losses. In the third quarter,
the Company approved the payment by an affiliate, the direct writer of the
surety bonds for the large national contractor, of approximately $16 million of
losses to settle outstanding bonded obligations of the contractor. The Company
will reimburse the affiliate pursuant to the terms of the Quota Share Treaty.
Also in the third quarter, the Company began a reevaluation of the contractor's
current restructuring efforts. Possible changes to the restructuring strategy
could result in higher loss estimates and result in additional reserve actions.
The Company expects to complete this reevaluation in the fourth quarter.
The Company intends to continue to provide surety bonds on behalf of the
contractor while re-evaluating the contractor's restructuring efforts, 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. The Company estimates that possible
additional losses, net of indemnification and subrogation recoveries but before
recoveries under reinsurance contracts to be approximately $160 million pre-tax.
However, the related party reinsurance treaty discussed above would limit the
Company's net loss exposure to an additional $20 million. In establishing its
overall reserves at September 30, 2005, the Company has contemplated the
potential need for additional loss reserves related to this contractor as well
as other potential exposures.
4. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the reserves for unpaid losses and loss adjustment expenses was
as follows (dollars in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------
2005 2004 2005 2004
-------- -------- -------- --------
Reserves at beginning of period:
Gross ................................................... $402,769 $412,367 $363,387 $413,539
Ceded reinsurance ....................................... 114,212 160,419 116,831 158,357
-------- -------- -------- --------
Net reserves at beginning of period .................. 288,557 251,948 246,556 255,182
-------- -------- -------- --------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period ....... 23,403 22,843 107,630 65,252
(Decrease) increase in provision for insured events
of prior periods .................................. (3,427) 4 (3,300) (567)
-------- -------- -------- --------
Total net incurred ................................... 19,976 22,847 104,330 64,685
-------- -------- -------- --------
Net payments attributable to:
Current period events ................................ 1,444 1,320 2,375 2,814
Prior period events .................................. 3,099 23,012 44,521 66,590
-------- -------- -------- --------
Total net payments ................................... 4,543 24,332 46,896 69,404
-------- -------- -------- --------
Net reserves at end of period ........................... 303,990 250,463 303,990 250,463
Ceded reinsurance at end of period ...................... 101,957 126,937 101,957 126,937
-------- -------- -------- --------
Gross reserves at end of period ...................... $405,947 $377,400 $405,947 $377,400
======== ======== ======== ========
14
As a result of the independent actuarial review performed during the third
quarter of 2005, the Company recorded net favorable reserve development of $3.4
million for the three months ended September 30, 2005.
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 September 30, 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 paid the Company
to commute the entire reinsurance treaty under which the Enron claim was made.
5. DEBT
On July 27, 2005, the Company refinanced $30.0 million in outstanding
borrowings under its previous credit facility with a new credit facility (the
"2005 Credit Facility"). The 2005 Credit Facility provides an aggregate of up to
$50.0 million in borrowings under a revolving credit facility. The 2005 Credit
Facility matures on June 30, 2008. No other debt matures in the next five years.
The term of borrowings under the 2005 Credit Facility may be fixed, at the
Company's option, for a period of one, two, three, or six months. The interest
rate is based on, among other rates, the London Interbank Offered Rate ("LIBOR")
plus the applicable margin. The margin, including a facility fee and utilization
fee, can vary based on the Company's leverage ratio (debt to total
capitalization) from 1.15% to 1.45%. The margin was 1.30% at September 30, 2005.
As of September 30, 2005, the weighted average interest rate on the 2005 Credit
Facility was 4.98% on the $30.0 million of outstanding borrowings.
The Company's previous credit facility (the "2002 Credit Facility"), as
amended September 30, 2003, provided an aggregate of up to $50.0 million in
borrowings divided between a revolving credit facility of $30.0 million and a
term loan facility (the "Term Loan Facility") of $20.0 million. 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 2005 Credit Facility contains, among other conditions, limitations on
the Company 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 2005 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 $375.0 million and c)
minimum fixed charge coverage ratio of 2.5 times. The Company was in compliance
with all covenants for the quarter ended September 30, 2005.
Due to the net loss reported in the quarter ended June 30, 2005, the
Company did not meet the minimum fixed charge coverage ratio of 2.5 times as of
June 30, 2005 as required by the 2002 Credit Facility. This issue was resolved
as a result of the replacement of the 2002 Credit Facility with the 2005 Credit
Facility.
In May of 2004, the Company, through a wholly-owned trust, privately issued
$30.0 million of preferred securities through two pooled transactions. These
securities bear interest at a rate of LIBOR plus 337.5 basis points with a
30-year term and are redeemable after five years. The securities were issued by
CNA Surety Capital Trust I (the "Issuer Trust"). The 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 September 30, 2005 the interest
rate on the junior subordinated debenture was 7.17%.
15
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.
The plans' combined net periodic postretirement benefit cost included the
following components (amounts in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2005 2004 2005 2004
----- ---- ----- -----
Net periodic benefit cost:
Service cost .......................... $107 $ 38 $ 181 $ 112
Interest cost ......................... 233 84 382 254
Prior service cost .................... (40) (40) (121) (121)
Recognized net actuarial (gain) loss .. 145 (1) 145 (3)
---- ---- ----- -----
Net periodic benefit cost ............. $445 $ 81 $ 587 $ 242
==== ==== ===== =====
The Company expects to contribute $0.3 million to the postretirement
benefit plans to pay benefits in 2005. As of September 30, 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 $36,000, a reduction in
interest cost of $71,000, and an increase in the amortization of unrecognized
gains of $83,000, for a total reduction in annual net periodic postretirement
benefit cost of $190,000.
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.
16
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.
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 September 30,
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............. $ 98,773 $136,781 $235,554
Commercial........... 100,955 57,730 158,685
Fidelity and other... 4,363 7,345 11,708
-------- -------- --------
Total................ $204,091 $201,856 $405,947
======== ======== ========
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
17
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 Condensed Consolidated Balance Sheets includes estimated
liabilities for unpaid losses and loss adjustment expenses of $405.9 million and
$363.4 million and reinsurance receivables related to unpaid losses of $102.0
million and $116.8 million at September 30, 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 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 September 30, 2005
and December 31, 2004 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
18
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.
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.
COMPARISON OF CNA SURETY RESULTS FOR THE THREE AND NINE MONTHS ENDED
SEPTEMBER 30, 2005 AND 2004
ANALYSIS OF NET INCOME
Net income for the three months ended September 30, 2005 was $19.8 million,
compared to a net income of $11.0 million for the same period in 2004. This
increase is a result of higher net earned premium, higher net investment income,
and the impacts of lower loss and expense ratios. The lower loss ratio reflects
favorable loss development on prior accident years of $3.4 million.
Net income for the nine months ended September 30, 2005 was $21.9 million
compared to $27.5 million for the same period in 2004. The decrease reflects
higher losses in large part due to the establishment of a $40 million loss
reserve related to the large
19
national contractor in the second quarter of 2005, partially offset by higher
net earned premium and higher net investment income. The decrease was also
offset by favorable loss development on prior accident years of $3.3 million.
The components of net income are discussed in the following sections.
RESULTS OF INSURANCE OPERATIONS
Underwriting components for the Company for the three and nine months ended
September 30, 2005 and 2004 are summarized in the following table (dollars in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------
2005 2004 2005 2004
-------- -------- -------- --------
Gross written premiums.................... $113,482 $102,151 $323,319 $301,094
======== ======== ======== ========
Net written premiums...................... $103,031 $ 86,417 $282,532 $244,083
======== ======== ======== ========
Net earned premiums....................... $ 91,061 $ 83,068 $256,881 $235,418
======== ======== ======== ========
Net losses and loss adjustment expenses... $ 19,976 $ 22,847 $104,330 $ 64,685
======== ======== ======== ========
Net commissions, brokerage and other
expenses................................ $ 51,891 $ 52,245 $150,593 $156,627
======== ======== ======== ========
Loss ratio................................ 21.9% 27.5% 40.6% 27.5%
Expense ratio............................. 57.0 62.9 58.6 66.5
-------- -------- -------- --------
Combined ratio............................ 78.9% 90.4% 99.2% 94.0%
======== ======== ======== ========
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------
2005 2004 2005 2004
-------- -------- -------- --------
Contract.......................... $ 71,044 $ 61,610 $194,179 $172,807
Commercial........................ 33,568 32,548 102,069 103,877
Fidelity and other................ 8,870 7,993 27,071 24,410
-------- -------- -------- --------
$113,482 $102,151 $323,319 $301,094
======== ======== ======== ========
Gross written premiums increased 11.1% to $113.5 million, for the three
months ended September 30, 2005 as compared with the same period in 2004.
Contract surety gross written premiums increased 15.3% to $71.0 million due
primarily to increased volume. Commercial surety gross written premiums
increased 3.1% to $33.6 million due to continued volume growth in small
commercial products, partially offset by declining premium volume on large
commercial accounts. Fidelity and other premiums increased by 11.0% primarily
due to the volume growth of related small commercial products.
Gross written premiums increased 7.4%, or $22.2 million, for the nine
months ended September 30, 2005 as compared with the same period in 2004. This
increase was primarily a result of a 12.4% or $21.4 million, increase in
contract surety as compared with the same period in 2004, due to volume growth.
Commercial surety decreased 1.7%, or $1.8 million, as continued strong volume
growth
20
in small commercial products was more than offset by declining premium volume on
large commercial accounts. Fidelity and other premiums increased by 10.9%
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -------------------
2005 2004 2005 2004
-------- ------- -------- --------
Contract............. $ 61,732 $45,775 $157,847 $130,384
Commercial........... 32,429 33,015 97,614 90,375
Fidelity and other... 8,870 7,627 27,071 23,324
-------- ------- -------- --------
$103,031 $86,417 $282,532 $244,083
======== ======= ======== ========
Net written premiums increased 19.2% or $16.6 million, for the three months
ended September 30, 2005 as compared with the same period in 2004, primarily due
to the increase in gross written premiums as described above and a decrease in
ceded written premiums. Ceded written premiums decreased $5.3 million for the
three months ended September 30, 2005 as compared with the same period in 2004,
reflecting the reduction in the cost of the Company's 2005 reinsurance program.
For the nine months ended September 30, 2005, net written premiums
increased 15.8%, or $38.4 million, as compared with the same period in 2004,
primarily due to the increase in gross written premiums as described above and a
decrease in ceded written premiums. Ceded written premiums decreased $16.2
million for the nine months ended September 30, 2005 as compared with the same
period in 2004, reflecting the reduction in the cost of the Company's 2005
reinsurance program. Net written premiums increased 17.8%, or $23.8 million, for
contract surety and 12.6%, or $10.9 million, for commercial surety for the nine
months ended September 30, 2005 as compared with the same period in 2004. Net
written premiums increased 16.1%, or $3.7 million, for fidelity and other
products for the nine months ended September 30, 2005 as compared with the same
period in 2004.
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.
The Services and Indemnity Agreement provides the Company's insurance
subsidiaries 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.
21
Through a surety quota share treaty (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.
For the quota share treaty in effect during 2004, the ceding commission
paid to CCC and CIC by Western Surety was 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 September 30, 2005.
Through a stop loss contract entered into at the Merger Date (the "Stop
Loss Contract"), the Company's insurance subsidiaries were protected 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 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. As of September 30, 2005,
the Company had billed and received $54.9 million under the Stop Loss Contract.
As a result of reevaluation and reduction of the net loss ratios for the
accident years subject to the Stop Loss Contract, the Company has established a
reinsurance payable to CCC of $9.0 million under this contract at September 30,
2005.
The Company and CCC previously participated in a $40 million excess of $60
million reinsurance contract effective from January 1, 2004 to December 31, 2004
providing coverage exclusively for the one large national contractor that is
excluded from the Company's third party reinsurance. 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. In the second quarter of 2005, this
contract was amended to provide unlimited coverage in excess of the $60 million
retention, to increase the premium to $7.0 million, and to eliminate the
additional premium provision. This treaty provides coverage for the life of
bonds either in force or written during the term of the treaty which is from
January 1, 2005 to December 31, 2005. As of September 30, 2005, no losses have
been ceded under this contract.
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 was $4.75 million plus an additional premium
of $14.0 million if a loss is ceded under this contract. In the second quarter
of 2005, this contract was amended to exclude coverage for the large national
contractor, to reduce the premium to $3.0 million, and to reduce the additional
premium to $7.0 million. As of September 30, 2005, no losses have been ceded
under this contract.
LARGE NATIONAL CONTRACTOR
The Company has provided significant surety bond protection guaranteeing
projects undertaken by the large national contract principal that is excluded
from the Company's third party insurance. As previously described, during the
second quarter of 2005, the Company and CCC executed amendments to the
reinsurance treaties that provide reinsurance protection for losses associated
with the large national contractor. Coverage for all losses in excess of an
aggregate $60 million is now provided under one treaty. Credit extended to the
principal by affiliates of the Company are described below.
22
CNAF CREDIT FACILITY
Commencing in 2003, CNAF 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 September
30, 2005 and 2004, $132 million (including accrued interest) and $85 million
(including accrued interest) had been advanced under the credit facility. Loews,
through a participation agreement with CNAF, provided funds for and owned a
participation of $39.6 million and $24.1 million of the loans outstanding as of
September 30, 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 September
30, 2005 and December 31, 2004, these guarantees and collateral obligations were
$11 million and $13 million, respectively.
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 pre-tax ($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 and future impairment charges with respect to amounts loaned
under the credit facility in 2005 of $13 million pre-tax ($9 million after-tax)
during the first quarter. Any future draws under the credit facility, if agreed
to by CNAF pursuant to additional credit facility amendment, or further changes
in the large national contractor's business plan or projections may necessitate
further impairment charges.
Representatives from the Company and CNAF met with senior management of the
national contractor in June of 2005 to review their actual cash flow through
that date, as well as expected future cash flow. As a result of the discussions
with the contractor and after consideration of the contractor's overall
performance to date under the restructuring plan, CNAF made a decision not to
provide additional liquidity to the national contractor beyond amounts currently
available under the existing facility. In addition, during the second quarter of
2005, CNAF recorded an additional impairment charge of $21 million pre-tax ($13
million after-tax).
ESTABLISHMENT OF SURETY LOSS RESERVE
The June 2005 discussions with the large national contractor revealed
significant deterioration of the contractor's operations and cash flow. This
deterioration was concentrated in an operating division of the contractor that
had previously been placed into run off. As a result of these developments, the
Company determined that the large national contractor will likely be unable to
meet its obligations that are covered under the surety bonds. Accordingly, in
the second quarter of 2005, the Company established a $40 million loss reserve
based on an initial estimate of probable surety losses. In the third quarter,
the Company approved the payment by an affiliate, the direct writer of the
surety bonds for the large national contractor, of approximately $16 million of
losses to settle outstanding bonded obligations of the contractor. The Company
will reimburse the affiliate pursuant to the terms of the Quota Share Treaty.
Also in the third quarter, the Company began a reevaluation of the contractor's
current restructuring efforts. Possible changes to the restructuring strategy
could result in higher loss estimates and result in additional reserve actions.
The Company expects to complete this reevaluation in the fourth quarter.
The Company intends to continue to provide surety bonds on behalf of the
contractor while re-evaluating the contractor's restructuring efforts, 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. The Company estimates that possible
additional losses, net of indemnification and subrogation recoveries but before
recoveries under reinsurance contracts to be approximately $160 million pre-tax.
However, the related party reinsurance treaty discussed above would limit the
Company's net loss exposure to an additional $20 million. In establishing its
overall reserves at September 30, 2005, the Company has contemplated the
potential need for additional loss reserves related to this contractor as well
as other potential exposures.
23
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 21.9% for the three months ended September 30, 2005
as compared with 27.5% for the same period in 2004. The lower loss ratio
reflects the favorable development on prior accident years of $3.4 million, or
approximately 4 percentage points, and lower loss estimates for the current
accident year due to improved loss experience. The loss ratio also benefited
from an increase in net earned premium that resulted from the reduction in the
cost of the Company's 2005 reinsurance program.
The net loss ratio was 40.6% for the nine months ended September 30, 2005
as compared with 27.5% for the same period in 2004. The increase in the loss
ratio reflects the reserve charge of $40 million related to the large national
contractor, which added 16 percentage points to this ratio. This was partially
offset by favorable development on prior accident years of $3.3 million and an
increase in net earned premium that resulted from the reduction in the cost of
the Company's 2005 reinsurance program.
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 September 30, 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 paid the Company
to commute the entire reinsurance treaty under which the Enron claim was made.
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 26.8% in 2005 on large
commercial accounts, which are defined as accounts with exposures in excess of
$10 million:
NUMBER OF ACCOUNTS TOTAL EXPOSURE (DOLLARS IN MILLIONS)
AS OF AS OF
---------------------------- ------------------------------------------
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, DECEMBER 31, % INCREASE/
COMMERCIAL ACCOUNT EXPOSURE 2005 2004 2005 2004 (DECREASE)
--------------------------- ------------- ------------ ------------- ------------ -----------
$100 million and larger 2 2 $ 247.8 $ 256.4 (3.4)%
$50 to $100 million 2 7 139.6 468.1 (70.2)%
$25 to $50 million 10 11 355.4 401.0 (11.4)%
$10 to $25 million 36 39 500.8 572.5 (12.5)%
--- --- -------- -------- -----
Total 50 59 $1,243.6 $1,698.0 (26.8)%
=== === ======== ======== =====
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 15
accounts each with a bonded backlog in excess of $150 million and 20 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.
24
EXPENSE RATIO
The expense ratio was 57.0% for the three months ended September 30, 2005
as compared with 62.9% for the same period in 2004. Approximately two percentage
points of this improvement resulted from the impact of the reduction in cost of
the Company's 2005 reinsurance program. The remaining improvement resulted from
premium volume growth and the impacts of cost reduction initiatives that began
in the first quarter of 2004.
The expense ratio was 58.6% for the nine months ended September 30, 2005 as
compared with 66.5% for the same period in 2004. Approximately three percentage
points of this improvement resulted from the impact of the reduction in cost of
the Company's 2005 reinsurance program. The improved expense ratio also reflects
higher premium volume and the impacts of cost reduction initiatives to simplify
and streamline the field organization that began in the first quarter of 2004.
The improved expense ratio also reflects the absence of expenses associated with
the cost reduction initiatives and the increased accrual for policyholder
dividends that were recorded in the first quarter of 2004. These items added 2.9
percentage points to the expense ratio for the first nine months of 2004.
INVESTMENT INCOME AND REALIZED INVESTMENT GAINS/LOSSES
Net investment income was $8.7 million for the three months ended September
30, 2005, as compared with $7.7 million for the same period in 2004. This is due
to the significant increase in invested assets. The annualized pre-tax yield was
4.3% for both the three months ended September 30, 2005 and 2004. The annualized
after-tax yield was 3.6% for both the three months ended September 30, 2005 and
2004. Net realized investment gains were negligible for both the three months
ended September 30, 2005 and 2004.
Net investment income was $24.7 million for the nine months ended September
30, 2005 as compared with $22.1 million for the same period in 2004. The
increase is due to the impact of higher overall invested assets, partially
offset by slightly lower yields. The annualized pre-tax yields were 4.3% and
4.4% for the nine months ended September 30, 2005 and 2004, respectively. The
annualized after-tax yield was 3.6% and 3.7% for the nine months ended September
30, 2005 and 2004, respectively. Net realized investment gains were $2.1 million
for the nine months ended September 30, 2005 as compared with $2.5 million for
the same period in 2004. The realized investment gain in 2005 resulted primarily
from the Company's sale of its interest in DeMontfort Group, Ltd. in the first
quarter of 2005.
The following summarizes net realized investment gains (losses) activity
(dollars in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2005 2004 2005 2004
---- ---- ------ ------
Gross realized investment gains.... $109 $194 $2,280 $2,481
Gross realized investment losses... (1) - (156) (5)
---- ---- ------ ------
Net realized investment gains...... $108 $194 $2,124 $2,476
==== ==== ====== ======
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.
INTEREST EXPENSE
Interest expense increased by 41.3% for the three months ended September
30, 2005 as compared with the same period in 2004, due to higher interest rates
associated with the Credit Facility and the subordinated debentures issued in
the second quarter of 2004. Weighted average debt outstanding was $60.9 million
for the three months ended September 30, 2005 as compared with $66.0 million for
the same period in 2004. The weighted average interest rate for the three months
ended September 30, 2005 was 5.9% as compared with 3.8% for the same period in
2004.
25
Interest expense also increased slightly for the nine months ended
September 30, 2005 as compared with the same period in 2004. Average debt
outstanding was $62.6 million for the nine months ended September 30, 2005
compared to $59.2 million in the same period in 2004. The weighted average
interest rate for the nine months ended September 30, 2005 was 5.3% as compared
with 3.3% for the same period in 2004.
INCOME TAXES
For the three and nine months ended September 30, 2004 and 2005, the
Company's effective tax rate differs from the statutory tax rate due primarily
to tax exempt investment income. The impact of tax exempt securities on taxable
income was $4.1 million and $12.1 million for the three and nine months ended
September 30, 2005. The impact of tax exempt securities on taxable income was
$3.6 million and $10.7 million for the three and nine months ended September 30,
2004.
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, sales and
maturities of investments, and reinsurance recoveries. 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,
reinsurance premiums, federal income taxes, and debt service. In general, surety
operations generate premium collections from customers in advance of cash
outlays for claims. Premiums are invested until such time as funds are required
to pay claims and claims adjusting expenses.
The Company believes that total invested assets, including cash and
short-term investments, are sufficient in the aggregate and have suitably
scheduled maturities to satisfy all policy claims and other operating
liabilities, including dividend and income tax sharing payments of its insurance
subsidiaries. At September 30, 2005, the carrying value of the Company's
insurance subsidiaries' invested assets was comprised of $710.9 million of fixed
income securities, $77.0 million of short-term investments, $1.0 million of
other investments and $4.6 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, $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 deposited $32.7 million with the affiliate in the third
quarter of 2005 to enable the affiliate to establish a trust to fund future
payments under the bond. Such deposit is included on the Company's Condensed
Consolidated Balance Sheets as "Deposit with affiliated ceding company". This
claim was previously fully reserved. The Company is entitled to the interest
income earned by the trust in excess of trust expenses.
Cash flow at the parent company level is derived principally from dividend
and tax sharing payments from its insurance subsidiaries. The principal
obligations at the parent company level are to service debt and pay operating
expenses, including income taxes. At September 30, 2005, the parent company's
invested assets consisted of $1.0 million of fixed income securities, $1.2
million of equity securities, $14.6 million of short-term investments and $1.7
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
September 30, 2005 and December 31, 2004 respectively, parent company short-term
investments and cash included $2.9 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 $12.5 million for the three months ended September 30, 2005 compared to net
cash flow provided by operating activities of $44.2 million for the comparable
period in 2004. The decrease in net cash flow provided by operating activities
primarily relates to the Company's deposit with an affiliate to establish the
trust discussed above.
The Company's consolidated net cash flow provided by operating activities
was $68.1 million for the nine months ended September 30, 2005 compared to net
cash flow provided by operating activities of $103.5 million for the comparable
period in 2004. The decrease in net cash flow provided by operating activities
primarily relates to the Company's deposit with an affiliate to establish the
trust discussed above.
26
On July 27, 2005, the Company refinanced $30.0 million in outstanding
borrowings under its previous credit facility with a new credit facility (the
"2005 Credit Facility"). The 2005 Credit Facility provides an aggregate of up to
$50.0 million in borrowings under a revolving credit facility. The 2005 Credit
Facility matures on June 30, 2008. No other debt matures in the next five years.
The term of the borrowings under the 2005 Credit Facility may be fixed, at
the Company's option, for a period of one, two, three, or six months. The
interest rate is based on, among other rates, the London Interbank Offered Rate
("LIBOR") plus the applicable margin. The margin, including a facility fee and
utilization fee, can vary based on the Company's leverage ratio (debt to total
capitalization) from 1.15% to 1.45%. The margin was 1.30% at September 30, 2005.
As of September 30, 2005, the weighted average interest rate on the 2005 Credit
Facility was 4.98% on the $30.0 million of outstanding borrowings.
The Company's previous credit facility (the "2002 Credit Facility"), as
amended September 30, 2003, provided an aggregate of up to $50.0 million in
borrowings divided between a revolving credit facility of $30.0 million and a
term loan facility (the "Term Loan Facility") of $20.0 million. 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 2005 Credit Facility contains, among other conditions, limitations on
the Company 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 2005 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 $375.0 million and c)
minimum fixed charge coverage ratio of 2.5 times. The Company is in compliance
with all covenants during the quarter ended September 30, 2005.
Due to the net loss reported in the quarter ended June 30, 2005, the
Company did not meet the minimum fixed charge coverage ratio of 2.5 times as of
June 30, 2005 as required by the 2002 Credit Facility. This issue was resolved
as a result of the replacement of the 2002 Credit Facility with the 2005 Credit
Facility.
In May of 2004, the Company, through a wholly-owned trust, privately issued
$30.0 million of preferred securities through two pooled transactions. These
securities bear interest at a rate of LIBOR plus 337.5 basis points with a
30-year term and are redeemable after five years. The securities were issued by
CNA Surety Capital Trust I (the "Issuer Trust"). The 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 September 30, 2005 the interest
rate on the junior subordinated debenture was 7.17%.
A summary of the Company's commitments as of September 30, 2005 is
presented in the following table (in millions):
SEPTEMBER 30, 2005 2005 2006 2007 2008 2009 THEREAFTER TOTAL
------------------ ----- ------ ----- ----- ----- ---------- ------
Debt (a)................................... $ 0.8 $ 3.7 $ 3.7 $33.2 $ 2.2 $ 85.1 $128.7
Operating leases........................... 0.5 1.9 1.7 1.5 1.5 3.8 10.9
Loss and loss adjustment expense reserves.. 72.3 157.2 69.9 29.5 21.1 55.9 405.9
Other long-term liabilities (b)............ 0.2 0.3 0.4 0.4 0.4 6.4 8.1
----- ------ ----- ----- ----- ------ ------
Total...................................... $73.8 $163.1 $75.7 $64.6 $25.2 $151.2 $553.6
===== ====== ===== ===== ===== ====== ======
(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
27
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 dividends of $10 million from its insurance subsidiaries during the
first nine months of 2005 and no dividends from its insurance subsidiaries
during the first nine months of 2004. CNA Surety received $1.5 million in
dividends from its non-insurance subsidiaries during the first nine months of
2005, including $0.5 million in cash. CNA Surety received no dividends from its
non-insurance subsidiaries during the first nine months of 2004.
Combined statutory surplus totaled $261.9 million at September 30, 2005,
resulting in a net written premium to statutory surplus ratio of 1.4 to 1.
Insurance regulations restrict Western Surety's maximum net retention on a
single surety bond to 10 percent of statutory surplus. Under the 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 $11.8 million from its subsidiaries for the nine months ended
September 30, 2005. CNA Surety distributed tax payments of $12.5 million to its
subsidiaries for the nine months ended September 30, 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 were $18.5 million
and $0.6 million, respectively. Effective July 1, 2005 through June 30, 2006,
the underwriting limitations of Western Surety and Surety Bonding are $24.6
million and $0.7 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.
Effective July 1, 2005 through June 30, 2006, the underwriting limitations of
CCC and its affiliates total $645.7 million. CNA Surety management believes that
the foregoing U.S. Treasury underwriting limitations are sufficient for the
conduct of its business.
Subject to the aforementioned uncertainties concerning the Company's per
principal net retentions, CNA Surety management believes that the Company has
sufficient available resources, including capital protection against large
losses provided by the Company's excess of loss reinsurance arrangements, to
meet its present capital needs.
28
FINANCIAL CONDITION
INVESTMENT PORTFOLIO
The estimated fair value and amortized cost or cost of fixed income and
equity securities held by CNA Surety at September 30, 2005 and December 31,
2004, by investment category, were as follows (dollars in thousands):
GROSS
UNREALIZED LOSSES
---------------------
AMORTIZED GROSS LESS MORE ESTIMATED
COST OR UNREALIZED THAN THAN FAIR
SEPTEMBER 30, 2005 COST GAINS 12 MONTHS 12 MONTHS VALUE
------------------ --------- ---------- --------- --------- ---------
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury................................... $ 15,650 $ 38 $ (131) $ (10) $ 15,547
U.S. Agencies................................... 14,120 26 (125) (61) 13,960
Collateralized mortgage obligations............. 18,661 449 (99) -- 19,011
Mortgage pass-through securities................ 48,736 110 (430) (352) 48,064
Obligations of states and political subdivisions... 465,506 16,461 (1,176) (358) 480,433
Corporate bonds.................................... 75,602 2,244 (656) (18) 77,172
Non-agency collateralized mortgage obligations..... 22,203 -- (459) -- 21,744
Other asset-backed securities:
Second mortgages/home equity loans.............. 25,924 133 (122) -- 25,935
Other........................................... 6,748 167 (70) -- 6,845
Redeemable preferred stock......................... 3,000 188 -- -- 3,188
-------- ------- ------- ----- --------
Total fixed income securities................... 696,150 19,816 (3,268) (799) 711,899
Equity securities.................................. 1,144 105 -- -- 1,249
-------- ------- ------- ----- --------
Total........................................... $697,294 $19,921 $(3,268) $(799) $713,148
======== ======= ======= ===== ========
GROSS
UNREALIZED LOSSES
---------------------
AMORTIZED GROSS LESS MORE ESTIMATED
COST OR UNREALIZED THAN THAN FAIR
DECEMBER 31, 2004 COST GAINS 12 MONTHS 12 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
======== ======= ===== ===== ========
29
The following table summarizes for fixed income securities in an unrealized
loss position at September 30, 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):
SEPTEMBER 30, 2005 DECEMBER 31, 2004
----------------------- -----------------------
GROSS GROSS
ESTIMATED UNREALIZED ESTIMATED UNREALIZED
UNREALIZED LOSS AGING FAIR VALUE LOSS FAIR VALUE LOSS
--------------------- ---------- ---------- ---------- ----------
Fixed income securities:
0-12 months..................... $238,276 $3,268 $107,401 $ 885
Greater than 12 months.......... 24,450 799 5,484 138
-------- ------ -------- ------
Total fixed income securities... $262,726 $4,067 $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 Condensed Consolidated Statements of Operations.
As of September 30, 2005, 70 separate securities held by the Company were
in an unrealized loss position. Of these, 46 securities were rated "AAA" by
Standard and Poor's ("S&P") and "Aaa" by Moody's Investor Services ("Moody's").
One security was rated below investment grade by Moody's and investment grade by
S&P. Only two securities were in loss positions that exceeded 5% of their
respective book values, with the largest unrealized loss being approximately 6%
of that security's book value. The Company believes that virtually all of the
unrealized losses have resulted from changes in interest rates. No
other-than-temporary impairments were recorded for the nine months ended
September 30, 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 Financial Accounting Standards Board ("FASB")
issued SFAS No. 123 (revised 2004), "Share-Based Payments" ("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 Opinion 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 No. 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
30
("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.
In May of 2005, the FASB issued Statement of Financial Accounting Standard
No. 154, Accounting Changes and Error Correction. This standard is a replacement
of Accounting Policy Board Opinion No. 20 and FASB Standard No. 3. Under the new
standard, any voluntary changes in accounting principles should be adopted via a
retrospective application of the accounting principle in the financial
statements presented in addition to obtaining an opinion from the auditors that
the new principle is preferred. In addition, adoption of a change in accounting
principle required by the issuance of a new accounting standard would also
require retroactive restatement, unless the new standard includes explicit
transition guidelines. This new standard is effective for fiscal years beginning
after December 14, 2005.
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;
31
- 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.
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 September 30, 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
SEPTEMBER 30, INTEREST RATE CHANGE IN STOCKHOLDERS'
2005 (BP=BASIS POINTS) INTEREST RATE EQUITY
------------- ----------------- -------------- --------------
(DOLLARS IN THOUSANDS)
U.S. Government and government agencies and
authorities..................................... $ 96,582 200 bp increase $ 87,366 (1.3)%
100 bp increase 92,266 (0.6)
100 bp decrease 99,804 0.5
200 bp decrease 102,002 0.8
States, municipalities and political subdivisions.. 480,433 200 bp increase 425,647 (7.7)
100 bp increase 452,732 (3.9)
100 bp decrease 509,779 4.1
200 bp decrease 541,521 8.6
Corporate bonds and all other...................... 134,884 200 bp increase 122,939 (1.7)
-------- 100 bp increase 128,728 (0.9)
100 bp decrease 141,348 0.9
200 bp decrease 148,141 1.9
Total fixed income securities...................... $711,899 200 bp increase 635,952 (10.7)
======== 100 bp increase 673,726 (5.4)
100 bp decrease 750,931 5.5
200 bp decrease 791,664 11.2
32
HYPOTHETICAL
ESTIMATED FAIR PERCENTAGE
HYPOTHETICAL VALUE AFTER INCREASE
FAIR VALUE AT CHANGE IN HYPOTHETICAL (DECREASE) IN
SEPTEMBER 30, INTEREST RATE CHANGE IN STOCKHOLDERS'
2005 (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
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 Note 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 - None.
ITEM 5. OTHER INFORMATION - Reports on Form 8-K:
July 28, 2005; CNA Surety Corporation Press Release issued on July 28, 2005
(Credit Facility Restructure)
33
ITEM 6. EXHIBITS
EXHIBIT NUMBER
--------------
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.
34
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
Senior Vice President and Chief Financial Officer
Date: October 31, 2005
35
EXHIBIT INDEX
31(1) Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act
of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002-Chief Executive Officer.
31(2) Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act
of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 -- Chief Financial Officer.
32(1) Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002- Chief Executive Officer.
32(2) Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002- Chief Financial Officer.
36