Edgar Filing: CNA SURETY CORP

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-K

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[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER: 1-13277

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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 ORGANIZATION)

CNA CENTER, CHICAGO, ILLINOIS 60685
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

(312) 822-5000
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

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Securities registered pursuant to Section 12(b) of the Act: NONE

Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $0.01 PAR VALUE
(Title of Class)

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Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes [ ] No [X].

Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X].

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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]

Indicate by a check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filers and large accelerated filer" in Rule 12b-2 of the Exchange
Act. (Check one):
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated
filer [ ].

Indicate by check mark whether the registrant is a shell company (as
defined by Rule 12b-2 of the Exchange Act) Yes [ ] No [X].

The aggregate market value of voting stock held by non-affiliates was
$251.8 million based upon the closing price of $15.76 per share on February 17,
2006, using beneficial ownership of stock rules adopted pursuant to Section 13
of the Securities Exchange Act of 1934 to exclude voting stock owned by
Directors, Officers and Major Stockholders, some of whom may not be held to be
affiliates upon judicial determination.

At February 17, 2006, 43,404,009 shares of the Registrant's Common Stock
were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the CNA Surety Corporation Proxy Statement prepared for the
2006 annual meeting of shareholders, pursuant to Regulation 14A, are
incorporated by reference into Part III of this report.

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CNA SURETY CORPORATION AND SUBSIDIARIES

TABLE OF CONTENTS

PAGE
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PART I
Item 1. Business..................................................... 2
General.................................................... 2
Formation of CNA Surety and Merger......................... 2
Description of Business.................................... 2
Financial Strength Ratings................................. 2
Product Information........................................ 3
Marketing.................................................. 5
Underwriting............................................... 6
Competition................................................ 6
Reinsurance................................................ 7
Reserves for Unpaid Losses and Loss Adjustment Expenses.... 7
Claims..................................................... 9
Environmental Claims....................................... 10
Regulation................................................. 10
Investments................................................ 11
Employees.................................................. 11
Availability of SEC Reports................................ 11
Item 1A. Risk Factors................................................. 12
Item 1B. Unresolved Staff Comments.................................... 14
Item 2. Properties................................................... 14
Item 3. Legal Proceedings............................................ 15
Item 4. Submission of Matters to a Vote of Security Holders.......... 15

PART II
Item 5. Market for the Registrant's Common Stock, Related Stockholder
Matters and Issuer Purchases of Equity Securities............ 16
Item 6. Selected Financial Data...................................... 17
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................... 18
Item 7A. Quantitative and Qualitative Discussions About Market Risk... 39
Item 8. Financial Statements and Supplementary Data.................. 42
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure..................................... 76
Item 9A. Controls and Procedures...................................... 76
Item 9B. Other Information............................................ 76

PART III
Item 10. Directors and Executive Officers of the Registrant........... 76
Item 11. Executive Compensation....................................... 76
Item 12. Security Ownership of Certain Beneficial Owners and
Management................................................... 76
Item 13. Certain Relationships and Related Transactions............... 76
Item 14. Principal Accountant Fees and Services....................... 76

PART IV
Item 15. Exhibits and Financial Statement Schedules................... 77

CNA SURETY CORPORATION AND SUBSIDIARIES

PART I.

ITEM 1. BUSINESS

GENERAL

CNA Surety Corporation ("CNA Surety" or "Company") is an insurance holding
company in the United States formed through the September 30, 1997 combination
of the surety business of CNA Financial Corporation with Capsure Holdings
Corp.'s ("Capsure") insurance subsidiaries. CNA Surety is currently one of the
largest surety providers in the United States with approximately an 8.3% market
share (based upon 2004 Surety Association of America ("SAA") written premium
data). Its wide selection of surety products range from very small commercial
bonds to large contract bonds.

FORMATION OF CNA SURETY AND MERGER

In December 1996, CNA Financial Corporation ("CNAF") and Capsure agreed to
merge (the "Merger") the surety business of CNAF with Capsure's insurance
subsidiaries, Western Surety Company ("Western Surety"), 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.

DESCRIPTION OF BUSINESS

The Company's corporate objective is to be the leading provider of surety
and surety-related products in North America and to be the surety of choice for
its customers and independent agents and brokers. CNA Surety's insurance
subsidiaries write surety and fidelity bonds in all 50 states through a combined
network of approximately 35,000 independent agencies. CNA Surety's insurance
subsidiaries are Western Surety, Surety Bonding, and USA. The insurance
subsidiaries write, on a direct basis or as business assumed from CCC and CIC,
small fidelity and non-contract surety bonds, referred to as commercial bonds;
small, medium and large contract bonds; and errors and omissions ("E&O")
liability insurance. Western Surety is a licensed insurer in all 50 states, the
District of Columbia and Puerto Rico. Surety Bonding is licensed in 28 states
and the District of Columbia. USA is licensed in 44 states and the District of
Columbia.

FINANCIAL STRENGTH RATINGS

A.M. BEST COMPANY, INC.

Western Surety is currently rated A (Excellent) with a stable rating
outlook, by A.M. Best Company, Inc. ("A.M. Best"). An A (Excellent) rating is
assigned to those companies which A.M. Best believes have an excellent ability
to meet their ongoing obligations to policyholders. A (Excellent) rated insurers
have been shown to be among the strongest in ability to meet policyholder and
other contractual obligations. The rating outlook indicates the potential
direction of a company's rating for an intermediate period, generally defined as
the next 12 to 36 months. Through inter-company reinsurance and related
agreements, CNA Surety's customers have access to CCC's broader underwriting
capacity. CCC is currently rated A (Excellent) with a negative outlook by A.M.
Best. A.M. Best's letter ratings range from A++ (Superior) to F (In Liquidation)
with A++ being highest.

STANDARD AND POOR'S ("S&P")

CCC and Western Surety are both currently rated A- (Strong), by S&P. On
August 7, 2003, S&P placed CCC and Western Surety on credit watch with negative
implications. S&P's letter ratings range from AAA+ (Extremely Strong) to CC
(Extremely Weak) with AAA+ being highest. Ratings from AA to CCC may be modified
by the addition of a plus or minus sign to show relative standing within the
major rating categories. An insurer rated A has strong financial security
characteristics, but is somewhat more likely to be affected by adverse business
conditions than are insurers with higher ratings.

PRODUCT INFORMATION

The United States surety market is represented by bonds required by federal
statutes, state laws, and local ordinances. These bonding requirements range
from federal construction projects, where the contractor is required to post
performance and payment bonds which guarantee performance of contracts to the
government as well as payment of bills to subcontractors and suppliers, to
license and permit bonds which guarantee compliance with legal requirements for
business operations.

PRODUCTS AND POLICIES

Unlike a standard, two-party insurance policy, surety bonds are three-party
agreements in which the issuer of the bond (the surety) joins with a second
party (the principal) in guaranteeing to a third party (the owner/obligee) the
fulfillment of some obligation on the part of the principal. The surety is the
party who guarantees fulfillment of the principal's obligation to the obligee.
In addition, sureties are generally entitled to recover from the principal any
losses and expenses paid to third parties. The surety's responsibility is to
evaluate the risk and determine if the principal meets the underwriting
requirements for the bond. Accordingly, surety bond premiums primarily reflect
the type and class of risk and related costs associated with both processing the
bond transaction and investigating the applicant including, if necessary, an
analysis of the applicant's credit worthiness and ability to perform.

There are two broad types of surety products -- contract surety and
commercial surety bonds. Contract surety bonds secure a contractor's performance
and/or payment obligation generally with respect to a construction project.
Contract surety bonds are generally required by federal, state and local
governments for public works projects. Commercial surety bonds include all
surety bonds other than contract and cover obligations typically required by law
or regulation.

Contract bond guarantee obligations include the following:

Bid bonds: used by contractors submitting proposals on potential
contracts. These bonds guarantee that a contractor will enter into a
contract at the amount bid and post the appropriate performance bonds.

Performance bonds: guarantee to the owner the performance of the
contractor's obligations according to the terms and conditions of the
contract.

Payment bonds: guarantee payment of the contractor's obligations under
the contract for labor, subcontractors, and materials supplied to the
project. Payment bonds are utilized in public projects where liens are not
permitted.

Other examples of contract bonds are completion, maintenance and supply
bonds.

Commercial surety business is comprised of bonds covering obligations
typically required by law or regulation, such as the following:

License and Permit bonds: required by statutes or ordinances for a
number of purposes including guaranteeing the payment of certain taxes and
fees and providing consumer protection as a condition to granting licenses
related to selling real estate or motor vehicles and contracting services.

Judicial and Fiduciary bonds: required by statutes, courts or legal
documents for the protection of those on whose behalf a fiduciary acts.
Examples of such fiduciaries include executors and administrators of
estates, and guardians of minors and incompetents.

Public Official bonds: required by statutes and ordinances to
guarantee the lawful and faithful performance of the duties of office by
public officials.

CNA Surety also writes direct contract and commercial surety bonds for
international risks. Such bonds are written to satisfy the international bond
requirements of domestic customers and for select foreign clients.

In addition, the Company markets surety related products such as fidelity
bonds and E&O insurance. Fidelity bonds cover losses arising from employee
dishonesty. Examples of purchasers of fidelity bonds are law firms, insurance
agencies and janitorial service companies. CNA Surety writes E&O policies for
two classes of insureds: notaries public and tax preparers. The notary public
E&O policy is marketed as a companion product to the notary public bond and the
tax preparer E&O policy is marketed to small tax return preparation firms.

Although all of its products are sold through the same independent
insurance agent and broker distribution network, the Company's underwriting is
organized by the two broad types of surety products -- contract surety and
commercial surety, which also includes fidelity bonds and other insurance
products for these purposes. These two operating segments have been aggregated
into one reportable business segment for financial reporting purposes because of
their similar economic and operating characteristics.

The following tables set forth, for each principal class of bonds, gross
written premiums, net written premiums and number of domestic bonds and policies
in force and the respective percentages of the total for the past three years
(amounts in thousands, except average bond amounts):

GROSS WRITTEN PREMIUMS
-------------------------------------------------
% OF % OF % OF
2005 TOTAL 2004 TOTAL 2003 TOTAL
-------- ----- -------- ----- -------- -----

Contract....................... $248,662 59.6% $221,577 56.9% $208,472 56.1%
Commercial:
License and permit........... 77,764 18.6 81,502 20.9 83,554 22.5
Judicial and fiduciary....... 23,142 5.5 22,590 5.8 24,075 6.5
Public official.............. 26,428 6.3 23,911 6.1 21,330 5.7
Other........................ 6,406 1.6 7,890 2.1 4,774 1.3
-------- ----- -------- ----- -------- -----
Total commercial............... 133,740 32.0 135,893 34.9 133,733 36.0
Fidelity and other............. 35,128 8.4 31,947 8.2 29,170 7.9
-------- ----- -------- ----- -------- -----
$417,530 100.0% $389,417 100.0% $371,375 100.0%
======== ===== ======== ===== ======== =====
Domestic....................... $415,520 99.5% $381,655 98.0% $363,290 97.8%
International.................. 2,010 0.5 7,762 2.0 8,085 2.2
-------- ----- -------- ----- -------- -----
$417,530 100.0% $389,417 100.0% $371,375 100.0%
======== ===== ======== ===== ======== =====

NET WRITTEN PREMIUMS
-------------------------------------------------
% OF % OF % OF
2005 TOTAL 2004 TOTAL 2003 TOTAL
-------- ----- -------- ----- -------- -----

Contract....................... $202,798 55.4% $172,274 54.1% $184,449 57.8%
Commercial..................... 128,022 35.0 115,454 36.3 106,899 33.5
Fidelity and other............. 35,128 9.6 30,556 9.6 27,862 8.7
-------- ----- -------- ----- -------- -----
$365,948 100.0% $318,284 100.0% $319,210 100.0%
======== ===== ======== ===== ======== =====
Domestic....................... $363,940 99.5% $311,620 97.9% $311,125 97.5%
International.................. 2,008 0.5 6,664 2.1 8,085 2.5
-------- ----- -------- ----- -------- -----
$365,948 100.0% $318,284 100.0% $319,210 100.0%
======== ===== ======== ===== ======== =====

DOMESTIC BONDS/POLICIES IN FORCE
----------------------------------------
% OF % OF % OF
2005 TOTAL 2004 TOTAL 2003 TOTAL
----- ----- ----- ----- ----- -----

Contract............................. 32 1.2% 33 1.4% 36 1.6%
Commercial........................... 1,901 72.4 1,803 73.8 1,723 74.6
Fidelity and other................... 693 26.4 606 24.8 550 23.8
----- ----- ----- ----- ----- -----
2,626 100.0% 2,442 100.0% 2,310 100.0%
===== ===== ===== ===== ===== =====

AVERAGE BOND PENALTY/POLICY
LIMIT(1)
------------------------------
2005 2004 2003
---------- -------- --------

Contract...................................... $1,011,252 $923,981 $834,798
Commercial.................................... $ 14,208 $ 14,673 $ 15,235
Fidelity and other............................ $ 20,380 $ 19,245 $ 17,660

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(1) The average bond penalty is a measure of the average limit of liability
associated with bonds in force at each reporting period.

In 2005, no individual agency generated more than 2.3% of aggregate gross
written premiums. Approximately $61.4 million, or 14.7%, of gross written
premiums were generated from national insurance brokers in 2005 with the single
largest national broker production comprising $13.3 million, or 3.2%, of gross
written premiums.

MARKETING

The Company principally markets its products in all 50 states, as well as
the District of Columbia and Puerto Rico. Its products are marketed primarily
through independent producers, including multi-line agents and brokers such as
surety specialists, many of whom are members of the National Association of
Surety Bond Producers. CNA Surety enjoys broad national distribution of its
products, which are marketed through approximately 35,000 of the approximately
44,000 independent property and casualty insurance agencies in the United
States. In addition, the Company employs 41 full-time salaried marketing
representatives and 5 telemarketing representatives to continually service its
vast producer network. Relationships with these independent producers are
maintained through the Company's 34 local branch offices.

The following table sets forth the distribution of the business of CNA
Surety, by state based upon gross written premiums in each of the last three
years:

YEARS ENDED
DECEMBER 31,
-------------------
2005 2004 2003
----- ----- -----

Gross Written Premiums by State:
California.......................................... 10.4% 10.4% 9.9%
Texas............................................... 8.7 8.8 9.8
Florida............................................. 7.4 6.6 6.6
Illinois............................................ 5.2 4.6 4.7
New York............................................ 4.1 4.0 4.6
Pennsylvania........................................ 3.4 3.1 3.0
Massachusetts....................................... 2.9 2.7 2.7
Michigan............................................ 2.8 2.7 3.0
Georgia............................................. 2.8 3.0 2.7
Arizona............................................. 2.6 2.0 1.9
All Other........................................... 49.7 52.1 51.1
----- ----- -----
Total............................................ 100.0% 100.0% 100.0%
===== ===== =====

Contract Surety

With respect to standard contract surety, the core target customers for the
Company are contractors with less than $50 million in contracted work in
progress. This segment is comprised of small contractors (less than $5 million
in work in progress), medium contractors ($5-$30 million) and the lower end of
the large contractors (greater than $30 million). These small and medium
contractors, as a group, represent a significant portion of the United States
construction market. The Company's marketing emphasis continues to be on small
and medium contractors, however the Company does have exposure to larger
contractors. These exposures are measured in terms of bonded backlog which is an
indication of the Company's exposure in event of default before indemnification
and salvage and subrogation recoveries. At December 31, 2005, the Company has 38
accounts each with a bonded backlog in excess of $100 million. The Company
actively monitors both the number of these large accounts and the exposure on
each account through a variety of underwriting methods. Some of these accounts
are maintained on a "co-surety" or joint insurer basis with other sureties in
order to manage aggregate exposure.

Commercial Surety

A large portion of the commercial surety market is comprised of small
obligations that are routine in nature and require minimal underwriting.
Customers are focused principally on prompt and efficient service. These small
transactional bonds represent approximately 81% of the Company's commercial
gross written premiums and 33% of the Company's total gross written premium.

The Company continues to focus its marketing efforts on this small
commercial bond market through its Sioux Falls, South Dakota service center. In
this market segment, CNA Surety emphasizes one-day response service, easy-to-use
forms and an extensive array of commercial bond products. In addition,
independent agents are provided pre-executed bond forms, powers of attorney, and
facsimile authorizations that allow them to issue many standard bonds in their
offices. CNA Surety's insurance subsidiaries may also direct their marketing to
particular industries or classes of bonds on a broad basis. For instance, the
Company maintains programs directed at notary bonds, mortgage broker compliance
bonds and grain warehouse dealer bonds (protecting funds associated with grain
storage).

CNA Surety also maintains a specific underwriting staff in Chicago
dedicated to middle market and "Fortune 1000" accounts. The Company's large
commercial account business is estimated to represent approximately 19% of the
Company's commercial gross written premiums and 8% of the Company's total gross
written premium.

UNDERWRITING

CNA Surety is focused on consistent underwriting profitability. The extent
and sophistication of underwriting activity varies by type of risk. Contractor
accounts and large commercial surety customers undergo credit, financial and
managerial review and analysis on a regular basis. Certain classifications of
bonds, such as fiduciary and court appeal bonds, also require more extensive
underwriting.

CNA Surety also targets various products in the surety and fidelity bond
market which are characterized by relatively low-risk exposure and small bond
amounts. The underwriting criteria, including the extent of bonding authority
granted to independent agents, varies depending on the class of business and the
type of bond. For example, relatively little underwriting information is
typically required of certain low-exposure risks such as notary bonds.

COMPETITION

The surety and fidelity market is highly competitive. According to 2004
data from the SAA, the U.S. market aggregates approximately $5.7 billion in
direct written premiums, comprised of approximately $4.3 billion in surety
premiums and approximately $1.4 billion in fidelity premiums. The 20 largest
surety companies account for approximately 78% of the domestic surety market and
95% of the domestic fidelity market. The large diversified insurance companies
hold the largest market shares. In 2004, CNA Surety was the second largest
surety provider with an 8.3% market share.

Primary competitors of CNA Surety are approximately 20 national, multi-line
companies participating in the surety market throughout the country. Management
believes that its principal strengths are diverse product offerings, service and
accessibility and long-term relationships with agents and accounts. Competition
has increased as a result of ten years of profitable underwriting experience
through 1999. This competition has typically manifested itself through reduced
premium rates and greater tolerance for relaxation of underwriting standards.
Beginning in 2000 and through the end of 2005, the surety industry's
underwriting performance began to be impacted by the significant increases in
corporate defaults. Although premium rates began firming in 2001, particularly
on large accounts due to deteriorating underwriting performance throughout the
surety industry, management believes such competition will continue and impact
the Company's ability to raise rates further.

REINSURANCE

The Company's insurance subsidiaries, in the ordinary course of business,
cede reinsurance to other insurance companies and affiliates. Reinsurance
arrangements are used to limit maximum loss, provide greater diversification of
risk and minimize exposure on larger risks. Reinsurance contracts do not
ordinarily relieve the Company of its primary obligations to claimants.
Therefore, a contingent liability exists with respect to reinsurance ceded to
the extent that any reinsurer is unable to meet the obligations assumed under
reinsurance contracts. The Company evaluates the financial condition of its
reinsurers, monitors concentrations of credit risk and establishes allowances
for uncollectible amounts when indicated. At December 31, 2005, the Company
holds approximately $4.3 million of letters of credit as collateral for
reinsurance receivables.

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. Refer to Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations and Note 6 of the Notes to the
Consolidated Financial Statements, Reinsurance, for further discussion.

CNA Surety's largest ceded reinsurance recoverable from an affiliate, CCC,
an A rated company by A.M. Best, was approximately $53.0 million and $5.4
million at December 31, 2005 and 2004, respectively.

In addition, due to the nature of the reinsurance products available to the
Company and other sureties, reinsurers may cover principals for whom the Company
writes surety bonds in one year, but then exclude or provide only limited
reinsurance for these same principals in subsequent years. As a result, the
Company may continue to have exposure to these principals with limited or no
reinsurance for bonds written during years that the Company had reinsurance
covering these principals.

RESERVES FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES

The estimated liability for unpaid losses and loss adjustment expenses
includes, on an undiscounted basis, estimates of (a) the ultimate settlement
value of reported claims, (b) incurred-but-not-reported ("IBNR") claims, (c)
future expenses to be incurred in the settlement of claims and (d) claim
recoveries, exclusive of reinsurance recoveries which are reported as an asset.
These estimates are determined based on the Company's and surety industry loss
experience as well as consideration of current trends and conditions. The
estimated liability for unpaid losses and loss adjustment expenses is an
estimate and there is the potential that actual future loss payments will differ
significantly from initial estimates. The methods of determining such estimates
and the resulting estimated liability are regularly reviewed and updated.
Changes in the estimated liability are reflected in operating income in the
period in which such changes are determined to be needed.

A table is included in Note 7 of the Notes to the Consolidated Financial
Statements, Reserves for Loss and Loss Adjustment Expenses, that presents the
activity in the reserves for unpaid losses and loss adjustment expenses for the
Company and is incorporated herein by reference. This table highlights the
impact of revisions to the estimated liability established in prior years.

The following table sets forth a reconciliation of the consolidated loss
reserves reported in accordance with generally accepted accounting principles
("GAAP"), and the reserves reported to state insurance regulatory authorities in
accordance with statutory accounting practices ("SAP") as of December 31, 2005
(dollars in thousands):

Net reserves at end of year, GAAP basis....................... $ 277,014
Ceded reinsurance, net of salvage and subrogation............. 147,435
---------
Gross reserves at end of year, GAAP basis..................... 424,449
Estimated reinsurance recoverable netted against gross
reserves for SAP............................................ (147,435)
Net reserves on retroactive reinsurance assumed............... (8,549)
---------
Net reserves at end of year, SAP basis........................ $ 268,465
=========

The following loss reserve development table illustrates the change over
time of reserves established for the Company's estimated losses and loss
adjustment expenses at the end of various calendar years. The first section
shows the reserves as originally reported at the end of the stated year. The
second section shows the cumulative amounts paid as of the end of successive
years with respect to that reserve liability. The third section shows re-
estimates of the original recorded reserve as of the end of each successive year
which is the result of management's expanded awareness of additional facts and
circumstances that pertain to the unsettled claims. The last section compares
the latest re-estimated reserve to the reserve originally established, and
indicates whether or not the original reserve was adequate or inadequate to
cover the estimated costs of unsettled claims.

The loss reserve development table is cumulative as of each December 31,
and, therefore, ending balances should not be added since the amount at the end
of each calendar year includes activity for both the current and prior years.
The loss reserve development table reflects, on a pro forma basis, the reserves
of the CCC Surety Operations and Capsure since 1994 and CIC since its
acquisition in May of 1995. Such historical development is not necessarily
indicative of the financial results that would have occurred under the ownership
and management of CNA Surety or of future operating results.

AS OF DECEMBER 31,
----------------------------------------------------------------------------------------------------
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
-------- -------- -------- -------- -------- -------- --------- --------- -------- --------

Gross reserves for
losses and loss
adjustment expenses.. $153,843 $142,282 $130,381 $150,020 $157,933 $204,457 $ 315,811 $ 303,433 $413,539 $363,387
Originally reported
ceded recoverable.... 5,932 5,218 7,656 7,986 20,464 70,159 166,318 137,301 158,357 116,831
-------- -------- -------- -------- -------- -------- --------- --------- -------- --------
Net reserves for losses
and loss adjustment
expenses............. 147,911 137,064 122,725 142,034 137,469 134,298 149,493 166,132 255,182 246,556
======== ======== ======== ======== ======== ======== ========= ========= ======== ========
Net paid (cumulative)
as of:
One year later....... 42,552 9,866 19,595 32,428 35,825 44,763 64,832 59,567 88,857 65,353
Two years later...... 43,179 20,171 30,775 52,524 47,795 75,825 98,885 100,595 128,607 --
Three years later.... 46,782 25,206 43,999 58,421 73,341 87,011 117,396 115,034 -- --
Four years later..... 48,960 32,918 47,144 67,451 81,788 93,154 132,891 -- -- --
Five years later..... 56,891 35,214 51,742 71,352 86,539 99,117 -- -- -- --
Six years later...... 54,724 38,371 54,659 74,462 91,520 -- -- -- -- --
Seven years later.... 57,275 41,058 57,211 77,916 -- -- -- -- -- --
Eight years later.... 59,153 43,525 60,330 -- -- -- -- -- -- --
Nine years later..... 61,365 44,374 -- -- -- -- -- -- -- --
Ten years later...... 62,225 -- -- -- -- -- -- -- -- --
Net reserves re-
estimated as of:
End of initial year.. 147,911 137,064 122,725 142,034 137,469 134,298 149,493 166,132 255,182 246,556
One year later....... 132,267 96,178 118,373 128,949 130,376 139,110 155,673 205,422 254,570 223,223
Two years later...... 103,466 90,796 102,304 114,605 128,134 140,094 182,812 199,865 231,619 --
Three years later.... 101,745 77,086 87,321 110,462 130,280 132,504 169,340 195,191 -- --
Four years later..... 89,348 62,217 86,271 113,748 122,469 120,051 174,346 -- -- --
Five years later..... 77,477 60,882 86,320 105,797 110,055 119,471 -- -- -- --
Six years later...... 72,879 61,443 79,029 93,768 109,874 -- -- -- -- --
Seven years later.... 73,428 57,375 69,923 93,447 -- -- -- -- -- --
Eight years later.... 71,844 51,857 69,963 -- -- -- -- -- -- --
Nine years later..... 68,321 47,656 -- -- -- -- -- -- -- --
Ten years later...... 65,269 -- -- -- -- -- -- -- -- --
======== ======== ======== ======== ======== ======== ========= ========= ======== ========
Total net (deficiency)
redundancy........... $ 82,642 $ 89,408 $ 52,762 $ 48,587 $ 27,595 $ 14,827 $(24,853) $(29,059) $ 23,563 $ 23,333
======== ======== ======== ======== ======== ======== ========= ========= ======== ========
Cumulative redundancy
(deficiency) as a
percentage of
original estimate.... 55.9% 65.2% 43.0% 34.2% 20.1% 11.0% (16.6)% (17.5)% 9.2% 9.5%
======== ======== ======== ======== ======== ======== ========= ========= ======== ========
Net reserves re-
estimated............ $ 65,269 $ 47,656 $ 69,963 $ 93,447 $109,874 $119,471 $ 174,346 $ 195,191 $231,619 $223,223
Re-estimated ceded
recoverable.......... 3,086 5,317 8,752 13,276 68,853 106,467 121,060 149,395 96,766 94,986
-------- -------- -------- -------- -------- -------- --------- --------- -------- --------
Gross reserves re-
estimated............ $ 68,355 $ 52,973 $ 78,715 $106,723 $178,727 $225,938 $ 295,406 $ 344,586 $328,385 $318,209
======== ======== ======== ======== ======== ======== ========= ========= ======== ========

AS OF
DECEMBER
31,
--------
2005
--------

Gross reserves for
losses and loss
adjustment expenses.. $424,449
Originally reported
ceded recoverable.... 147,435
--------
Net reserves for losses
and loss adjustment
expenses............. 277,014
========
Net paid (cumulative)
as of:
One year later....... --
Two years later...... --
Three years later.... --
Four years later..... --
Five years later..... --
Six years later...... --
Seven years later.... --
Eight years later.... --
Nine years later..... --
Ten years later...... --
Net reserves re-
estimated as of:
End of initial year.. 277,014
One year later....... --
Two years later...... --
Three years later.... --
Four years later..... --
Five years later..... --
Six years later...... --
Seven years later.... --
Eight years later.... --
Nine years later..... --
Ten years later...... --
========
Total net (deficiency)
redundancy........... $ --
========
Cumulative redundancy
(deficiency) as a
percentage of
original estimate.... -- %
========
Net reserves re-
estimated............
Re-estimated ceded
recoverable..........
Gross reserves re-
estimated............

CLAIMS

Proactive claims management is an important factor for the profitable
underwriting of surety and fidelity products. The Company maintains an
experienced and dedicated staff of in-house claim specialists. Claim handling
for the Company's contract and large commercial account business is performed in
Chicago. Claims for the Company's small commercial bonds and the related
fidelity bonds and E&O insurance are handled in Sioux Falls. The disposition of
claims and other claim-related activity is performed in accordance with
established policies, procedures and expense controls designed to minimize loss
costs and maximize salvage and subrogation recoveries. Indemnity and subrogation
rights exist on a significant portion of the business written, enabling the
Company to pursue loss recovery from the principal.

ENVIRONMENTAL CLAIMS

The Company does not typically bond contractors that specialize in
hazardous environmental remediation work. The Company does however provide
bonding programs for several accounts that have incidental environmental
exposure. In the commercial surety market, the Company provides bonds to large
corporations that are in the business of mining various minerals and are
obligated to post reclamation bonds that guarantee that property which was
disturbed during mining is returned to an acceptable condition when the mining
is completed. The Company also provides court and other surety bonds for large
corporations wherein the underlying action involves environmental related
issues. While no environmental responsibility is overtly provided by commercial
or contract bonds, some risk of environmental exposure may exist if the surety
were to assume certain rights in the completion of a defaulted project or
through salvage recovery. The Company estimates its net case incurred losses on
known claims of this nature to be $10.3 million as of December 31, 2005.

REGULATION

The Company's insurance subsidiaries are subject to varying degrees of
regulation and supervision in the jurisdictions in which they transact business
under statutes that delegate regulatory, supervisory and administrative powers
to state insurance regulators. In general, an insurer's state of domicile has
principal responsibility for such regulation which is designed generally to
protect policyholders rather than investors and relates to matters such as the
standards of solvency which must be maintained; the licensing of insurers and
their agents; the examination of the affairs of insurance companies, including
periodic financial and market conduct examinations; the filing of annual and
other reports, prepared on a statutory basis, on the financial condition of
insurers or for other purposes; establishment and maintenance of reserves for
unearned premiums and losses; and requirements regarding numerous other matters.
Licensed or admitted insurers generally must file with the insurance regulators
of such states, or have filed on its behalf, the premium rates and bond and
policy forms used within each state. In some states, approval of such rates and
forms must be received from the insurance regulators in advance of their use.

Western Surety is domiciled in South Dakota and licensed in all 50 states
and the District of Columbia and Puerto Rico. Surety Bonding is domiciled in
South Dakota and licensed in 28 states and the District of Columbia. USA is
domiciled in Texas and licensed in 44 states and the District of Columbia.

Insurance regulations generally also require registration and periodic
disclosure of certain information concerning ownership, financial condition,
capital structure, general business operations and any material transactions or
agreements by or among affiliates. Such regulation also typically restricts the
ability of any one person to acquire 10% or more, either directly or indirectly,
of a company's stock without prior approval of the applicable insurance
regulatory authority. In addition, dividends and other distributions to
stockholders generally may be paid only out of unreserved and unrestricted
statutory earned surplus. Such distributions may be subject to prior regulatory
approval, including a review of the implications on Risk-Based Capital
requirements. A discussion of Risk-Based Capital requirements for property and
casualty insurance companies is included in both Management's Discussion and
Analysis of Financial Condition and Results of Operations and Note 13 of the
Notes to the Consolidated Financial Statements, Statutory Financial Data.
Without prior regulatory approval in 2006, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $39.1 million in the aggregate. For the year
ended December 31, 2005, CNA Surety received $20.0 million in dividends from its
insurance subsidiaries.

CNA Surety's insurance subsidiaries are subject to periodic financial and
market conduct examinations. These examinations are generally performed by the
domiciliary state insurance regulatory authorities. During 2005, both the South
Dakota Department of Commerce and Regulation-Insurance Division and the Texas
Department of Insurance issued their respective reports of examination for the
two-year period ended December 31, 2003. These exams were initiated in
connection with an examination of the insurance subsidiaries of CNAF undertaken
by the Illinois Department of Insurance. The examinations of Western Surety and
Surety Bonding were completed on January 21, 2005. The examination of USA was
completed on August 3, 2005. The matters noted in these examination reports were
largely administrative in nature and are being addressed by management. The
matters noted do not have a material impact on the insurance subsidiaries'
statutory surplus, nor have they resulted in any fines or penalties to CNA
Surety or any of its subsidiaries. The examination report for Western Surety did
address the Company's exposure to the large national contractor (discussed
later) that had previously been discussed with

the regulators. The Company has agreed to provide the regulators with an ongoing
update and review of this exposure.

Certain states in which CNA Surety's insurance subsidiaries conduct their
business require insurers to join a guaranty association. Guaranty associations
provide protection to policyholders of insurers licensed in such states against
the insolvency of those insurers. In order to provide the associations with
funds to pay certain claims under policies issued by insolvent insurers, the
guaranty associations charge members assessments based on the amount of direct
premiums written in that state. Such assessments were not material to CNA
Surety's results of operations in 2005.

Western Surety and Surety Bonding each qualifies as an acceptable surety
for federal and other public works project bonds pursuant to U.S. Department of
Treasury regulations. U.S. Treasury underwriting limitations are based on an
insurer's statutory surplus. The underwriting limitations of Western Surety and
Surety Bonding, based on each insurer's statutory surplus, were $18.5 million
and $0.6 million, respectively, for the twelve-month period ended June 30, 2005.
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, 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.

INVESTMENTS

CNA Surety insurance subsidiaries' investment practices must comply with
insurance laws and regulations and must also comply with certain covenants under
CNA Surety's credit facility. Generally, insurance laws and regulations
prescribe the nature and quality of, and set limits on, the various types of
investments that may be made by CNA Surety's insurance subsidiaries.

The Company's investment portfolio generally is managed to maximize after-
tax investment return, while minimizing credit risk with investments
concentrated in high quality 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.

An investment committee of CNA Surety's Board of Directors establishes
investment policy and oversees the management of each portfolio. A professional
independent investment adviser has been engaged to assist in the management of
each insurance subsidiary investment portfolio pursuant to established
investment committee guidelines. The insurance subsidiaries pay an advisory fee
based on the market value of the assets under management.

EMPLOYEES

As of December 31, 2005, the Company employed 747 persons. CNA Surety has
not experienced any work stoppages. Management of CNA Surety believes its
relations with its employees are good.

AVAILABILITY OF SEC REPORTS

A copy of this Annual Report on Form 10-K, as well as CNA Surety's
subsequent Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any
amendments to such reports are available, free of charge, on the Internet at CNA
Surety's website (www.cnasurety.com) as soon as reasonably practicable after
being filed with or submitted to the Securities and Exchange Commission (the
"SEC"). Prior to the filing of this Form 10-K, CNA Surety provided links to the
SEC's website (www.sec.gov) which contained the equivalent of the reports
described above. Any materials the Company files with the SEC may be read and
obtained at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington,
DC 20549. Information regarding the operation of the Public Reference

Room may be obtained by calling the SEC at 1-800-SEC-0330. This reference to the
CNA Surety's website or the SEC's address does not constitute incorporation by
reference of the information contained on the website and should not be
considered part of this document.

ITEM 1A. RISK FACTORS

Our business faces many risks. Some of the more significant risks that we
face are described below. There may be additional risks that we do not currently
perceive to be significant or that we are not currently aware of that may also
impact our business. Each of the risks and uncertainties described below could
lead to events or circumstances that have a material adverse effect on our
business, results of operations, financial condition or equity.

In addition, ownership of our common stock may be subject to risks
associated with the liquidity of the investment. Approximately 63% of our common
stock is owned by affiliates of CNAF. This concentration of ownership may reduce
the number of market participants willing to purchase our stock and limit the
ability of a minority owner to liquidate their position.

WE MAY DETERMINE THAT OUR LOSS RESERVES ARE INSUFFICIENT TO COVER OUR ESTIMATED
ULTIMATE UNPAID LIABILITY FOR CLAIMS AND WE MAY NEED TO INCREASE THEM.

We maintain loss reserves to cover our estimated ultimate unpaid liability
for claims and claim adjustment expenses for reported and unreported claims.
Reserves represent our best estimate at a given accounting date. Loss reserves
are not an exact calculation of liability but instead are complex estimates
derived by us, generally utilizing a variety of reserve estimation techniques
from numerous assumptions and expectations about future events, many of which
are highly uncertain, such as estimates of claims severity, frequency of claims,
inflation, claims handling, case reserving policies and procedures, underwriting
and pricing policies, changes in the legal and regulatory environment and the
lag time between the occurrence of an insured event and the time of its ultimate
settlement. Many of these uncertainties are not precisely quantifiable and
require significant judgment on our part.

In light of the many uncertainties associated with establishing the
estimates and making the assumptions necessary to establish reserve levels, we
review and change our reserve estimates in a regular and ongoing process as
experience develops and further claims are reported and settled. If estimated
reserves are insufficient for any reason, the required increase in reserves
would be recorded as a charge against our earnings for the period in which
reserves are determined to be insufficient.

SURETY LOSSES AND OUR RESULTS CAN BE VOLATILE.

In the past, our results have been adversely impacted by a relatively small
number of large claims. In addition, our results have been significantly
impacted by increases in corporate default rates. These past occurrences
illustrate that our loss experience and results can be volatile.

WE HAVE A SIGNIFICANT CONCENTRATION OF EXPOSURE TO CONSTRUCTION FIRMS.

A significant portion of our business is guaranteeing the performance of
construction firms. Therefore, we are exposed to the challenges that the
construction industry faces. Over the recent past, the construction industry has
enjoyed very strong demand for its services. However, if the construction
economy encounters difficulties, we may experience a higher frequency of claims
and higher losses.

OUR PREMIUM WRITINGS AND PROFITABILITY ARE IMPACTED BY THE AVAILABILITY AND COST
OF REINSURANCE AND OUR REINSURANCE PURCHASING DECISIONS.

Reinsurance coverage is an important component of our capital structure.
Reinsurance allows us to meet certain regulatory restrictions that would
otherwise limit the size of bonds that we write and limit the market segments in
which we could compete. In addition, reinsurance reduces the potential
volatility of earnings and protects our capital by limiting the amount of loss
associated with any one bond principal. We have experienced periods where it was
difficult for us to buy as much reinsurance as we desired and when reinsurance
costs have risen substantially. The availability and cost of reinsurance
protection depends on a number of factors such as our loss

experience, the surety industry's loss experience, the number of reinsurers
willing to provide coverage, and broader economic conditions. If sufficient
reinsurance is not available or is too costly or if we purchase insufficient
reinsurance, we may need to reduce our premium writings and may be susceptible
to higher losses.

WE MAY NOT BE ABLE TO COLLECT AMOUNTS OWED TO US BY REINSURERS.

Amounts recoverable from reinsurers are reported as receivables in our
balance sheets and are estimated in a manner consistent with loss and loss
adjustment expense reserves. The ceding of insurance does not, however,
discharge our primary liability for claims. As a result, we are subject to
credit risk relating to our ability to recover amounts due from reinsurers. It
is possible that future financial deterioration of our reinsurers could result
in certain balances becoming uncollectible.

WE RELY UPON AFFILIATED COMPANIES THAT WE DO NOT CONTROL TO CONDUCT CERTAIN
ASPECTS OF OUR BUSINESS.

Due to regulatory restrictions that limit the size of the bonds that our
insurance subsidiaries can write, we utilize the capacity of affiliated
companies to service some parts of our business. If this capacity is no longer
available to us, or no longer satisfies the regulatory requirements, we may need
to stop servicing parts of our business.

RATING AGENCIES MAY DOWNGRADE THEIR RATINGS FOR US OR FOR AFFILIATED COMPANIES
THAT WE RELY ON TO WRITE BUSINESS. THIS WOULD ADVERSELY AFFECT OUR ABILITY TO
WRITE BUSINESS.

Our customers often refer to the financial strength ratings assigned by
A.M. Best, S&P and other similar companies when they are choosing a surety
company. Because we use the underwriting capacity of CCC, an affiliate, to serve
larger accounts, our financial strength ratings, as well as those of CCC, factor
into customers' decisions. After reporting a significant net loss in the third
quarter of 2003, our A.M. Best rating was lowered from A+ to A with a negative
outlook. CCC also reported a significant net loss in the third quarter of 2003,
but A.M. Best affirmed CCC's rating of A with a negative outlook. In the second
quarter of 2005, our outlook was raised from negative to stable. However, if our
ratings or CCC's ratings are downgraded, we may experience a significant
reduction in premium writings.

WE FACE INTENSE COMPETITION.

All aspects of the insurance industry are highly competitive and we must
continuously allocate resources to refine and improve our products and services.
Insurers compete on the basis of factors including products, price, services,
ratings and financial strength. Although we seek pricing that will result in
what we believe are adequate returns on the capital allocated to our business,
we may lose business to competitors offering competitive products at lower
prices. We compete with a large number of stock and mutual insurance companies
and other entities for both distributors and customers. We also compete against
providers of substitute products such as letters of credit in certain markets.

DEMAND FOR OUR PRODUCTS IS CREATED BY LAWS THAT COULD BE CHANGED.

We believe that the vast majority of the demand for our products results
from federal, state and local laws that mandate the use of surety bonds. If
these laws are loosened or eliminated, our business would be severely impacted.

WE ARE SUBJECT TO CAPITAL ADEQUACY REQUIREMENTS AND, IF WE DO NOT MEET THESE
REQUIREMENTS, REGULATORY AGENCIES MAY RESTRICT OR PROHIBIT US FROM OPERATING OUR
BUSINESS.

Insurance companies are subject to risk-based capital standards set by
state regulators to help identify companies that merit further regulatory
attention. These standards apply specified risk factors to various asset,
premium and reserve components of our statutory capital and surplus reported in
our statutory financial statements. Current rules require companies to maintain
statutory capital and surplus at a specified minimum level determined using the
risk-based capital formula. If we do not meet these minimum requirements, state
regulators may restrict or prohibit us from operating our business.

OUR INSURANCE SUBSIDIARIES, UPON WHOM WE DEPEND FOR DIVIDENDS AND ADVANCES IN
ORDER TO FUND OUR WORKING CAPITAL NEEDS, ARE LIMITED BY STATE REGULATORS IN
THEIR ABILITY TO PAY DIVIDENDS.

We are a holding company and are dependent upon dividends, advances, loans
and other sources of cash from our subsidiaries in order to meet our
obligations. Dividend payments, however, must be approved by the subsidiaries'
domiciliary state departments of insurance and are generally limited to amounts
determined by formula which varies by state. If we are restricted, by regulatory
rule or otherwise, from paying or receiving inter-company dividends, we may not
be able to fund our working capital needs and debt service requirements from
available cash. As a result, we would need to look to other sources of capital
which may be more expensive or may not be available at all.

SOME OF THE CREDIT EXTENDED TO US REQUIRES ONGOING COMPLIANCE WITH CONDITIONS
AND LIMITATIONS REGARDING OUR PROFITABILITY AND FINANCIAL CONDITION.

We borrow money from banks under a credit facility that requires that we
meet certain tests of profitability and financial condition. If we do not meet
these tests, we may be required to repay outstanding borrowings. If we are
capable of repaying the borrowings, we may experience a reduction in capital
strength that may hamper our ability to conduct business. If we are not capable
of repaying the borrowings, we would need to look to other sources of capital
which may be more expensive or may not be available at all.

OUR INVESTMENT PORTFOLIO MAY SUFFER REDUCED RETURNS OR LOSSES.

Investment returns are an important part of our overall profitability.
General economic conditions, fluctuations in interest rates, and many other
factors beyond our control can adversely affect the returns and the overall
value of our investment portfolio and our ability to control the timing of the
realization of investment income. In addition, any defaults in the payments due
to us for our investments, especially with respect to liquid corporate and
municipal bonds, could reduce our investment income and realized investment
gains or could cause us to incur investment losses. As a result of these
factors, we may not realize an adequate return on our investments, may incur
losses on sales of our investments and may be required to write down the value
of our investments.

WE RELY ON OUR INFORMATION TECHNOLOGY AND TELECOMMUNICATIONS SYSTEMS TO CONDUCT
OUR BUSINESS.

Our business is highly dependent upon the successful and uninterrupted
functioning of our information technology and telecommunications systems. We
rely on these systems to process new and renewal business, provide customer
service, make claims payments and facilitate collections and cancellations, as
well as to perform actuarial and other analytical functions necessary for
pricing and product development.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

CNA Surety leases its executive offices and its shared branch locations
with Continental Casualty Company ("CCC") under the Administrative Services
Agreement. CNA Surety currently uses approximately 123,200 square feet and
related personal property at 32 branch locations and its home and executive
offices (30,360 square feet), in Chicago, Illinois. CNA Surety's annual rent for
this space is approximately $2.9 million. CNA Surety may terminate its use of
these locations as set forth in the Administrative Services Agreement, without
material penalty, by providing CCC with 30 days written notice. In 2006, CNA
Surety intends to enter into separate lease or sub-lease agreements with CCC for
several of these shared locations.

CNA Surety leases approximately 81,100 square feet of office space for its
primary processing and service center at 101 South Phillips Avenue, Sioux Falls,
South Dakota, under a lease expiring in 2012. The annual rent, which is subject
to annual adjustments, was $1.4 million as of December 31, 2005. CNA Surety also
leased space for contract and commercial branch offices in Tallahassee, Florida,
New York, New York; Troy, Michigan; Roseville,

California; Houston, Texas; and San Juan, Puerto Rico. Annual rent for these
offices was $0.5 million with leases terminating in 2006, 2007, 2005, 2007,
2006, and 2006, respectively.

ITEM 3. LEGAL PROCEEDINGS

The Company and its subsidiaries are parties to various lawsuits arising in
the normal course of business. The Company believes the resolution of these
lawsuits will not have a material adverse effect on its financial condition or
its results of operations.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company will file a definitive proxy statement with the Securities and
Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act
of 1934 (the "Proxy Statement") relating to the Company's Annual Meeting of
Stockholders to be held on April 25, 2006, not later than 120 days after the end
of the fiscal year covered by this Form 10-K. Information required by Item 4
will appear in the Proxy Statement and is incorporated herein by reference.

PART II.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The Company's common stock ("Common Stock") trades on the New York Stock
Exchange under the symbol SUR. On February 17, 2006, the last reported sale
price for the Common Stock was $15.76 per share. The following table shows the
range of high and low sales prices for shares of the Common Stock as reported on
the New York Stock Exchange during 2005 and 2004.

HIGH LOW
---- ---

2005
1st Quarter............................................. $14.45 $12.42
2nd Quarter............................................. $15.17 $12.66
3rd Quarter............................................. $15.34 $12.14
4th Quarter............................................. $15.56 $12.80
2004
1st Quarter............................................. $11.50 $ 9.46
2nd Quarter............................................. $12.93 $ 9.99
3rd Quarter............................................. $11.05 $ 9.99
4th Quarter............................................. $13.96 $10.38

The number of stockholders of record of Common Stock on February 17, 2006,
was approximately 2,600.

DIVIDENDS

Effective November 21, 2002, the Company announced that its Board of
Directors suspended its quarterly cash dividend. The Board reassessed the level
of dividends which would be appropriate based upon a number of factors,
including CNA Surety's financial condition, operating characteristics, projected
earnings and growth, capital requirements of its insurance subsidiaries and debt
service obligations. The reintroduction of a quarterly or annual dividend and
the amount of any such dividend will be reassessed at future Board meetings.

ITEM 6. SELECTED FINANCIAL DATA

The following financial information has been derived from the Consolidated
Financial Statements and Notes thereto.

The following information presented for CNA Surety is as of and for the
years ended December 31, 2005, 2004, 2003, 2002 and 2001.

2005 2004 2003 2002 2001
---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)

Total revenues.................. $ 384,082 $ 350,789 $ 332,576 $ 318,487 $ 350,471
========== ========== ========== ========== ==========
Gross written premiums.......... $ 417,530 $ 389,417 $ 371,375 $ 359,892 $ 333,003
========== ========== ========== ========== ==========
Net written premiums............ $ 365,948 $ 318,284 $ 319,210 $ 306,654 $ 315,804
========== ========== ========== ========== ==========
Net earned premium.............. $ 348,361 $ 317,857 $ 304,449 $ 298,319 $ 320,910
Net losses and loss adjustment
expenses...................... 127,841 87,356 172,476 94,198 80,836
Net commissions, brokerage and
other underwriting expenses... 202,521 207,166 190,740 179,827 202,877
Net investment income........... 33,747 30,181 26,301 27,754 29,515
Net realized investment gains
(losses)...................... 1,974 2,751 1,826 (7,586) 46
Interest expense................ 3,545 2,260 1,523 1,708 3,925
Amortization of intangible
assets(2)..................... -- -- -- -- 6,097
---------- ---------- ---------- ---------- ----------
Income (loss) before income
taxes......................... 50,175 54,007 (32,163) 42,754 56,736
Income tax expense (benefit).... 11,744 14,297 (18,102) 12,635 19,828
---------- ---------- ---------- ---------- ----------
Net income (loss)............... $ 38,431 $ 39,710 $ (14,151) $ 30,119 $ 36,908
========== ========== ========== ========== ==========
Basic and diluted earnings
(loss) per common share....... $ 0.89 $ 0.92 $ (0.33) $ 0.70 $ 0.86
========== ========== ========== ========== ==========
Loss ratio(1)................... 36.7% 27.5% 56.7% 31.6% 25.2%
Expense ratio................... 58.1 65.2 62.6 60.3 63.2
---------- ---------- ---------- ---------- ----------
Combined ratio(1)............... 94.8% 92.7% 119.3% 91.9% 88.4%
========== ========== ========== ========== ==========
Invested assets and cash........ $ 797,914 $ 766,387 $ 654,072 $ 638,204 $ 579,657
Intangible assets, net of
amortization.................. 138,785 138,785 138,785 143,785 143,785
Total assets.................... 1,262,614 1,174,494 1,169,123 1,093,380 1,061,598
Insurance reserves.............. 665,496 589,406 637,607 519,646 516,190
Debt............................ 50,589 65,488 50,418 60,816 76,195
Total liabilities............... 786,039 728,123 758,982 672,819 673,170
Stockholders' equity............ 476,575 446,371 410,141 420,561 388,428
Book value per share............ $ 11.00 $ 10.38 $ 9.54 $ 9.79 $ 9.08
Dividends paid per share........ $ -- $ -- $ -- $ 0.45 $ 0.54

--------------

(1) Includes the effect of recording revisions of prior year reserves. The
dollar amount and the percentage point effect on the loss ratio of these
reserve revisions were a reduction of $23,333, or 6.7%, for the year ended
December 31, 2005, a reduction of $613, or 0.2% for the year ended December
31, 2004, an addition of $39,290, or 12.9%, for the year ended December 31,
2003, an addition of $6,180, or 2.1%, for the year ended December 31, 2002,
and an addition of $4,812, or 1.5%, for the year ended December 31, 2001.

(2) As of January 1, 2002, the Company adopted Statement of Financial Accounting
Standards No. 142 concerning the accounting for goodwill and other
intangible assets. The adoption of this standard eliminated the Company's
amortization of goodwill and intangibles after December 31, 2001 and
therefore, increased the Company's reported 2002 net income by $5.7 million,
or 13 cents per share, respectively, as compared to the same period in 2001.
If the provisions of this standard were applied to prior periods, net income
for the year ended December 31, 2001 would have been $42.6 million or $0.99
per share.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following is a discussion and analysis of CNA Surety Corporation ("CNA
Surety" or "Company") and its subsidiaries' operating results, liquidity and
capital resources, and financial condition. The most significant risk and
uncertainties impacting the operating performance and financial condition of the
Company are discussed in Item 1A, Risk Factors of this Form 10-K. This
discussion should be read in conjunction with the Consolidated Financial
Statements of CNA Surety and Notes thereto.

CRITICAL ACCOUNTING POLICIES

Management believes the most significant accounting policies and related
disclosures for purposes of understanding the Company's results of operations
and financial condition pertain to reserves for unpaid losses and loss
adjustment expenses and reinsurance, investments, goodwill and other intangible
assets, recognition of premium revenue and the related unearned premium
liability, 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 December 31,
2005 for unpaid claims applicable to reported claims and to IBNR (dollars in
thousands) for each sub-line of business:

GROSS CASE LOSS GROSS IBNR LOSS TOTAL GROSS
AND LAE RESERVES AND LAE RESERVES RESERVES
---------------- ---------------- -----------

Contract............................... $140,251 $117,811 $258,062
Commercial............................. 101,932 52,745 154,677
Fidelity and other..................... 4,356 7,354 11,710
-------- -------- --------
Total.................................. $246,539 $177,910 $424,449
======== ======== ========

The Company retains an independent actuarial firm of national standing to
perform periodic actuarial analysis of the Company's loss reserves. This
analysis is based on a variety of techniques that involve detailed statistical
analysis of past claim reporting, settlement activity, and salvage and
subrogation activity, as well as claim frequency and severity data when
sufficient information exists to lend statistical credibility to the analysis.
The analysis may be based upon internal loss experience or industry experience.
Techniques may vary depending on the type of claim being estimated. While
techniques may vary, each employs significant judgments and assumptions. This
analysis results in both a range of reasonable loss reserve estimates as well as
a point estimate of the indicated loss reserves. Surety results, especially for
contract and certain commercial products like insurance program bonds, workers
compensation insurance bonds and reclamation bonds, tend to be impacted by
fewer, but more severe, losses. With this type of loss experience, it is more
difficult to estimate the required reserves, particularly for the most current
accident years which may have few reported claims. As a result, the range of
reasonable loss reserve estimates may be broader than that associated with
traditional property/casualty insurance products.

The independent actuarial firm's analysis is the primary tool that
management utilizes in determining its best estimate of loss reserves. However,
the carried reserve may differ from the independent actuarial firm's point
estimate as a result of management's consideration of the impact of factors such
as the following, especially as they relate to the current accident year:

- Current claim activity, including the frequency and severity of current
claims

- Changes in underwriting standards and business mix such as the Company's
efforts to reduce exposures to large commercial bonds

- Changes in the claims handling process

- Current economic conditions, especially corporate default rates and the
condition of the construction economy

Management believes that the impact of the factors listed above, and
others, may not be fully quantifiable through actuarial analysis. Accordingly,
management may apply its judgment of the impact of these factors, and others, to
its selection of the recorded loss reserves.

Receivables recorded with respect to insurance losses ceded to reinsurers
under reinsurance contracts are estimated in a manner similar to liabilities for
insurance losses and, therefore, are also subject to uncertainty. In addition to
the factors cited above, estimates of reinsurance recoveries may prove
uncollectible if the reinsurer is unable to perform under the contract.
Reinsurance contracts do not relieve the ceding company of its obligations to
indemnify its own policyholders.

The Company's Consolidated Balance Sheet includes estimated liabilities for
unpaid losses and loss adjustment expenses of $424.4 million and reinsurance
receivables related to unpaid losses of $147.4 million at December 31, 2005
compared to estimates of $363.4 million and $116.8 million, respectively, at
December 31, 2004.

At December 31, 2005, the range of reasonable loss reserve estimates, net
of reinsurance receivables, calculated by the independent actuarial firm and
adopted by management was from $229 million to $325 million. Ranges of
reasonable loss reserve estimates are not calculated for the sub-lines of
business. Management believes that the range calculated over total reserves
provides the most meaningful information due to the importance of correlation of
losses between the sub-lines of business related to the impact of general
economic conditions. 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 as a
component of losses incurred in the period such changes are determined to be
needed.

Investments

Company considers all of its fixed income securities (bonds and redeemable
preferred stocks) and equity securities as available-for-sale. These securities
are reported at fair value, with unrealized gains and losses, net of deferred
income taxes, reported as a separate component of stockholders' equity. Cash
flows from purchases, sales and maturities are reported gross in the investing
activities section of the cash flow statement.

The amortized cost of fixed income securities is determined based on cost
and the cumulative effect of amortization of premiums and accretion of discounts
to maturity. Such amortization and accretion are included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective-yield method based on estimated cash flows. All
securities transactions are recorded on the trade date. Investment gains or
losses realized on the sale of securities are determined using the specific
identification method. Investments with an other-than-temporary decline in value
are written down to fair value, resulting in losses that are included in
realized investment gains and losses.

Short-term investments that generally include U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents, are carried at amortized cost which approximates fair value.
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 materially affect the
amounts reported in the Consolidated Balance Sheets and Consolidated Statements
of Income.

Intangible Assets

CNA Surety's Consolidated Balance Sheet as of December 31, 2005 includes
intangible assets of $138.8 million. This amount represents goodwill and
identified intangibles with indefinite useful lives arising from the acquisition
of Capsure. The Company performs impairment tests of these intangible assets
annually, or more frequently if certain conditions are met.

A significant amount of judgment is required in performing goodwill
impairment tests. Such tests include periodically determining or reviewing the
estimated fair value of CNA Surety's reporting units. Under the relevant
standard, 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.
The Company uses a valuation technique based on discounted cash flows. If the
carrying amount of a reporting unit, including goodwill, exceeds the estimated
fair value, then individual assets, including identifiable intangible assets,
and liabilities of the reporting unit are estimated at fair value. The excess of
the estimated fair value of the reporting unit over the estimated fair value of
net assets would establish the implied value of goodwill. The excess of the
recorded amount of intangible assets over the implied value of intangible assets
is recorded as an impairment loss.

Insurance Premiums

Insurance premiums are recognized as revenue ratably over the term of the
related policies in proportion to the insurance protection provided. Premium
revenues are net of amounts ceded to reinsurers. Unearned premiums represent the
portion of premiums written, before ceded reinsurance which is shown as an
asset, applicable to the unexpired terms of policies in force determined on a
pro rata basis.

Deferred Policy Acquisition Costs

Policy acquisition costs, consisting of commissions, premium taxes and
other underwriting expenses which vary with, and are primarily related to, the
production of business, net of reinsurance commissions, are deferred and
amortized as a charge to income as the related premiums are earned. The Company
periodically tests that deferred acquisition costs are recoverable based on the
expected profitability embedded in the reserve for unearned premium. If the
expected profitability is less than the balance of deferred acquisition costs, a
charge to net income is taken and the deferred acquisition cost balance is
reduced to the amount determined to be recoverable. Anticipated investment
income is considered in the determination of the recoverability of deferred
acquisition costs.

RESULTS OF OPERATIONS

Financial Measures

The Management's Discussion and Analysis of Financial Condition and Results
of Operations ("MD&A") discusses certain generally accepted accounting
principles ("GAAP") and non-GAAP financial measures in order to provide
information used by management to monitor the Company's operating performance.
Management utilizes various financial measures to monitor the Company's
insurance operations and investment portfolio. Underwriting results, which are
derived from certain income statement amounts, are considered a non-GAAP
financial measure and are used by management to monitor performance of the
Company's insurance operations. The Company's investment portfolio is monitored
through analysis of various quantitative and qualitative factors and certain
decisions related to the sale or impairment of investments produce realized
gains and losses, which is also a component used in the calculation of net
income and is a non-GAAP financial measure.

Underwriting results are computed as net earned premiums less net loss and
loss adjustment expenses and net commissions, brokerage and other underwriting
expenses. Management uses underwriting results to monitor the results of its
insurance operations without the impact of certain factors, including net
investment income, net realized investment gains (losses) and interest expense.
Management excludes these factors in order to analyze the direct relationship
between net earned premiums and the related net loss and loss adjustment
expenses along with net commissions, brokerage and other underwriting expenses.

Operating ratios are calculated using insurance results and are widely used
by the insurance industry and regulators such as state departments of insurance
and the National Association of Insurance Commissioners for financial regulation
and as a basis of comparison among companies. The ratios discussed in the
Company's MD&A are calculated using GAAP financial results and include the net
loss and loss adjustment expense ratio ("loss ratio") as well as the net
commissions, brokerage and other underwriting expense ratio ("expense ratio")
and combined ratio. The loss ratio is the percentage of net incurred claim and
claim adjustment expenses to net earned premiums. The expense ratio is the
percentage of net commissions, brokerage and other underwriting expenses,
including the amortization of deferred acquisition costs, to net earned
premiums. The combined ratio is the sum of the loss and expense ratios.

The Company's investment portfolio is monitored by management through
analyses of various factors including unrealized gains and losses on securities,
portfolio duration, and exposure to interest rate, market and credit risk. Based
on such analyses, the Company may record an other-than-temporary impairment on
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 its 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 ACTUAL RESULTS FOR THE YEARS ENDED DECEMBER 31, 2005,
2004 AND 2003

Analysis of Net Income (Loss)

The Company had net income of $38.4 million for the year ended December 31,
2005 as compared to $39.7 million for the year ended December 31, 2004, and a
net loss of $14.2 million for the year ended December 31, 2003. The decrease in
2005 reflects higher losses in large part due to the establishment of a $60.0
million net loss reserve related to the large national contractor (discussed
later), partially offset by increased favorable loss development on prior
accident years of $22.7 million. The higher losses were also offset by higher
net earned premium, higher net investment income, and lower expenses. The
increase in 2004 compared to 2003 reflects the absence of adverse loss
development of $39.0 million which occurred during the third quarter of 2003,
higher net earned premium and higher net investment income, partially offset by
higher expenses.

Analysis of the components of net income are discussed in the following
sections.

Results of Insurance Operations

Underwriting components for the Company for the years ended December 31,
2005, 2004 and 2003 are summarized in the following table (dollars in
thousands):

YEARS ENDED DECEMBER 31,
----------------------------
2005 2004 2003
-------- -------- --------

Gross written premium.......................... $417,530 $389,417 $371,375
======== ======== ========
Net written premium............................ $365,948 $318,284 $319,210
======== ======== ========
Net earned premium............................. $348,361 $317,857 $304,449
======== ======== ========
Net losses and loss adjustment expenses........ $127,841 $ 87,356 $172,476
======== ======== ========
Net commissions, brokerage and other
underwriting expenses........................ $202,521 $207,166 $190,740
======== ======== ========
Loss ratio..................................... 36.7% 27.5% 56.7%
Expense ratio.................................. 58.1 65.2 62.6
-------- -------- --------
Combined ratio................................. 94.8% 92.7% 119.3%
======== ======== ========

Premiums Written

CNA Surety primarily markets contract and commercial surety bonds. Contract
surety bonds generally secure a contractor's performance and/or payment
obligation with respect to a construction project. Contract surety bonds are
generally required by federal, state and local governments for public works
projects. The most common types include bid, performance and payment bonds.
Commercial surety bonds include all surety bonds other than contract and cover
obligations typically required by law or regulation. The commercial surety
market includes numerous types of bonds categorized as court judicial, court
fiduciary, public official, license and permit and many miscellaneous bonds that
include guarantees of financial performance. The Company also writes fidelity
bonds that cover losses arising from employee dishonesty and other insurance
products that are generally companion products to certain surety bonds. For
example, the Company writes surety bonds for notaries and also offers related
errors and omissions ("E&O") insurance coverage.

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 for the years ended December 31, 2005, 2004 and 2003
are shown in the table below (dollars in thousands) for each sub-line of
business:

YEARS ENDED DECEMBER 31,
----------------------------
2005 2004 2003
-------- -------- --------

Contract....................................... $248,662 $221,577 $208,472
Commercial..................................... 133,740 135,893 133,733
Fidelity and other............................. 35,128 31,947 29,170
-------- -------- --------
$417,530 $389,417 $371,375
======== ======== ========

Gross written premiums for the year ended December 31, 2005 increased 7.2%
to $417.5 million as compared to 2004. Gross written premiums for contract
surety increased 12.2 percent to $248.7 million due to volume growth, some of
which is attributed to several competitors exiting the contract surety market.
Commercial surety premiums decreased 1.6 percent to $133.7 million as continued
strong volume growth in small commercial products was more than offset by
declining premium volume on large commercial accounts due to the Company's
ongoing efforts to

reduce aggregate exposures to large commercial accounts. Fidelity and other
products increased 10.0% to $35.1 million, for the year ended December 31, 2005
as compared to the same period in 2004 due primarily to volume growth in related
small commercial products.

Gross written premiums for the year ended December 31, 2004 increased 4.9%
to $389.4 million as compared to 2003. Gross written premiums for contract
surety increased 6.3% to $221.6 million, due primarily to improving rates on
large contract bonds. Commercial surety premiums increased 1.6% to $135.9
million as continued strong volume growth in small commercial products more than
offset the volume decline due to the Company's ongoing efforts to reduce
aggregate exposures to large commercial accounts. Fidelity and other premiums
increased by 7.7% to $31.9 million in 2004 primarily due to the volume growth of
related small commercial products.

Net written premiums for the years ended December 31, 2005, 2004 and 2003
are shown in the table below (dollars in thousands) for each sub-line of
business:

YEARS ENDED DECEMBER 31,
----------------------------
2005 2004 2003
-------- -------- --------

Contract....................................... $202,798 $172,274 $184,449
Commercial..................................... 128,022 115,454 106,899
Fidelity and other............................. 35,128 30,556 27,862
-------- -------- --------
$365,948 $318,284 $319,210
======== ======== ========

For the year ended December 31, 2005, net written premiums increased by
$47.7 million to $365.9 million as compared to 2004 reflecting the increase in
gross written premiums discussed previously and the reduction in the cost of the
Company's 2005 reinsurance program. Ceded written premiums decreased $19.6
million to $51.6 million for the year ended December 31, 2005 compared to the
prior year. Net written premiums for contract surety business increased 17.7% to
$202.8 million. Net written premiums for commercial surety increased 10.9% to
$128.0 million for the year ended December 31, 2005. Significant reductions in
exposures to large commercial bonds have caused a greater share of reinsurance
protection to be allocated to contract bonds. Fidelity and other products
increased 15.0% to $35.1 million for the year 2005 as compared to 2004
reflecting the increase in gross written premiums discussed previously.

For the year ended December 31, 2004, net written premiums decreased
slightly to $318.3 million as compared to 2003, reflecting higher reinsurance
costs. Ceded written premiums increased $19.0 million to $71.1 million for the
year ended December 31, 2004 compared to 2003 primarily due to the Company's
decision to reduce its per principal retention by purchasing additional
reinsurance protection. Net written premiums for contract surety business
decreased 6.6% to $172.3 million due to a higher allocation of reinsurance costs
in 2004. Because of the significant reductions in exposures to large commercial
bonds, a greater share of the reinsurance protection is related to contract
bonds. Net written premiums for commercial surety increased 8.0% to $115.5
million for the year ended December 31, 2004. Fidelity and other products
increased 9.7% to $30.5 million for the year 2004 as compared to 2003.

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. At December 31, 2005, American Re-Insurance Company, Renaissance
Reinsurance LTD, XL Reinsurance America, Inc., and Odyssey America Reinsurance
Corporation (all rated at least A by A.M. Best) were the four unaffiliated
reinsurers from which the Company had its largest reinsurance receivables.

2004 Third Party Reinsurance Compared to 2003 Third Party Reinsurance

Loss Treaty"), as well as a $40 million excess of $60 million per principal
treaty and a $3 million excess of $12 million treaty that had been provided by
CCC. The material differences between the 2004 Excess of Loss Treaty and the
2003 Excess of Loss Treaty were as follows. The annual aggregate coverage
increased from $110 million in 2003 to $157 million in 2004. The premium for the
2004 Excess of Loss Treaty was $50.6 million compared to a total of $42.0
million of reinsurance premiums paid in 2003 for the 2003 Excess of Loss Treaty,
the $40 million excess of $60 million treaty and the $3 million excess of $12
million treaty. The 2004 Excess of Loss Treaty also provided for somewhat less
restrictive special acceptance provisions for larger contract accounts than
those contained in the 2003 Excess of Loss Treaty. In addition to the large
national contractor (described later) and two commercial principals (excluded
based upon class of business), the Company's reinsurers had excluded three other
contract principals from the 2003 Excess of Loss Treaty, for a total of six
excluded principals. The large national contractor and the two commercial
principals remained excluded from the 2004 Excess of Loss Treaty.

With respect to the three contract principals other than the large national
contractor, two contract principals that have completed asset sales and other
reorganization efforts were accepted into the 2004 Excess of Loss Treaty. The
Company received claims related to the third contract principal in 2003, making
it ineligible for inclusion in the 2004 Excess of Loss Treaty.

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 remained at $10.0 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 increased from $157 million in 2004 to
$185 million in 2005. The actual annual premium for the 2005 Excess of Loss
Treaty was $41.3 million compared to the actual cost of the 2004 Excess of Loss
Treaty of $50.6 million. 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 remained excluded from the 2005 Excess of Loss Treaty.

2006 Third Party Reinsurance Compared to 2005 Third Party Reinsurance

Effective January 1, 2006, CNA Surety entered into a new excess of loss
treaty ("2006 Excess of Loss Treaty") with a group of third party reinsurers on
terms similar to the 2005 Excess of Loss Treaty. Under the 2006 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 material differences between the 2006 Excess
of Loss Treaty and the Company's 2005 Excess of Loss Treaty are as follows. The
base annual premium for the 2006 Excess of Loss Treaty is $36.9 million compared
to the actual cost of the 2005 Excess of Loss Treaty of $41.3 million. The
contract includes an optional 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 beyond 2006
on bonds that were in force during 2006. Only the large national contractor
(described later) that was excluded from the 2005 Excess of Loss Treaty remains
excluded from the 2006 Excess of Loss Treaty.

Related Party Reinsurance

Reinsurance agreements together with the Services and Indemnity Agreement
that are described below provide for the transfer of the surety business written
by CCC and CIC to Western Surety. All of these agreements originally were
entered into on September 30, 1997 (the "Merger Date"): (i) the Surety Quota
Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop Loss
Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety Excess of
Loss Reinsurance Contract (the "Excess of Loss Contract"). All of these
contracts have expired. Some have been renewed on different terms as described
below.

The Services and Indemnity Agreement provides the Company's insurance
subsidiaries with the authority to perform various administrative, management,
underwriting and claim functions in order to conduct the business of CCC and CIC
and to be reimbursed by CCC for services rendered. In consideration for
providing the foregoing services, CCC has agreed to pay Western Surety a
quarterly fee of $50,000. This agreement was renewed on January 1, 2006 and
expires on December 31, 2006; and is annually renewable thereafter. There was no
amount due to the CNA Surety insurance subsidiaries as of December 31, 2005.

Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all
surety business written or renewed by CCC and CIC after the Merger Date. 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.

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 has not been any
adverse reserve development for the period from September 30, 1997 (date of
inception) through December 31, 2005.

The Quota Share Treaty was renewed on January 1, 2004 on substantially the
same terms with an expiration date of December 31, 2004; and is annually
renewable thereafter. The ceding commission paid to CCC and CIC by Western
Surety remained at 28% of net written premiums and contemplated an approximate
4% override commission for fronting fees to CCC and CIC on their actual direct
acquisition costs. 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%. The Quota Share Treaty was renewed for
one year on January 1, 2005 on substantially the same terms except that the
ceding commission to CCC and CIC was reduced to 25% in order to provide an
approximate 4% override commission to CCC and CIC. The Quota Share Treaty was
renewed for one year on January 1, 2006 on substantially the same terms as 2005.

Through 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 exceeds 24% in any of the accident years 1997 through 2000
on certain insured accounts (the "Loss Ratio Cap"), the Stop Loss Contract
requires CCC at the end of each calendar quarter following the Merger Date, to
pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if
any, by which their actual accident year net loss ratio exceeds the applicable
Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. In
consideration for the coverage provided by the Stop Loss Contract, the insurance
subsidiaries paid to CCC an annual premium of $20,000. The CNA Surety insurance
subsidiaries have paid CCC all required annual premiums. As of December 31,
2005, the net amount billed and received under the Stop Loss Contract was $45.9
million, which included a return of $9.0 million in 2005 due to a reduction of
net loss ratios for years covered by the contract.

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 December 31, 2005, the Company has
ceded $50.0 million under the terms of this contract. In November 2005, the
Company and CCC agreed by addendum to extend this contract for twelve months.
This extension, expiring December 31, 2006, was

for an additional minimum premium of $0.8 million, subject to adjustment based
on the level of actual premiums written on bonds for the large national
contractor.

The Company and CCC entered into a $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 was 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 $4.8 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 December 31, 2005, no losses have been ceded
under this contract, which has not been renewed for 2006.

As of December 31, 2005 and December 31, 2004, CNA Surety had an insurance
receivable balance from CCC and CIC of $61.0 million and $16.4 million,
respectively. CNA Surety had no reinsurance payables to CCC and CIC as of
December 31, 2005 and December 31, 2004.

Large National Contractor

The Company has provided significant surety bond protection guaranteeing
projects undertaken by the large national contract principal that is excluded
from the Company's third party reinsurance. 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 $60.0 million is now provided under one treaty. Credit extended to the
principal by affiliates of the Company is 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 $106.0 million
from $86.0 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 $126.0 million. As of
December 31, 2005 and 2004, respectively, $132.0 million (including accrued
interest) and $99.0 million had been advanced under the credit facility. Loews,
through a participation agreement with CNAF, provided funds for and owned a
participation of $40.0 million and $29.0 million of the loans outstanding as of
December 31, 2005 and 2004, respectively, and has agreed to a participation of
one-third of any additional loans which may be made above the original $86.0
million credit facility limit up to the $126.0 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 December
31, 2005 and December 31, 2004, these guarantees and collateral obligations
aggregated $13.0 million.

The contractor implemented a restructuring plan intended to reduce costs
and improve cash flow, and appointed a chief restructuring officer to manage
execution of the plan. In the course of addressing various expense, operational
and strategic issues, however, the contractor has decided to substantially
reduce the scope of its original business and to concentrate on those segments
determined to be potentially profitable. As a consequence, operating cash flow,
and in turn the capacity to service debt, has been reduced below previous
levels. Restructuring plans have also been extended to accommodate these
circumstances. In light of these developments, CNAF recorded an impairment
charge of $56.0 million pre-tax ($36.0 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, and an additional pre-tax impairment charge of $13.0
million ($9.0 million after-tax) during the first quarter of 2005.

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 $21.0 million pre-tax
($13.0 million after-tax) to fully impair the loan.

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 $40.0 million loss reserve
based on an initial estimate of loss. In the third quarter of 2005, the Company
began a re-evaluation of the contractor's current restructuring efforts. Through
this re-evaluation that was completed in the fourth quarter, the Company
determined that there had been further deterioration of the contractor's actual
and projected cash flows. As a result, the Company increased its gross loss
reserves for this account by $70.0 million in the fourth quarter of 2005. After
applying expected reinsurance recoveries from CCC, the Company's net incurred
loss is $60.0 million, which is the Company's maximum exposure, net of
reinsurance, on this account. As of December 31, 2005, the Company has paid
approximately $26.0 million of losses to settle outstanding bonded obligations
of the contractor.

The Company intends to continue to provide limited surety bonds on behalf
of the contractor to support the continuing restructuring efforts. However,
existing reinsurance agreements limit the Company's net loss exposure to the
$60.0 million that has already been recorded. The Company estimates that
possible additional losses, net of indemnification and subrogation recoveries
but before recoveries under reinsurance contracts to be approximately $90.0
million pre-tax.

The Company has had discussions with its insurance regulatory authorities
regarding the level of bonds provided for this principal and will continue to
keep the insurance regulators informed of its ongoing gross exposure to this
account.

Net Loss Ratio

The loss ratios for the years ended December 31, 2005, 2004 and 2003 were
36.7%, 27.5% and 56.7%, respectively. The loss ratios reflect $23.3 million and
$0.6 million of net favorable loss reserve development for the years ended
December 31, 2005 and 2004, respectively, and $39.3 million in net unfavorable
loss reserve development for the year ended December 31, 2003.

The higher loss ratio in 2005 compared to 2004 reflects the net reserve
increase of $60.0 million related to the large national contractor discussed
earlier, which added approximately 17 percentage points to this ratio. This was
partially offset by increased favorable development from prior accident years
and an increase in net earned premium that resulted from the reduction in the
cost of the Company's 2005 reinsurance program.

The improvement in the loss ratio from 2003 to 2004 is primarily due to the
absence of both the adverse development on prior accident years that was
recorded in 2003 and other large losses related to accident year 2003. Past
changes in the Company's business mix and reinsurance program along with
increased corporate default rates were the primary drivers of the need to
substantially increase reserve levels in 2003. Beginning in the late 1990's, the
Company began writing more bonds for large corporate clients. Shortly
thereafter, corporate default rates increased dramatically. These exposures
proved to be more volatile than the Company's more traditional contract and
small commercial surety products, and began resulting in a higher frequency of
severe losses. As a result, the Company's reinsurers significantly increased
rates, reduced the amount of coverage available to the Company and excluded
certain accounts from the reinsurance program. For 2002, the Company's per
principal retention increased from $5.0 million to $20.0 million. Although the
Company reduced its per principal retention to $15.0 million for 2003, these
higher retentions, at a time of continuing higher frequency of severe losses,
further increased the volatility of results.

Reported claim activity improved dramatically in 2004 and continued at
lower levels through 2005. Management believes that this is a result of ongoing
efforts to reduce its exposures to large corporate clients, continued
underwriting discipline in its traditional contract and small commercial
products and a reduction in corporate default rates. In 2005, the Company was
able to achieve favorable settlements on several large claims that resulted in
claim payments that were substantially less than had been previously expected.
Two of these favorable settlements were on cases that were part of the adverse
loss development recorded in 2003 that is discussed below. In one of these
cases, the Company's negotiating position turned out to be stronger than
expected. In the other case, the Company was able to negotiate a settlement that
included significant recoveries that were not previously expected. In addition,
the Company was able to reduce reserves on several large open claims based on
new information that emerged in 2005. The independent actuarial review conducted
in 2005 confirmed that the favorable claim settlements, the lower reserves on
open claims and the reduced level of new claim activity had resulted in a
reserve redundancy. Accordingly, the Company recorded favorable loss development
of $23.3 million in 2005, primarily for accident years 2002 and 2003.

The favorable loss development recorded in 2004 for prior accident years
resulted from loss adjustment expense payments related to prior years that were
lower than previously expected. The adverse development on prior accident years
that occurred in 2003 was directly related to a significant increase in large
claim activity. Management concluded that this claim activity exceeded the
assumptions regarding the frequency of severe losses used in determining the
then existing reserves. First, additional contract bond claims were received
during the third quarter of 2003 on a contractor that had filed for bankruptcy
in February, 2003. Upon review and verification of these new claims, the
existing case reserve was increased by $7.2 million, net of applicable
reinsurance. Second, a demand was made during the third quarter of 2003 against
a $45 million insurance program bond issued on behalf of a national trucking
concern that had entered bankruptcy. This demand was in contradiction of
previous information provided by the obligee on the bond. Based on this new
information, management reserved the full remaining limits on this bond which
resulted in $15.0 million of net adverse development after the application of
available reinsurance. Third, claims were also received in the third quarter of
2003 on worker's compensation self insurance bonds written between 1975 and 1986
on behalf of two principals. After verifying coverage and obtaining supporting
actuarial information on the underlying workers' compensation claims, the
Company increased the case reserves on these bonds by $8.4 million, net of
applicable reinsurance. Fourth, after receiving a demand on another insurance
program bond in the third quarter of 2003, management identified an outstanding
insurance program bond written on behalf of a contractor now in bankruptcy.
Based on recent experience with this type of bond, which typically has few
defenses available to the surety, and in particular with the obligee on this
bond, management recorded a loss provision on this bond of $6.0 million.
Finally, management determined that the case reserve on a particular claim was
insufficient due to the amount of legal fees that the Company was incurring on
the case. Based on their estimate of future legal expenses, management increased
the reserve on this bond by $3.0 million.

In addition to the net unfavorable loss reserve development, the higher net
loss ratio in 2003 primarily relates to net reserve additions of approximately
$49.0 million for the 2003 accident year due to material adverse loss severity
on the Company's branch commercial and contract business. The net additions to
reserves for the 2003 accident year resulted from three large contract bond
claims totaling $28.0 million incurred in 2003, an approximately $15.0 million
net loss on an insurance program bond for a now bankrupt large commercial
account, and changes in estimates of large losses resulting from this
significant adverse claim activity.

The surety business assumed from CCC and CIC is subject to the Stop Loss
Contract between CCC and the Company that limits the Company's accident year net
loss ratio on this business to 24% for accident years 1997 (October 1, 1997 to
December 31, 1997), 1998, 1999 and 2000. The Company recorded a reduction in
estimated recoveries from CCC of $9.0 million in 2005, and estimated reinsurance
recoveries from CCC of $29.9 in 2003, $2.5 million in 2002, $16.6 million in
2001 and $5.8 million in 2000 under this contract. As of December 31, 2005,
there were no unpaid balances related to amounts due under the Stop Loss
Contract.

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 December 31, 2005, the Company billed a total of $37.1 million
to its reinsurers. All nine reinsurers responsible for payment of the treaty
proceeds either have paid their portions of the claim or paid the Company to
commute the entire reinsurance treaty under which the Enron claim was made.

Exposure Management

As the foregoing results indicate, the Company's business is subject to
certain risks and uncertainties associated with the current economic environment
and corporate credit conditions. In response to these risks and uncertainties,
the Company has enacted various exposure management initiatives, particularly to
reduce its risks on large commercial accounts. As the following table depicts,
the Company has reduced its exposure, before the effects of reinsurance, by
33.0% in 2005 on large commercial accounts, which are defined as accounts with
exposures in excess of $10.0 million:

NUMBER OF
ACCOUNTS
AS OF
DECEMBER TOTAL EXPOSURE
31, AS OF DECEMBER 31,
---------- -------------------------------
COMMERCIAL ACCOUNT EXPOSURE 2005 2004 2005 2004 % REDUCTION
--------------------------- ---- ---- -------- -------- -----------
(DOLLARS IN MILLIONS)

$100 million and larger............... 2 2 $ 246.6 $ 256.4 3.8%
$50 to $100 million................... 2 7 137.6 468.1 70.6%
$25 to $50 million.................... 9 11 307.7 401.0 23.3%
$10 to $25 million.................... 32 39 445.6 572.5 22.2%
-- -- -------- --------
Total................................. 45 59 $1,137.5 $1,698.0 33.0%
== == ======== ========

With respect to contract surety, the Company's portfolio is predominantly
comprised of contractors with bonded backlog of less than $30.0 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 38
accounts each with a bonded backlog in excess of $100.0 million.

The Company manages 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.

Expense Ratio

The expense ratio decreased to 58.1% for 2005 as compared to 65.2% for
2004. The decrease in the expense ratio for 2005 primarily reflects higher net
earned premium resulting from lower reinsurance costs, the impacts of cost
reduction initiatives that began in the first quarter of 2004, and the absence
of expenses associated with the increased accrual for policyholder dividends
discussed below. These changes decreased the expense ratio by 2.7, 2.9, and 1.5
percentage points, respectively. Ceded earned premium decreased by $15.5 million
in 2005 as compared to 2004. Operating expenses decreased 2.2% for 2005
primarily due to the impacts of cost reduction initiatives that began in the
first quarter of 2004 and the absence of expenses associated with the increased
accrual for policyholder dividends.

The expense ratio increased to 65.2% for 2004 as compared to 62.6% for
2003. The increase in the expense ratio for 2004 primarily reflects the impact
of higher reinsurance costs on net earned premiums and higher operating
expenses. Ceded earned premium increased by $10.5 million in 2004, primarily due
to the Company's decision to reduce its per principal retention from $15 million
in 2003 to $10 million in 2004. The higher ceded earned premium increased the
2004 expense ratio by 2.1 percentage points. Operating expenses increased 8.6%
for 2004 primarily due to a 6.6% increase in gross earned premium. 2004
operating expenses were impacted by a $4.9 million increase to the accrual for
policyholder dividends. This increase added approximately 1.5 percentage points
to the

2004 expense ratio. The Company streamlined its field office structure during
2004 in order to add consistency to operations and to reduce expenses. No
significant expense impact occurred in 2004 due to severance costs associated
with this effort.

Investment Income

For 2005, net investment income was $33.7 million compared to net
investment income for 2004 and 2003 of $30.2 million and $26.3 million,
respectively. The annualized pre-tax yield was 4.4%, 4.5% and 4.4% for 2005,
2004 and 2003, respectively. The annualized after-tax yield was 3.7%, 3.7% and
3.6% for 2005, 2004 and 2003, respectively. The increase in investment income
for 2005 is attributable to higher overall invested assets resulting primarily
from significant cash flow from operations.

Realized Investment Gains and Losses

Net realized investment gains were $2.0 million, $2.8 million and $1.8
million for 2005, 2004 and 2003, respectively. The net realized investment gains
in 2005 resulted primarily from the Company's sale of its interest in De
Montfort Group, Ltd in the first quarter of 2005. The net realized investment
gains realized in 2004 and 2003 resulted from opportunities to sell securities
that the Company believed would maximize the total return on its portfolio.

The following summarizes net realized investment gains for the years ended
December 31, 2005, 2004, and 2003:

YEARS ENDED DECEMBER
31,
----------------------
2005 2004 2003
------ ------ ------

Gross realized investment gains..................... $2,302 $2,765 $2,368
Gross realized investment losses.................... (328) (14) (542)
------ ------ ------
Net realized investment gains....................... $1,974 $2,751 $1,826
====== ====== ======

Interest Expense

Interest expense increased $1.3 million, or 56.9%, for 2005 compared to
2004, primarily due to higher interest rates on debt outstanding. The weighted
average interest rate for 2005 was 5.5% compared to 3.6% and 2.4% for the
periods ended December 31, 2004 and 2003, respectively. Interest expense
increased $0.7 million, or 48.4%, for 2004 compared to the same period in 2003,
due primarily to higher outstanding debt levels and higher interest rates
associated with the debt outstanding. Average debt outstanding was $61.2 million
in 2005 compared to $60.9 million and $55.6 million in 2004 and 2003,
respectively.

Income Taxes

The Company's income tax expense was $11.7 million for 2005 and $14.3
million for 2004, compared to an income tax benefit of $18.0 million for 2003.
The effective income tax rates were 23.4%, 26.5% and (56.0)% for 2005, 2004 and
2003, respectively. The effective tax rates are primarily impacted by the
Company's significant investments in tax-exempt securities. The impact of tax-
exempt securities on taxable income was $16.3 million, $14.4 million, and $13.7
million for 2005, 2004 and 2003, respectively.

LIQUIDITY AND CAPITAL RESOURCES

It is anticipated that the liquidity requirements of CNA Surety will be met
primarily by funds generated from operations. The principal sources of operating
cash flows are premiums, investment income, recoveries under reinsurance
contracts and sales and maturities of investments. CNA Surety also may generate
funds from additional borrowings under the credit facility described below. The
primary cash flow uses are payments for claims, operating expenses, federal
income taxes and debt service, as well as dividends to CNA Surety stockholders.
In general, surety operations generate premium collections from customers in
advance of cash outlays for claims. Premiums are invested until such time as
funds are required to pay claims and claims adjusting expenses.

The Company believes that total invested assets, including cash and short-
term investments, are sufficient in the aggregate and have suitably scheduled
maturities to satisfy all policy claims and other operating liabilities,
including dividend and income tax sharing payments of its insurance
subsidiaries. If cash requirements unexpectedly exceed cash inflows, the Company
may raise additional cash by liquidating fixed income securities ahead of their
scheduled maturity. Depending on the interest rate environment at that time, the
Company could generate realized gains or losses that would increase or decrease
net income for the period. The extent of these gains or losses would depend on a
number of factors such as the prevailing interest rates and credit spreads, the
duration of the assets sold, and the marketability of the assets. The need to
liquidate fixed income securities would be expected to cause a reduction in
future investment income.

The Company might also access available or new credit facilities to meet
cash needs. This would increase interest expense by increasing the amount of
debt outstanding and potentially increasing the interest rate on previously
outstanding debt. The Company currently has $30.0 million of borrowing capacity
on existing facilities. The Company's ability to enter into new facilities is
limited by covenants in the existing facility.

At December 31, 2005, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $721.3 million of fixed income
securities, $48.4 million of short-term investments, $1.0 million of other
investments and $4.3 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 2005 to
enable the affiliate to establish a trust to fund future payments under the
bond. This deposit is included on the Company's 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.

Cash flow at the parent company level is derived principally from dividend
and tax sharing payments from its insurance subsidiaries, and to a lesser
extent, investment income. The principal obligations at the parent company level
are to service debt and pay operating expenses, including income taxes. At
December 31, 2005, the parent company's invested assets consisted of $1.0
million of fixed income securities, $1.3 million of equity securities, $16.6
million of short-term investments and $2.6 million of cash. At December 31,
2004, the parent company's invested assets consisted of $6.4 million of fixed
income securities, $1.2 million of equity securities, $5.8 million of short-term
investments and $1.8 million of cash. As of December 31, 2005 and December 31,
2004, parent company short-term investments and cash included $6.6 million and
$5.1 million, respectively, 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 $70.0 million, $108.0 million and $25.2 million for 2005, 2004 and 2003,
respectively. The decrease in net cash flow provided by operating activities in
2005 primarily relates to the deposit with the affiliated ceding company
discussed earlier and higher loss payments. The increase in net cash flow
provided by operating activities in 2004 primarily relates to higher premiums
received, lower loss payments, receipts from reinsurers and an income tax refund
related to the operating loss of 2003.

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. In November of 2005, the Company reduced
outstanding borrowings by $10.0 million to $20.0 million. 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 1.25% at

December 31, 2005. As of December 31, 2005, the weighted average interest rate
on the 2005 Credit Facility was 5.69% on the $20.0 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 as of and for the period ended December 31, 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 Company's investment of $0.9
million in the Issuer Trust is carried at cost in "Other assets" in the
Company's Consolidated Balance Sheet. 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 December 31, 2005 the interest
rate on the junior subordinated debenture was 7.71%.

A summary of the Company's commitments as of December 31, 2005 is presented
in the following table:

COMMITMENTS

DECEMBER 31, 2005 2006 2007 2008 2009 2010 THEREAFTER TOTAL
----------------- ------ ------ ----- ----- ----- ---------- ------
(IN MILLIONS)

Debt....................... $ 3.5 $ 3.5 $23.1 $ 2.4 $ 2.4 $ 86.7 $121.6
Operating leases........... 1.9 1.8 1.6 1.6 1.6 2.3 10.8
Loss and loss adjustment
expense reserves......... 178.3 159.8 39.2 8.6 7.8 30.7 424.4
Other long-term
liabilities(a)........... 0.4 0.4 0.5 0.5 0.6 5.7 8.1
------ ------ ----- ----- ----- ------ ------
Total...................... $184.1 $165.5 $64.4 $13.1 $12.4 $125.4 $564.9
====== ====== ===== ===== ===== ====== ======

-----------

(a) reflects unfunded post-retirement benefit plan payments

As an insurance holding company, CNA Surety is dependent upon dividends and
other permitted payments from its insurance subsidiaries to pay operating
expenses and meet debt service requirements, as well as to pay cash dividends.
The payment of dividends by the insurance subsidiaries is subject to varying
degrees of supervision by the insurance regulatory authorities in South Dakota
and Texas. In South Dakota, where Western Surety and Surety Bonding are
domiciled, insurance companies may only pay dividends from earned surplus
excluding surplus arising

from unrealized capital gains or revaluation of assets. In Texas, where USA is
domiciled, an insurance company may only declare or pay dividends to
stockholders from the insurer's earned surplus. The insurance subsidiaries may
pay dividends without obtaining prior regulatory approval only if such dividend
or distribution (together with dividends or distributions made within the
preceding 12-month period) is less than, as of the end of the immediately
preceding year, the greater of (i) 10% of the insurer's surplus to policyholders
or (ii) statutory net income. In South Dakota, net income includes net realized
capital gains in an amount not to exceed 20% of net unrealized capital gains.
All dividends must be reported to the appropriate insurance department prior to
payment.

The dividends that may be paid without prior regulatory approval are
determined by formulas established by the applicable insurance regulations, as
described above. The formulas that determine dividend capacity in the current
year are dependent on, among other items, the prior year's ending statutory
surplus and statutory net income. Dividend capacity for 2006 is based on
statutory surplus and income at and for the year ended December 31, 2005.
Without prior regulatory approval in 2006, CNA Surety's insurance subsidiaries
may pay to CNA Surety dividends of $39.1 million in the aggregate. CNA Surety
received dividends of $20.0 million from its insurance subsidiaries during 2005
and no dividends from its insurance subsidiaries during 2004. CNA Surety
received $1.5 million in dividends from its non-insurance subsidiaries during
2005, including $0.5 million in cash. CNA Surety received no dividends from its
non-insurance subsidiaries during 2004.

Combined statutory surplus totaled $275.2 million at December 31, 2005,
resulting in a net written premium to statutory surplus ratio of 1.3 to 1.0.
Insurance regulations restrict Western Surety's maximum net retention on a
single surety bond to 10 percent of statutory surplus. Under the 2006 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. At December 31,
2005, Western Surety's statutory surplus was $275.2 million. This surplus
requirement may limit the amount of future dividends Western Surety could
otherwise pay to CNA Surety.

In accordance with the provisions of inter-company 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. Inter-company
tax payments are made at such times when estimated tax payments would be
required by the Internal Revenue Service ("IRS"). CNA Surety received tax-
sharing payments of $11.8 million from its subsidiaries for 2005 and $10.9
million for 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, 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 and on January 1, 2004 and January 1, 2005 on substantially
the same terms. 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.

FINANCIAL CONDITION

Investment Portfolio

The following table summarizes the distribution of the Company's fixed
income and equity portfolios at estimated fair values as of December 31, 2005
and 2004 (dollars in thousands):

DECEMBER 31, DECEMBER 31,
2005 2004
ESTIMATED % OF ESTIMATED % OF
FAIR VALUE TOTAL FAIR VALUE TOTAL
------------ ----- ------------ -----

Fixed income securities:
U.S. Treasury securities and obligations
of U.S. Government and agencies:
U.S. Treasury.......................... $ 15,452 2.1% $ 56,034 7.7%
U.S. Agencies.......................... 39,905 5.5 4,557 0.6
Collateralized mortgage obligations.... 18,905 2.6 18,745 2.6
Mortgage pass-through securities....... 44,594 6.2 56,772 7.8
Obligations of states and political
subdivisions........................... 477,084 65.9 454,617 62.3
Corporate bonds.......................... 70,346 9.7 99,069 13.6
Non-agency collateralized mortgage
obligations............................ 21,510 3.0 2,081 0.3
Other asset-backed securities:
Second mortgages/home equity loans..... 25,764 3.6 21,114 2.8
Credit card receivables................ -- -- 867 0.1
Other.................................. 5,591 0.8 8,185 1.1
Redeemable preferred stock............... 3,128 0.4 6,297 0.9
-------- ----- -------- -----
Total fixed income securities............ 722,279 99.8% 728,338 99.8%
Equity securities........................ 1,306 0.2 1,198 0.2
-------- ----- -------- -----
Total.................................... $723,585 100.0% $729,536 100.0%
======== ===== ======== =====

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.

The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety by investment category, were as follows (dollars
in thousands):

GROSS UNREALIZED
LOSSES
GROSS --------------------
AMORTIZED COST UNREALIZED LESS THAN MORE THAN ESTIMATED FAIR
DECEMBER 31, 2005 OR 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............ $ 15,637 $ -- $ (32) $ (153) $ 15,452
U.S. Agencies............ 40,055 131 (195) (86) 39,905
Collateralized mortgage
obligations........... 18,696 432 (223) -- 18,905
Mortgage pass-through
securities............ 45,607 87 (647) (453) 44,594
Obligations of states and
political subdivisions... 464,417 14,424 (1,282) (475) 477,084
Corporate bonds............ 69,626 1,885 (1,152) (13) 70,346
Non-agency collateralized
mortgage obligations..... 22,200 -- (690) -- 21,510
Other asset-backed
securities:
Second mortgages/home
equity loans.......... 25,924 21 (181) -- 25,764
Other.................... 5,613 93 (115) -- 5,591
Redeemable preferred
stock.................... 3,000 128 -- -- 3,128
-------- ------- ------- ------- --------
Total fixed income
securities............... 710,775 17,201 (4,517) (1,180) 722,279
Equity securities.......... 1,201 105 -- -- 1,306
-------- ------- ------- ------- --------
Total.................... $711,976 $17,306 $(4,517) $(1,180) $723,585
======== ======= ======= ======= ========

Invested assets are exposed to various risks, such as interest rate, market
and credit. Due to the level of risk associated with certain of these invested
assets and the level of uncertainty related to changes in the value of these
assets, it is possible that changes in risks in the near term may significantly
affect the amounts reported in the Consolidated Balance Sheets and Consolidated
Statements of Income. The Company's Quantitative and Qualitative Discussion
about Market Risk is contained in Item 7A of this Form 10-K.

The following table sets forth the ratings assigned by S&P or Moody's
Investor Services, Inc. ("Moody's") of the fixed income securities portfolio of
the Company as of December 31, 2005 and 2004 (dollars in thousands):

2005 2004
---------------------- ----------------------
CREDIT RATING FAIR VALUE % OF TOTAL FAIR VALUE % OF TOTAL
------------- ---------- ---------- ---------- ----------

AAA/Aaa................................. $557,883 77.2% $508,309 69.8%
AA/Aa................................... 97,565 13.5 109,736 15.1
A/Aa.................................... 49,346 6.8 62,342 8.6
BBB/Baa................................. 16,485 2.3 39,640 5.4
Not Rated............................... 1,000 0.2 8,311 1.1
-------- ----- -------- -----
Total................................... $722,279 100.0% $728,338 100.0%
======== ===== ======== =====

As of December 31, 2005 and 2004, 99% of the Company's fixed income
securities were considered investment grade by S&P or Moody's and 91% and 85%
were rated at least "AA" by those agencies for 2005

and 2004, respectively. The Company's investments in fixed income securities do
not contain any industry concentration of credit risk.

As of December 31, 2005, municipal securities from the State of Michigan,
the State of Florida, the State of Pennsylvania, the State of Texas, and the
State of Washington, and each state's related political subdivisions each
represent 4.3%, 4.1%, 3.9%, 3.7%, and 3.5% respectively, of the estimated fair
value of the Company's fixed income securities. Municipal securities from each
other state individually represent less than 3.4% of the Company's fixed income
portfolio.

The following table provides the composition of fixed income securities
with an unrealized loss at December 31, 2005 in relation to the total of all
fixed maturity securities by contractual maturities:

% OF % OF
MARKET UNREALIZED
CONTRACTUAL MATURITY VALUE LOSS
-------------------- ------ ----------

Due in one year or less.................................. 1% -- %
Due after one year through five years.................... 16 13
Due after five years through ten years................... 33 35
Due after ten years...................................... 18 11
Asset-backed securities.................................. 32 41
--- ---
Total.................................................... 100% 100%
=== ===

The following table summarizes for fixed income securities in an unrealized
loss position at December 31, 2005 and 2004, the aggregate fair value and gross
unrealized loss by length of time those securities have been continuously in an
unrealized loss position (dollars in thousands):

DECEMBER 31, 2005 DECEMBER 31, 2004
--------------------------- ---------------------------
ESTIMATED GROSS ESTIMATED GROSS
UNREALIZED LOSS AGING FAIR VALUE UNREALIZED LOSS FAIR VALUE UNREALIZED LOSS
--------------------- ---------- --------------- ---------- ---------------

Fixed income securities:
Investment grade:
0-6 months........................ $224,117 $3,468 $ 69,500 $ 338
7-12 months....................... 32,630 1,049 37,901 547
13-24 months...................... 32,429 1,105 5,484 138
Greater than 24 months............ 1,089 75 -- --
-------- ------ -------- ------
Total investment grade............ $290,265 $5,697 $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 net
realized gains/losses in the Consolidated Statements of Income.

As of December 31, 2005, 93 separate securities held by the Company were in
an unrealized loss position. The Company believes that 92 of these securities
are in this position because of changes in interest rates. Of these 92
securities, 67 were rated "AAA" by S&P and "Aaa" by Moody's. Only one of these
92 securities was in a loss position that exceeded 5% of its book value.

The remaining security that was in a loss position was issued by the
financing subsidiary of a large domestic automaker. The security was in a loss
position of approximately 13% of its book value and was rated below investment
grade by S&P and investment grade by Moody's. The Company believes that the
financial condition and near-term prospects of the issuer are strong, and
expects that the unrealized loss will reverse. The Company intends and believes
it has the ability to hold this investment until the expected recovery in value,
which may be until maturity.

Based on the foregoing information, the Company believes there are no
other-than-temporary impairments at December 31, 2005. No other-than-temporary
impairments were recorded for 2004 or 2003.

Risk Based Capital ("RBC") and Other Regulatory Ratios

The National Association of Insurance Commissioners ("NAIC") has
promulgated RBC requirements for property and casualty insurance companies to
evaluate the adequacy of statutory capital and surplus in relation to investment
and insurance risks such as asset quality, loss reserve adequacy, and other
business factors. The RBC information is used by state insurance regulators as
an early warning mechanism to identify insurance companies that potentially are
inadequately capitalized. In addition, the formula defines minimum capital
standards that supplement the current system of fixed minimum capital and
surplus requirements on a state-by-state basis. Regulatory compliance is
determined by a ratio (the "Ratio") of the enterprise's regulatory total
adjusted capital, as defined by the NAIC, to its authorized control level RBC,
as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized
control level RBC requires no corrective actions on behalf of a company or
regulators. As of December 31, 2005, each of CNA Surety's insurance subsidiaries
had a Ratio that was in compliance with minimum RBC requirements.

CNA Surety's insurance subsidiaries require capital to support premium
writings. In accordance with industry and regulatory guidelines, the net written
premiums to surplus ratio of a property and casualty insurer generally should
not exceed 3 to 1. On December 31, 2005, Western Surety and its insurance
subsidiaries had a combined statutory surplus of $275.2 million and a net
written premiums to surplus ratio of 1.3 to 1. On December 31, 2004, CNA Surety
had a combined statutory surplus of $252.4 million and a net written premium to
surplus ratio of 1.3 to 1. The Company believes that each insurance company's
statutory surplus is sufficient to support its current and anticipated premium
levels.

The NAIC has also developed a rating system, the Insurance Regulatory
Information System ("IRIS"), primarily intended to assist state insurance
departments in overseeing the financial condition of all insurance companies
operating within their respective states. IRIS consists of twelve financial
ratios that address various aspects of each insurer's financial condition and
stability. In 2005 and 2004, most of the ratios for Western Surety, USA and
Surety Bonding were within the "usual" ranges as defined by the NAIC, except as
noted. For 2005, the Investment Yield for each of the insurance companies was
outside the usual range due to a concentration of short-term and tax-exempt
investments. This concentration of short-term and tax-exempt investments also
caused Western Surety's Investment Yield to be outside of the usual range for
2004. Also for 2004, Western Surety's Two Year Reserve Development to
Policyholders' Surplus result was outside the usual range due to adverse claim
development in the third quarter of 2003.

IMPACT OF PENDING ACCOUNTING STANDARDS

In December of 2004, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 123 (revised
2004), "Share-Based Payment" ("SFAS 123R"), that amends Statement of Financial
Accounting Standards 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 Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees (APB 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, modifies, repurchases or cancels 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, 1994) 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. The Company plans to use the
modified prospective transition method. SFAS 123R is effective for the Company
January 1, 2006. The above pro forma disclosure of the effect of SFAS 123 on
results generally reflects the expected impact of adoption of SFAS 123R on the
Company, which is not expected to have a material impact on the results of
operations and/or equity of the Company.

In May 2005, the FASB issued Statement of Financial Accounting Standards
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. Adoption of this standard is not expected to
have a material impact on the Company's results of operations and/or equity.

In November of 2005, the FASB issued FASB Staff Position ("FSP") No. 115-1
and No. 124-1 "The Meaning of Other-than-Temporary Impairment and its
Application to Certain Investments" ("FSP 115-1 and 124-1"), as applicable to
debt and equity securities that are within the scope of SFAS No. 115,
"Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115")
and equity securities that are accounted for using the cost method specified in
Accounting Principles Board Opinion No. 18, "The Equity Method of Accounting for
Investments in Common Stock." FSP 115-1 and 124-1 nullified certain requirements
of Emerging Issues Task Force ("EITF") Issue No. 03-1, "The Meaning of Other-
Than-Temporary Impairment and its Application to Certain Investments" ("EITF 03-
1"), which was originally issued in March, 2004 and was effective for reporting
periods beginning after June 15, 2004. This FSP will replace guidance set forth
in EITF 03-1 with references to existing other-than-temporary impairment
guidance and will clarify that an investor should recognize an impairment loss
no later than when the impairment is deemed other-than-temporary, even if a
decision to sell has not been made. The FSP carries forward the requirements in
EITF 03-1 regarding required disclosures in the financial statements and
requires additional disclosure related to factors considered in reaching the
conclusion that the impairment is other-than-temporary. In addition, in periods
subsequent to the recognition of an other-than-temporary impairment loss for
debt securities, the FSP allows for amortization of the discount or reduced
premium over the remaining life of the security based on future estimated cash
flows. This new guidance for determining whether impairment is other-than-
temporary is effective for reporting periods beginning after December 15, 2005.
Adoption of this standard is not expected to have a material impact on our
results of operations and/or equity.

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 incurred losses and
loss and loss adjustment expense reserves; the impact of routine ongoing
insurance reserve

reviews being conducted by the Company; the ongoing state regulatory
examinations of the Company's insurance company subsidiaries, and the Company's
responses to the results of those reviews and examinations; the Company's
expectations concerning its revenues, earnings, expenses and investment
activities; expected cost savings and other results from the Company's expense
reduction and restructuring activities; and the Company's proposed actions in
response to trends in its business.

Forward-looking statements, by their nature, are subject to a variety of
inherent risks and uncertainties that could cause actual results to differ
materially from the results projected. Many of these risks and uncertainties
cannot be controlled by the Company. Some examples of these risks and
uncertainties are:

- general economic and business conditions;

- changes in financial markets such as fluctuations in interest rates,
long-term periods of low interest rates, credit conditions and currency,
commodity and stock prices;

- the ability of the Company's contract principals to fulfill their bonded
obligations;

- the effects of corporate bankruptcies on surety bond claims, as well as
on capital markets;

- changes in foreign or domestic political, social and economic conditions;

- regulatory initiatives and compliance with governmental regulations,
judicial decisions, including interpretation of policy provisions,
decisions regarding coverage, trends in litigation and the outcome of any
litigation involving the Company, and rulings and changes in tax laws and
regulations;

- regulatory limitations, impositions and restrictions upon the Company,
including the effects of assessments and other surcharges for guaranty
funds and other mandatory pooling arrangements;

- the impact of competitive products, policies and pricing and the
competitive environment in which the Company operates, including changes
in the Company's books of business;

- product and policy availability and demand and market responses,
including the level of ability to obtain rate increases and decline or
non-renew underpriced accounts, to achieve premium targets and
profitability and to realize growth and retention estimates;

- development of claims and the impact on loss reserves, including changes
in claim settlement practices;

- the performance of reinsurance companies under reinsurance contracts with
the Company;

- results of financing efforts, including the availability of bank credit
facilities;

- changes in the Company's composition of operating segments;

- the sufficiency of the Company's loss reserves and the possibility of
future increases in reserves;

- the risks and uncertainties associated with the Company's loss reserves
as outlined in the Reserves for Unpaid Losses and Loss Adjustment
Expenses section of this MD&A; 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 7A. QUANTITATIVE AND QUALITATIVE DISCUSSIONS ABOUT MARKET RISK

CNA Surety's investment portfolio is subject to economic losses due to
adverse changes in the fair value of its financial instruments, or market risk.
Interest rate risk represents the largest market risk factor affecting the
Company's consolidated financial condition due to its significant level of
investments in fixed income securities. Increases and decreases in prevailing
interest rates generally translate into decreases and increases in the fair
value

of the Company's fixed income portfolio. The fair value of these interest rate
sensitive instruments may also be affected by the credit worthiness of the
issuer, prepayment options, relative value of alternative investments, the
liquidity of the instrument, income tax considerations and general market
conditions. The Company manages its exposure to interest rate risk primarily
through an asset/liability matching strategy. The Company's exposure to interest
rate risk is mitigated by the relative short-term nature of its insurance and
other liabilities. The targeted effective duration of the Company's investment
portfolio is approximately 5 years, consistent with the expected duration of its
insurance and other liabilities.

The tables below summarize the estimated effects of certain hypothetical
increases and decreases in interest rates. It is assumed that the changes occur
immediately and uniformly across each investment category. The hypothetical
changes in market interest rates selected reflect the Company's expectations of
the reasonably possible best or worst-case scenarios over a one-year period. The
hypothetical fair values are based upon the same prepayment assumptions that
were utilized in computing fair values as of December 31, 2005. Significant
variations in market interest rates could produce changes in the timing of
repayments due to prepayment options available. The fair value of such
instruments could be affected and therefore actual results might differ from
those reflected in the following table.

HYPOTHETICAL
ESTIMATED FAIR PERCENTAGE
HYPOTHETICAL VALUE AFTER INCREASE
FAIR VALUE AT CHANGE IN HYPOTHETICAL (DECREASE) IN
DECEMBER 31, INTEREST RATE CHANGE IN STOCKHOLDERS'
2005 (BP=BASIS POINTS) INTEREST RATE EQUITY
------------- ----------------- -------------- -------------
(DOLLARS IN THOUSANDS)

U.S. Government and government
agencies and authorities.......... $118,856 200 bp increase $108,293 (1.4)%
100 bp increase 113,974 (0.7)
100 bp decrease 122,326 0.5
200 bp decrease 124,776 0.8
States, municipalities and political
subdivisions...................... 477,084 200 bp increase 424,215 (7.2)
100 bp increase 450,423 (3.6)
100 bp decrease 509,862 4.5
200 bp decrease 540,451 8.6
Corporate bonds and all other....... 126,339 200 bp increase 110,645 (2.1)
-------- 100 bp increase 115,724 (1.4)
100 bp decrease 126,871 0.1
200 bp decrease 132,628 0.9
Total fixed income securities
available-for-sale................ $722,279 200 bp increase 643,153 (10.8)
======== 100 bp increase 680,121 (5.8)
100 bp decrease 759,059 5.0
200 bp decrease 797,855 10.3

HYPOTHETICAL
ESTIMATED FAIR PERCENTAGE
HYPOTHETICAL VALUE AFTER INCREASE
FAIR VALUE AT CHANGE IN HYPOTHETICAL (DECREASE) IN
DECEMBER 31, INTEREST RATE CHANGE IN STOCKHOLDERS'
2004 (BP=BASIS POINTS) INTEREST RATE EQUITY
------------- ----------------- -------------- -------------
(DOLLARS IN THOUSANDS)

U.S. Government and government
agencies and authorities.......... $136,108 200 bp increase $123,990 (1.8)%
100 bp increase 130,255 (0.9)
100 bp decrease 141,248 0.7
200 bp decrease 145,997 1.4
States, municipalities and political
subdivisions...................... 454,617 200 bp increase 398,451 (8.2)
100 bp increase 426,163 (4.1)
100 bp decrease 484,149 4.3
200 bp decrease 515,785 8.9
Corporate bonds and all other....... 137,613 200 bp increase 122,449 (2.2)
-------- 100 bp increase 128,147 (1.4)
100 bp decrease 141,072 0.5
200 bp decrease 148,431 1.6
Total fixed income securities
available-for-sale................ $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 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois

We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that CNA
Surety Corporation and subsidiaries (the "Company") maintained effective
internal control over financial reporting as of December 31, 2005, based on
criteria established in Internal Control -- Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission. The Company's
management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
management's assessment and an opinion on the effectiveness of the Company's
internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinions.

A company's internal control over financial reporting is a process designed
by, or under the supervision of, the company's principal executive and principal
financial officers, or persons performing similar functions, and effected by the
company's board of directors, management, and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial
reporting, including the possibility of collusion or improper management
override of controls, material misstatements due to error or fraud may not be
prevented or detected on a timely basis. Also, projections of any evaluation of
the effectiveness of the internal control over financial reporting to future
periods are subject to the risk that the controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.

In our opinion, management's assessment that the Company maintained
effective internal control over financial reporting as of December 31, 2005, is
fairly stated, in all material respects, based on the criteria established in
Internal Control -- Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Also in our opinion, the Company
maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2005, based on the criteria established in Internal
Control -- Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated financial
statements and financial statement schedules as of and for the year ended
December 31, 2005 of the Company and our report dated February 24, 2006
expressed an unqualified opinion on those consolidated financial statements and
financial statement schedules.

/s/ Deloitte & Touche LLP

Chicago, Illinois
February 24, 2006

MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of CNA Surety Corporation ("CNAS" or the "Company") and
subsidiaries is responsible for establishing and maintaining adequate internal
control over financial reporting. CNAS' internal control system was designed to
provide reasonable assurance to the Company's management, its Audit Committee
and Board of Directors regarding the preparation and fair presentation of
published financial statements.

There are inherent limitations to the effectiveness of any internal control
or system of control, however well designed, including the possibility of human
error and the possible circumvention or overriding of such controls or systems.
Moreover, because of changing conditions the reliability of internal controls
may vary over time. As a result even effective internal controls can provide no
more than reasonable assurance with respect to the accuracy and completeness of
financial statements and their process of preparation.

CNAS management assessed the effectiveness of the Company's internal
control over financial reporting as of December 31, 2005. In making this
assessment, it used the criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) in Internal
Control -- Integrated Framework. Based on our assessment we believe that, as of
December 31, 2005, the Company's internal control over financial reporting is
effective based on those criteria.

CNAS' independent registered public accountant, Deloitte & Touche LLP, has
issued an audit report covering our assessment of the Company's internal control
over financial reporting. This report appears on page 42.

CNA Surety Corporation

Chicago, Illinois
February 24, 2006

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois

We have audited the accompanying consolidated balance sheets of CNA Surety
Corporation and subsidiaries (the "Company") as of December 31, 2005 and 2004,
and the related consolidated statements of income, stockholders' equity, and
cash flows for each of the three years in the period ended December 31, 2005.
Our audits also included the financial statement schedules listed in the Index
at Item 15. These financial statements and financial statement schedules are the
responsibility of the Company's management. Our responsibility is to express an
opinion on the financial statements and financial statement schedules based on
our audits.

We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of the Company and as of December
31, 2005 and 2004, and the results of their operations and their cash flows for
each of the three years in the period ended December 31, 2005, in conformity
with accounting principles generally accepted in the United States of America.
Also, in our opinion, such financial statement schedules, when considered in
relation to the basic consolidated financial statements taken as a whole,
present fairly, in all material respects, the information set forth therein.

We have also audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the effectiveness of the
Company's internal control over financial reporting as of December 31, 2005,
based on the criteria established in Internal Control -- Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
and our report dated February 24, 2006 expressed an unqualified opinion on
management's assessment of the effectiveness of the Company's internal control
over financial reporting and an unqualified opinion on the effectiveness on the
Company's internal control over financial reporting.

/s/ Deloitte & Touche LLP

Chicago, Illinois
February 24, 2006

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

DECEMBER 31,
----------------------
2005 2004
---------- ----------
(AMOUNTS IN THOUSANDS,
EXCEPT PER SHARE DATA)

ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost:
$710,775 and $698,374)................................ $ 722,279 $ 728,338
Equity securities, at fair value (cost: $1,201 and
$1,084)............................................... 1,306 1,198
Short-term investments, at cost (approximates fair
value)................................................ 65,041 28,457
Other investments, at fair value (cost: $965 and
$1,058)............................................... 965 1,058
---------- ----------
Total invested assets................................. 789,591 759,051
Cash....................................................... 8,323 7,336
Deferred policy acquisition costs.......................... 102,833 102,128
Insurance receivables:
Premiums, including $7,947 and $11,012 from affiliates,
(net of allowance for doubtful accounts: $1,490 and
$2,153)............................................... 33,359 32,340
Reinsurance, including $53,025 and $5,364 from
affiliates............................................ 119,670 98,874
Deposit with affiliated ceding company..................... 32,287 --
Intangible assets (net of accumulated amortization: $25,523
and $25,523)............................................. 138,785 138,785
Property and equipment, at cost (less accumulated
depreciation and amortization: $24,887 and $21,600)...... 19,674 15,358
Prepaid reinsurance premiums............................... 5,396 7,955
Accrued investment income.................................. 9,522 8,891
Other assets............................................... 3,174 3,776
---------- ----------
Total assets........................................ $1,262,614 $1,174,494
========== ==========

LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses............... $ 424,449 $ 363,387
Unearned premiums........................................ 241,047 226,019
---------- ----------
Total reserves........................................ 665,496 589,406
Debt....................................................... 50,589 65,488
Deferred income taxes, net................................. 18,820 27,024
Current income taxes payable............................... 6,459 3,491
Reinsurance and other payables to affiliates............... 174 461
Accrued expenses........................................... 16,532 17,090
Other liabilities.......................................... 27,969 25,163
---------- ----------
Total liabilities..................................... $ 786,039 $ 728,123
Commitments and contingencies (See Note 6, 7 & 8)

STOCKHOLDERS' EQUITY
Preferred stock, par value $.01 per share, 20,000 shares
authorized; none issued and outstanding.................. -- --
Common stock, par value $.01 per share, 100,000 shares
authorized; 44,734 shares issued and 43,334 shares
outstanding at December 31, 2005 and 44,423 shares issued
and 43,015 shares outstanding at December 31, 2004....... 447 444
Additional paid-in capital................................. 259,684 255,996
Retained earnings.......................................... 223,927 185,496
Accumulated other comprehensive income..................... 7,546 19,551
Treasury stock, at cost.................................... (15,029) (15,116)
---------- ----------
Total stockholders' equity............................ 476,575 446,371
---------- ----------
Total liabilities and stockholders' equity.......... $1,262,614 $1,174,494
========== ==========

The accompanying notes are an integral part of these consolidated financial
statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

YEARS ENDED DECEMBER 31,
----------------------------
2005 2004 2003
-------- -------- --------
(AMOUNTS IN THOUSANDS,
EXCEPT PER SHARE DATA)

Revenues:
Net earned premium................................. $348,361 $317,857 $304,449
Net investment income.............................. 33,747 30,181 26,301
Net realized investment gains...................... 1,974 2,751 1,826
-------- -------- --------
Total revenues.................................. 384,082 350,789 332,576
-------- -------- --------
Expenses:
Net losses and loss adjustment expenses............ 127,841 87,356 172,476
Net commissions, brokerage and other underwriting
expenses........................................ 202,521 207,166 190,740
Interest expense................................... 3,545 2,260 1,523
-------- -------- --------
Total expenses.................................. 333,907 296,782 364,739
Income (loss) before income taxes.................... 50,175 54,007 (32,163)
Income tax expense (benefit)......................... 11,744 14,297 (18,012)
-------- -------- --------
Net income (loss).................................... $ 38,431 $ 39,710 $(14,151)
======== ======== ========
Earnings (loss) per common share..................... $ 0.89 $ 0.92 $ (0.33)
======== ======== ========
Earnings (loss) per common share, assuming dilution.. $ 0.89 $ 0.92 $ (0.33)
======== ======== ========
Weighted average shares outstanding.................. 43,205 42,998 42,967
======== ======== ========
Weighted average shares outstanding, assuming
dilution........................................... 43,357 43,143 42,989
======== ======== ========

The accompanying notes are an integral part of these consolidated financial
statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

ACCUMULATED
COMMON COMPREHENSIVE OTHER TREASURY TOTAL
STOCK SHARES COMMON ADDITIONAL INCOME RETAINED COMPREHENSIVE STOCK STOCKHOLDERS'
OUTSTANDING STOCK PAID-IN CAPITAL (LOSS) EARNINGS INCOME (AT COST) EQUITY
------------ ------ --------------- ------------- -------- ------------- --------- -------------
(AMOUNTS IN THOUSANDS)

Balance, December 31,
2002................... 42,947 $444 $255,765 $159,937 $ 19,861 $(15,446) $420,561
====== ==== ======== ======== ======== ======== ========
Comprehensive income:
Net income (loss)........ -- -- -- (14,151) (14,151) -- -- (14,151)
Other comprehensive
income (loss):
Change in unrealized
gains (losses) on
securities, after
income tax expense of
$1,380 (net of
reclassification
adjustment of $1,618
after income tax
benefit of $869)....... -- -- -- 3,490 -- 3,490 -- 3,490
--------
Total comprehensive
income (loss)..... $(10,661)
========
Issuance of treasury
stock to employee stock
purchase program....... 18 -- (71) -- -- 190 119
Stock options exercised
and other.............. 15 -- 122 -- -- -- 122
------ ---- -------- -------- -------- -------- --------
Balance, December 31,
2003................... 42,980 $444 $255,816 $145,786 $ 23,351 $(15,256) $410,141
====== ==== ======== ======== ======== ======== ========
Comprehensive income:
Net income............... -- -- -- 39,710 39,710 -- -- 39,710
Other comprehensive
income:
Change in unrealized
gains on securities,
after income tax
benefit of $2,046 (net
of reclassification
adjustment of $1,753
after income tax
expense of $944)....... -- -- -- (3,800) -- (3,800) -- (3,800)
--------
Total comprehensive
income............ $ 35,910
========
Issuance of treasury
stock to employee stock
purchase program....... 13 -- (34) -- -- 140 106
Stock options exercised
and other.............. 22 -- 214 -- -- -- 214
------ ---- -------- -------- -------- -------- --------
Balance, December 31,
2004................... 43,015 $444 $255,996 $185,496 $ 19,551 $(15,116) $446,371
====== ==== ======== ======== ======== ======== ========
Comprehensive income:
Net income............... -- -- -- 38,431 38,431 -- -- 38,431
Other comprehensive
income:
Change in unrealized
gains on securities,
after income tax
benefit of $6,464 (net
of reclassification
adjustment of $1,193
after income tax
expense of $643)....... -- -- -- (12,005) -- (12,005) -- (12,005)
--------
Total comprehensive
income............ $ 26,426
========
Issuance of treasury
stock to employee stock
purchase program....... 8 -- (5) -- -- 87 82
Stock options exercised
and other.............. 311 3 3,693 -- -- -- 3,696
------ ---- -------- -------- -------- -------- --------
Balance, December 31,
2005................... 43,334 $447 $259,684 $223,927 $ 7,546 $(15,029) $476,575
====== ==== ======== ======== ======== ======== ========

The accompanying notes are an integral part of these consolidated financial
statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31,
------------------------------
2005 2004 2003
--------- --------- --------
(AMOUNTS IN THOUSANDS)

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)................................... $ 38,431 $ 39,710 $(14,151)
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization.................. 4,486 4,551 4,197
Accretion of bond discount, net................ 2,310 2,930 2,093
Net realized investment (gains)................ (1,974) (2,751) (1,826)
Changes in:
Insurance receivables............................. (21,815) 86,016 (41,846)
Reserve for unearned premiums..................... 15,028 1,951 7,855
Reserve for unpaid losses and loss adjustment
expenses....................................... 61,062 (50,151) 110,106
Deposits with affiliated ceding company........... (31,886) -- --
Deferred policy acquisition costs................. (705) 2,546 (8,288)
Deferred income taxes, net........................ (1,740) (1,667) (1,872)
Reinsurance and other payables to affiliates...... (287) 270 (22,811)
Prepaid reinsurance premiums...................... 2,559 (1,523) 6,905
Accrued expenses.................................. (558) 2,236 2,003
Other assets and liabilities...................... 5,033 23,837 (17,144)
--------- --------- --------
Net cash provided by operating activities........... 69,944 107,955 25,221
--------- --------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Fixed income securities:
Purchases......................................... (174,192) (270,679) (88,311)
Maturities........................................ 35,591 22,686 30,251
Sales............................................. 124,363 93,558 53,394
Purchases of equity securities...................... (817) (313) (439)
Proceeds from the sale of equity securities......... 809 280 294
Changes in short-term investments................... (36,157) 35,437 (13,193)
Purchases of property and equipment, net............ (8,424) (3,527) (3,903)
Other, net.......................................... 1,567 (1,353) (57)
--------- --------- --------
Net cash (used in) provided by investing
activities..................................... (57,260) (123,911) (21,964)
--------- --------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term debt........................ -- 30,930 --
Principal payments on debt.......................... (15,000) (15,417) (10,398)
Debt issuance costs................................. (125) (506) --
Issuance of treasury stock to employee stock
purchase plan..................................... 82 106 119
Employee stock option exercises and other........... 3,346 214 8
--------- --------- --------
Net cash provided by (used in) financing
activities........................................ (11,697) 15,327 (10,271)
--------- --------- --------
Increase (decrease) in cash......................... 987 (629) (7,014)
Cash at beginning of period......................... 7,336 7,965 14,979
--------- --------- --------
Cash at end of period............................... $ 8,323 $ 7,336 $ 7,965
========= ========= ========
Supplemental Disclosure of Cash Flow Information:
Cash paid (received) during the period for:
Interest............................................ $ 3,271 $ 2,066 $ 1,260
Income taxes........................................ $ 10,156 $ (8,840) $ 5,816

The accompanying notes are an integral part of these consolidated financial
statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SIGNIFICANT ACCOUNTING POLICIES

Formation of CNA Surety Corporation and Merger

In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings
Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF
with Capsure's insurance subsidiaries, Western Surety Company ("Western
Surety"), Surety Bonding Company of America ("Surety Bonding") and Universal
Surety of America ("USA"), into CNA Surety Corporation ("CNA Surety" or
"Company"). 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.

Investments

Management believes the Company has the ability to hold all fixed income
securities to maturity. However, the Company may dispose of securities prior to
their scheduled maturity due to changes in interest rates, prepayments, tax and
credit considerations, liquidity or regulatory capital requirements, or other
similar factors. As a result, the Company considers all of its fixed income
securities (bonds and redeemable preferred stocks) and equity securities as
available-for-sale. These securities are reported at fair value, with unrealized
gains and losses, net of deferred income taxes, reported as a separate component
of stockholders' equity.

Deferred Policy Acquisition Costs

Policy acquisition costs, consisting of commissions, premium taxes and
other underwriting expenses that vary with, and are primarily related to, the
production of business, net of reinsurance commissions, are deferred and
amortized as the related premiums are earned. The Company periodically tests
that deferred acquisition costs are

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

Intangible Assets

CNA Surety's Consolidated Balance Sheet as of December 31, 2005 includes
intangible assets of $138.8 million. These amounts represent goodwill and
identified intangibles with indefinite useful lives arising from the acquisition
of Capsure. The Company performs impairment tests of these intangible assets
annually, or when certain conditions are present.

A significant amount of judgment is required in performing intangible asset
impairment tests. Such tests include periodically determining or reviewing the
estimated fair value of CNA Surety's reporting units. Under the relevant
standard, 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 charged-off as an impairment loss.

The Company used a valuation technique based on discounted cash flows to
complete its annual intangible asset impairment test as of October 1, 2005. No
impairment was indicated.

Reserves for Unpaid Losses and Loss Adjustment Expenses

The estimated liability for unpaid losses and loss adjustment expenses
includes, on an undiscounted basis, estimates of (a) the ultimate settlement
value of reported claims, (b) incurred-but-not-reported ("IBNR") claims, (c)
future expenses to be incurred in the settlement of claims and (d) claim
recoveries, before reinsurance recoveries, which are reported as an asset. These
estimates are determined based on the facts and circumstances of each claim and
the Company's loss experience as well as consideration of industry experience,
current trends and conditions. The estimated liability for unpaid losses and
loss adjustment expenses is an estimate and there is the potential that actual
future loss payments will differ significantly from recorded amounts. The
methods of determining such estimates and the resulting estimated liability are
regularly reviewed and updated. Changes in the estimated liability are reflected
in the Consolidated Statements of Income in the period in which such changes are
determined to be needed.

Insurance Premiums

Insurance premiums are recognized as revenue ratably over the terms of the
related policies in proportion to the insurance protection provided. Premium
revenues are net of amounts ceded to reinsurers. Unearned premiums represent the
portion of premiums written, before ceded reinsurance which is shown as an
asset, applicable to the unexpired terms of policies in force determined on a
pro rata basis.

Reinsurance

The Company assumes and cedes insurance with other insurers and reinsurers
to limit maximum loss, provide greater diversification of risk and minimize
exposure on larger risks. Premiums and loss and loss adjustment expenses that
are ceded under reinsurance arrangements reduce the respective revenues and
expenses. Amounts recoverable

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

from reinsurers are estimated in a manner consistent with the claim liability
associated with the reinsured policy and are reported as reinsurance
receivables. The Company evaluates the financial condition of its reinsurers,
monitors concentrations of credit risk and establishes allowances for
uncollectible amounts when indicated.

Stock-Based Compensation

As allowed under Statement of Accounting Standards ("SFAS") No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123"), the Company accounts for
its stock option plans in accordance with Accounting Principles Board ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). The
Company has not issued stock options where the exercise price is less than the
fair market value of the Company's common stock on the date of grant and,
accordingly, no compensation expense has been recognized.

Income Taxes

The Company accounts for income taxes under the liability method. Under the
liability method, deferred income taxes are established for the future tax
effects of temporary differences between the tax and financial reporting bases
of assets and liabilities using currently enacted tax rates. Such temporary
differences primarily relate to unearned premium reserves and deferred policy
acquisition costs. The effect on deferred taxes of a change in tax rates is
recognized in income in the period of enactment.

Property and Equipment

Property and equipment are carried at cost less accumulated depreciation.
The Company records depreciation using the straight-line method based on the
estimated useful lives of the various classes of property and equipment ranging
from 3 years to 20 years. Depreciation and amortization expense for 2005, 2004
and 2003 was $4.4 million, $4.5 million and $4.2 million, respectively. The cost
of maintenance and repairs is charged to income as incurred; major improvements
are capitalized.

Earnings Per Share

Basic earnings per common share is computed by dividing income available to
common stockholders by the weighted average number of common shares outstanding
for the period. Diluted earnings per common share is computed based on the
weighted average number of shares outstanding plus the dilutive effect of common
stock equivalents which is computed using the treasury stock method.

The computation of earnings (loss) per share is as follows (amounts in
thousands, except for per share data):

YEARS ENDED DECEMBER 31,
--------------------------
2005 2004 2003
------- ------- --------

Net income (loss)................................ $38,431 $39,710 $(14,151)
======= ======= ========
Shares:
Weighted average shares outstanding.............. 43,015 42,980 42,947
Weighted average shares of options exercised..... 190 18 20
------- ------- --------
Total weighted average shares outstanding........ 43,205 42,998 42,967
Effect of dilutive options....................... 152 145 --
------- ------- --------
Total weighted average shares outstanding,
assuming dilution.............................. 43,357 43,143 42,967
======= ======= ========
Earnings (loss) per share........................ $ 0.89 $ 0.92 $ (0.33)
======= ======= ========
Earnings (loss) per share, assuming dilution..... $ 0.89 $ 0.92 $ (0.33)
======= ======= ========

No adjustments were made to reported net income (loss) in the computation
of earnings per share.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Accounting Pronouncements

In November of 2005, the Financial Accounting Standards Board ("FASB")
issued FASB Staff Position ("FSP") No. 115-1 and No. 124-1 "The Meaning of
Other-than-Temporary Impairment and its Application to Certain Investments"
("FSP 115-1 and 124-1"), as applicable to debt and equity securities that are
within the scope of Statement of Financial Accounting Standards No. 115,
"Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115")
and equity securities that are accounted for using the cost method specified in
Accounting Principles Board Opinion No. 18, "The Equity Method of Accounting for
Investments in Common Stock". FSP 115-1 and 124-1 nullified certain requirements
of Emerging Issues Task Force Issue No. 03-1, "The Meaning of Other-Than-
Temporary Impairment and its Application to Certain Investments" ("EITF 03-1"),
which was originally issued in March, 2004 and was effective for reporting
periods beginning after June 15, 2004. This FSP will replace guidance set forth
in EITF 03-1 with references to existing other-than-temporary impairment
guidance and will clarify that an investor should recognize an impairment loss
no later than when the impairment is deemed other than temporary, even if a
decision to sell has not been made. The FSP carries forward the requirements in
EITF 03-1 regarding required disclosures in the financial statements and
requires additional disclosure related to factors considered in reaching the
conclusion that the impairment is other-than-temporary. In addition, in periods
subsequent to the recognition of an other-than-temporary impairment loss for
debt securities, the FSP allows for amortization of the discount or reduced
premium over the remaining life of the security based on future estimated cash
flows. This new guidance for determining whether impairment is other-than-
temporary is effective for reporting periods beginning after December 15, 2005.
Adoption of this standard is not expected to have a material impact on our
results of operations and/or equity.

2. INVESTMENTS

The estimated fair value and amortized cost of fixed income and equity
securities held by investment category, were as follows (dollars in thousands):

GROSS UNREALIZED
LOSSES
GROSS --------------------
AMORTIZED COST UNREALIZED LESS THAN MORE THAN ESTIMATED
DECEMBER 31, 2005 OR COST GAINS 12 MONTHS 12 MONTHS FAIR VALUE
----------------- -------------- ---------- --------- --------- ----------

Fixed income securities:
U.S. Treasury securities and
obligations of U.S.
Government and agencies:
U.S. Treasury........... $ 15,637 $ -- $ (32) $ (153) $ 15,452
U.S. Agencies........... 40,055 131 (195) (86) 39,905
Collateralized mortgage
obligations........... 18,696 432 (223) -- 18,905
Mortgage pass-through
securities............ 45,607 87 (647) (453) 44,594
Obligations of states and
political subdivisions..... 464,417 14,424 (1,282) (475) 477,084
Corporate bonds.............. 69,626 1,885 (1,152) (13) 70,346
Non-agency collateralized
mortgage obligations....... 22,200 -- (690) -- 21,510
Other asset-backed
securities:
Second mortgages/home
equity loans............ 25,924 21 (181) -- 25,764
Other...................... 5,613 93 (115) -- 5,591

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Redeemable preferred stock... 3,000 128 -- -- 3,128
-------- ------- ------- ------- --------
Total fixed income
securities................. 710,775 17,201 (4,517) (1,180) 722,279
Equity securities............ 1,201 105 -- -- 1,306
-------- ------- ------- ------- --------
Total................... $711,976 $17,306 $(4,517) $(1,180) $723,585
======== ======= ======= ======= ========

GROSS UNREALIZED
LOSSES
GROSS ---------------------
AMORTIZED COST UNREALIZED LESS THAN MORE THAN ESTIMATED
DECEMBER 31, 2004 OR COST GAINS 12 MONTHS 12 MONTHS FAIR 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 insurance subsidiaries, as required by state law, deposit
certain securities with state insurance regulatory authorities. At December 31,
2005, securities on deposit had an aggregate carrying value of $3.3 million.

Short-term investments are generally comprised of U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The amortized cost and estimated fair value of fixed income securities, by
contractual maturity, at December 31, 2005 and 2004 are shown below. Actual
maturities may differ from contractual maturities as borrowers may have the
right to call or prepay obligations with or without call or prepayment penalties
(dollars in thousands):

2005 2004
------------------------- -------------------------
AMORTIZED ESTIMATED FAIR AMORTIZED ESTIMATED FAIR
COST VALUE COST VALUE
--------- -------------- --------- --------------

Fixed income securities:
Due within one year................ $ 5,531 $ 5,532 $ 52,045 $ 52,186
Due after one year but within five
years............................ 102,853 103,045 44,305 45,513
Due after five years but within ten
years............................ 384,625 396,412 350,909 371,964
Due after ten years................ 99,726 100,926 144,478 150,911
-------- -------- -------- --------
592,735 605,915 591,737 620,574
Mortgage pass-through securities,
collateralized mortgage
obligations and asset-backed
securities....................... 118,040 116,364 106,637 107,764
-------- -------- -------- --------
$710,775 $722,279 $698,374 $728,338
======== ======== ======== ========

Major categories of net investment income were as follows (dollars in
thousands):

YEARS ENDED DECEMBER 31,
-------------------------
2005 2004 2003
------- ------- -------

Investment income:
Fixed income securities........................ $31,694 $29,682 $26,152
Equity securities.............................. 37 87 306
Short-term investments......................... 2,592 1,396 556
Other investments.............................. 73 (17) 25
------- ------- -------
Total investment income on available-for-sale
securities.................................. 34,396 31,148 27,039
Investment income on deposits with affiliated
ceding company................................. 401 -- --
Investment expenses.............................. (1,050) (967) (738)
------- ------- -------
Net investment income............................ $33,747 $30,181 $26,301
======= ======= =======

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Net unrealized investment gains and losses and the net change in unrealized
gains and losses of available-for-sale securities were as follows (dollars in
thousands):

YEARS ENDED DECEMBER 31,
-------------------------
2005 2004 2003
-------- ------- ------

Net realized investment gains (losses):
Fixed income securities:
Gross realized investment gains.............. $ 1,622 $ 2,702 $2,276
Gross realized investment losses............. (325) (10) (5)
-------- ------- ------
Net realized investment gains on fixed
income securities....................... $ 1,297 $ 2,692 $2,271
-------- ------- ------
Equity securities:
Gross realized investment gains.............. $ 83 $ 63 $ 4
Gross realized investment losses............. (3) (4) (9)
-------- ------- ------
Net realized investment gains (losses) on
equity securities....................... $ 80 $ 59 $ (5)
-------- ------- ------
Other........................................ $ 597 $ -- $ (440)
-------- ------- ------
Net realized investment gains................... $ 1,974 $ 2,751 $1,826
======== ======= ======
Net change in unrealized gains (losses):
Fixed income securities...................... $(18,460) $(5,891) $4,681
Equity securities............................ (9) 45 160
Other........................................ -- -- 527
-------- ------- ------
Total net change in unrealized gains
(losses)................................ $(18,469) $(5,846) $5,368
-------- ------- ------
Net realized gains (losses) and change in
unrealized gains (losses).................... $(16,495) $(3,095) $7,194
======== ======= ======

The net realized investment gains in 2005 resulted primarily from the
Company's sale of its interest in De Montfort Group, Ltd in the first quarter of
2005. This transaction, which settled on January 5, 2005, was discussed as a
subsequent event in the Company's 2004 Form 10-K. The net realized investment
gains realized in 2004 and 2003 resulted from opportunities to sell securities
that the Company believed would maximize the total return on its portfolio.

The following table provides the composition of fixed income securities
with an unrealized loss at December 31, 2005 in relation to the total of all
fixed income securities by contractual maturities:

% OF % OF
MARKET UNREALIZED
CONTRACTUAL MATURITY VALUE LOSS
-------------------- ------ ----------

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

DECEMBER 31, 2005 DECEMBER 31, 2004
---------------------- ----------------------
GROSS GROSS
ESTIMATED UNREALIZED ESTIMATED UNREALIZED
UNREALIZED LOSS AGING FAIR VALUE LOSS FAIR VALUE LOSS
--------------------- ---------- ---------- ---------- ----------

Fixed income securities:
Investment grade:
0-6 months.............................. $224,117 $3,468 $ 69,500 $ 338
7-12 months............................. 32,630 1,049 37,901 547
13-24 months............................ 32,429 1,105 5,484 138
Greater than 24 months.................. 1,089 75 -- --
-------- ------ -------- ------
Total investment grade.................. $290,265 $5,697 $112,885 $1,023
======== ====== ======== ======

As of December 31, 2005, 93 separate securities held by the Company were in
an unrealized loss position. The Company believes that 92 of these securities
are in this position because of changes in interest rates. Of these 92
securities, 67 were rated "AAA" by Standard and Poor's ("S&P") and "Aaa" by
Moody's Investor Services ("Moody's"). Only one of these 92 securities was in a
loss position that exceeded 5% of its book value.

The remaining security that was in a loss position was issued by the
financing subsidiary of a large domestic automaker. The security was in a loss
position of approximately 13% of its book value and was rated below investment
grade by S&P and investment grade by Moody's. The Company believes that the
financial condition and near-term prospects of the issuer are strong and expects
that the unrealized loss will reverse. The Company intends and believes it has
the ability to hold this investment until the expected recovery in value, which
may be until maturity.

Based on the foregoing information, the Company believes there are no
other-than-temporary impairments at December 31, 2005. No other-than-temporary
impairments were recorded for 2004 or 2003.

3. 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.
In November 2005, the Company reduced the outstanding borrowings by $10.0
million to $20.0 million.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 Company, Inc. ("A. M. Best")
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 of the 2005 Credit Facility as of and for the
period ended December 31, 2005.

In May 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 Company's investment of $0.9
million in the Issuer Trust is carried at cost in "Other assets" in the
Company's Consolidated Balance Sheet. 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 2034. As of December 31, 2005 and 2004, the
interest rate on the junior subordinated debenture was 7.71% and 5.67%,
respectively.

4. FAIR VALUE OF FINANCIAL INSTRUMENTS

The following table summarizes fair value information about financial
instruments, whether or not recognized in the balance sheet, for which it is
practicable to estimate that value. In cases where quoted market prices are not
available, fair values may be based on estimates using present value or other
valuation techniques. These techniques are significantly affected by the
assumptions used, including the discount rates and estimates of future cash
flows. Potential taxes and other transaction costs have not been considered in
estimating fair value. Accordingly, the estimates presented herein are
subjective in nature and are not necessarily indicative of the amounts that the
Company could realize in a current market exchange. This information excludes
certain financial instruments such as insurance contracts and all non-financial
instruments from fair value disclosure. Therefore, these fair value amounts
cannot be aggregated to determine the underlying economic value of the Company.

The carrying amounts and estimated fair values of financial instruments at
December 31, 2005 and 2004 were as follows (dollars in thousands):

2005 2004
-------------------- --------------------
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
-------- ---------- -------- ----------

Fixed income securities................. $722,279 $722,279 $728,338 $728,338
Equity securities....................... 1,306 1,306 1,198 1,198
Short-term investments.................. 65,041 65,041 28,457 28,457
Other investments....................... 965 965 1,058 1,058
Cash.................................... 8,323 8,323 7,336 7,336
Debt.................................... 50,589 50,589 65,488 65,488

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following methods and assumptions were used by the Company in
estimating fair values of financial instruments:

Investments -- The estimated fair values for the fixed income securities
and equity securities are based upon quoted market prices, where available.
For fixed income securities not actively traded, the estimated fair values
are determined using values obtained from independent pricing services or,
in the case of private placements, by discounting expected future cash
flows using a current market rate applicable to the yield, credit quality
and maturity of the investments.

Cash, Short-term Investments and Other Investments -- The carrying value
for these instruments approximates their estimated fair values.

Debt -- The estimated fair value of the Company's debt is based on the
quoted market prices for the same or similar issues or on the current rates
offered to the Company for debt of the same remaining maturity.

5. DEFERRED POLICY ACQUISITION COSTS AND OTHER OPERATING EXPENSES

Policy acquisition costs deferred and the related amortization of deferred
policy acquisition costs were as follows (dollars in thousands):

YEARS ENDED DECEMBER 31,
-------------------------------
2005 2004 2003
--------- --------- ---------

Balance at beginning of period................ $ 102,128 $ 104,674 $ 96,386
Costs deferred.............................. 157,347 147,925 149,938
Amortization................................ (156,642) (150,471) (141,650)
--------- --------- ---------
Balance at end of period...................... $ 102,833 $ 102,128 $ 104,674
========= ========= =========

Net commissions, brokerage and other underwriting expenses were comprised
as follows (dollars in thousands):

YEARS ENDED DECEMBER 31,
----------------------------
2005 2004 2003
-------- -------- --------

Amortization of deferred policy acquisition
costs........................................ $156,642 $150,471 $141,650
Other operating expenses....................... 45,879 56,695 49,090
-------- -------- --------
Net commissions, brokerage and other
underwriting expenses..................... $202,521 $207,166 $190,740
======== ======== ========

6. REINSURANCE

The Company's insurance subsidiaries, in the ordinary course of business,
cede insurance to other insurance companies and affiliates. Reinsurance
arrangements are used to limit maximum loss, provide greater diversification of
risk and minimize exposure on larger risks. Reinsurance contracts do not relieve
the Company of its primary obligations to claimants. Therefore, a contingent
liability exists with respect to insurance ceded to the extent that any
reinsurer is unable to meet the obligations assumed under the reinsurance
contracts. The Company evaluates the financial condition of its reinsurers,
assesses the need for allowances for uncollectible amounts and monitors
concentrations of credit risk. At December 31, 2005, CNA Surety's largest
reinsurance receivable from an affiliate, CCC, an A (Excellent) rated company by
A.M. Best was approximately $53.0 million. At December 31, 2005, CNA Surety's
largest reinsurance receivable from a non-affiliate reinsurer was approximately
$14.1 million with a company rated A (Excellent) by A.M. Best.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The effect of reinsurance on premiums written and earned was as follows
(dollars in thousands):

YEARS ENDED DECEMBER 31,
----------------------------------------------------------
2005 2004 2003
------------------ ------------------ ------------------
WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED
-------- -------- -------- -------- -------- --------

Direct.................. $311,435 $288,994 $267,371 $238,309 $195,786 $168,510
Assumed................. 106,095 113,508 122,046 149,158 175,589 195,004
Ceded................... (51,582) (54,141) (71,133) (69,610) (52,165) (59,065)
-------- -------- -------- -------- -------- --------
Net premiums............ $365,948 $348,361 $318,284 $317,857 $319,210 $304,449
======== ======== ======== ======== ======== ========

Assumed premiums primarily 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 inter-company 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.

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):

YEARS ENDED DECEMBER 31,
-------------------------------------------------------
2005 2004 2003
--------------- -------------- ----------------
$ RATIO $ RATIO $ RATIO
-------- ----- ------- ----- -------- ------

Gross losses and loss
adjustment expenses......... $176,416 43.8% $65,550 16.9% $257,016 70.7%
(Increase) decrease in
reinsurance recoverables.... (48,575) (89.7)% 21,806 31.3% (84,540) (143.1)%
-------- ------- --------
Net losses and loss adjustment
expenses.................... $127,841 36.7% $87,356 27.5% $172,476 56.7%
======== ======= ========

During 2004, the Company reduced certain gross reserves, with corresponding
reductions in ceded reserves, reflecting changes in estimates of incurred-but-
not-reported reserves for large losses and the associated estimates of
reinsurance recoverables. Although there is no impact to net losses and loss
adjustment expenses, these actions did result in unusual fluctuations in the
gross and ceded amounts shown above.

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. Due to the terms of conditions of these excess of loss
treaties, reinsurers may cover some principals in one year but then exclude
these same principals in subsequent years. As a result, the Company may have
exposures to these principals that have limited or no reinsurance coverage.

Excess of Loss Reinsurance

2004 Third Party Reinsurance Compared to 2003 Third Party Reinsurance

Effective January 1, 2004, CNA Surety entered into a new excess of loss
treaty ("2004 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal to $10 million with a 5% co-
participation in the $90 million layer of third party reinsurance coverage above
the Company's retention. This new excess of loss treaty replaced the $45 million
excess of $15 million per principal coverage ("2003 Excess of Loss Treaty"), as
well as a $40 million excess of $60 million per principal treaty and a $3
million excess of $12 million treaty that had been provided by CCC. The material
differences between the 2004 Excess of Loss Treaty and the 2003 Excess of Loss
Treaty were as follows. The annual aggregate coverage increased from $110
million in 2003 to

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

$157 million in 2004. The premium for the 2004 Excess of Loss Treaty was $50.6
million compared to a total of $42.0 million of reinsurance premiums paid in
2003 for the 2003 Excess of Loss Treaty, the $40 million excess of $60 million
treaty and the $3 million excess of $12 million treaty. The 2004 Excess of Loss
Treaty also provided for somewhat less restrictive special acceptance provisions
for larger contract accounts than those contained in the 2003 Excess of Loss
Treaty. In addition to the large national contractor (described later) and two
commercial principals (excluded based upon class of business), the Company's
reinsurers had excluded three other contract principals from the 2003 Excess of
Loss Treaty, for a total of six excluded principals. The large national
contractor and the two commercial principals remained excluded from the 2004
Excess of Loss Treaty.

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 remained at $10.0 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 increased from $157 million in 2004 to
$185 million in 2005. The actual annual premium for the 2005 Excess of Loss
Treaty was $41.3 million compared to the actual cost of the 2004 Excess of Loss
Treaty of $50.6 million. The 2005 Excess of Loss Treaty provided 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 remained excluded from the 2005 Excess of Loss Treaty.

Related Party Reinsurance

Reinsurance agreements, together with the Services and Indemnity Agreement
that are described below, provide for the transfer of the surety business
written by CCC and CIC to Western Surety. All of these agreements originally
were entered into on September 30, 1997 (the "Merger Date"): (i) the Surety
Quota Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop Loss
Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety Excess of
Loss Reinsurance Contract (the "Excess of Loss Contract"). All of these
contracts have expired. Some have been renewed on different terms as described
below.

The Services and Indemnity Agreement provides the Company's insurance
subsidiaries with the authority to perform various administrative, management,
underwriting and claim functions in order to conduct the business of CCC and CIC
and to be reimbursed by CCC for services rendered. In consideration for
providing the foregoing services, CCC has agreed to pay Western Surety a
quarterly fee of $50,000. This agreement was renewed on January 1, 2005 and
expires on December 31, 2005; and is annually renewable thereafter. There was no
amount due to the CNA Surety insurance subsidiaries as of December 31, 2005.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Quota Share Treaty was renewed on January 1, 2004 on substantially the
same terms with an expiration date of December 31, 2004; and is annually
renewable thereafter. The ceding commission paid to CCC and CIC by Western
Surety remained at 28% of net written premiums and contemplates an approximate
4% override commission for fronting fees to CCC and CIC on their actual direct
acquisition costs. 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%. The Quota Share Treaty was renewed for
one year on January 1, 2005 on substantially the same terms except that the
ceding commission to CCC and CIC was reduced to 25% in order to provide an
approximate 4% override commission to CCC and CIC.

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 exceeds 24% in any of the accident years 1997 through 2000 on certain
insured accounts (the "Loss Ratio Cap"), the Stop Loss Contract requires CCC at
the end of each calendar quarter following the Merger Date, to pay to the
insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which
their actual accident year net loss ratio exceeds the applicable Loss Ratio Cap,
multiplied by (ii) the applicable net earned premiums. In consideration for the
coverage provided by the Stop Loss Contract, the insurance subsidiaries paid to
CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have
paid CCC all required annual premiums. As of December 31, 2005, the net amount
billed and received under the Stop Loss Contract was $45.9 million, which
included a return of $9.0 million in 2005 due to a reduction of net loss ratios
for years covered by the 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 was 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 $4.8 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 December 31, 2005, no losses have been ceded
under this contract.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Large National Contractor

The Company has provided significant surety bond protection guaranteeing
projects undertaken by the large national contract principal that is excluded
from the Company's third party reinsurance. 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 is 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 $106.0 million
from $86.0 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 $126.0 million. As of
December 31, 2005 and 2004, respectively, $132.0 million (including accrued
interest) and $99.0 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 $40.0 million and $29.0 million
of the loans outstanding as of December 31, 2005 and 2004, respectively, and has
agreed to a participation of one-third of any additional loans which may be made
above the original $86.0 million credit facility limit up to the $126.0 million
maximum available line.

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 $56.0 million pre-tax for the fourth quarter of 2004, net of the
participation by Loews, with respect to amounts loaned under the credit facility
and an additional pre-tax impairment charge of $13.0 million.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Establishment of Surety Loss Reserve

7. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES

Activity in the reserves for unpaid losses and loss adjustment expenses was
as follows (dollars in thousands):

YEARS ENDED DECEMBER 31,
----------------------------
2005 2004 2003
-------- -------- --------

Reserves at beginning of period:
Gross.......................................... $363,387 $413,539 $303,433
Ceded reinsurance.............................. 116,831 158,357 137,301
-------- -------- --------
Net reserves at beginning of period............ 246,556 255,182 166,132
-------- -------- --------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current
period.................................... 151,174 87,969 133,186
Increase (decrease) in provision for insured
events of prior periods................... (23,333) (613) 39,290
-------- -------- --------
Total net incurred........................ 127,841 87,356 172,476
-------- -------- --------
Net payments attributable to:
Current period events........................ 32,030 7,125 23,859
Prior period events.......................... 65,353 88,857 59,567
-------- -------- --------
Total net payments........................ 97,383 95,982 83,426
-------- -------- --------
Net reserves at end of period.................. 277,014 246,556 255,182
Ceded reinsurance at end of period............. 147,435 116,831 158,357
-------- -------- --------
Gross reserves at end of period........... $424,449 $363,387 $413,539
======== ======== ========

The increase in the provision for insured events of current period and net
payments attributable to current period events in 2005 reflects the
establishment of the reserve for and payments related to the large national
contractor described in Note 6. The Company recorded net loss reserve
development in prior accident years which

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

resulted in a decrease of the estimated liability of $23.3 million and $0.6
million for 2005 and 2004 respectively and an increase in the estimated
liability of $39.3 million for 2003. The favorable development in 2005 resulted
from favorable outcomes on several specific large claims and lower than expected
emergence of additional large claims primarily in the 2003 and 2002 accident
years. The decrease in the estimated liability recorded in 2004 for prior
accident years resulted from loss adjustment expense payments related to prior
accident years that were lower than previously expected. Adverse claim trends in
the 2002 and 2003 accident years, particularly increased claim severity on large
commercial accounts, had resulted in increased gross and net incurred loss and
loss adjustment expenses for 2003.

Incurred loss and loss adjustment expenses for 2003 included net adverse
development on prior accident years of $39.3 million that primarily relates to
accident years 2001 and 2002 and changes in estimates of large losses resulting
from the material adverse claim activity in the third quarter of 2003. The $39.3
million of net adverse development recorded in 2003 was a result of previously
unexpected claim activity reported during the third quarter of 2003. First,
additional contract bond claims were received during the third quarter of 2003
on a contractor that had filed for bankruptcy in February, 2003. Upon review and
verification of these new claims, the existing case reserve was increased by
$7.2 million, net of applicable reinsurance. Second, a demand was made during
the third quarter of 2003 against a $45 million insurance program bond issued on
behalf of a national trucking concern that was now in bankruptcy. This demand
was in contradiction of previous information provided by the obligee on the
bond. Based on this new information, management reserved the full remaining
limits on this bond which resulted in $15.0 million of net adverse development
after the application of available reinsurance. Third, claims were also received
in the third quarter of 2003 on worker's compensation self insurance bonds
written between 1975 and 1986 on behalf of two principals. After verifying
coverage and obtaining supporting actuarial information on the underlying
workers' compensation claims, the Company increased the case reserves on these
bonds by $8.4 million, net of applicable reinsurance. Fourth, after receiving a
demand on another insurance program bond in the third quarter of 2003,
management identified an outstanding insurance program bond written on behalf of
a contractor now in bankruptcy. Based on recent experience with this type of
bond, which typically has few defenses available to the surety, and in
particular with the obligees on this bond, management recorded a loss provision
on this bond of $6.0 million. Finally, management determined that the case
reserve on a particular claim was insufficient due to the amount of legal fees
that the Company was incurring on the case. Based on their estimate of future
legal expenses, management increased the reserve on this bond by $3.0 million.

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 $78.0 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 December 31, 2005, the Company billed a total of $37.1
million to its reinsurers. All nine reinsurers responsible for payment of the
treaty proceeds either have paid their portions of the claim or paid the Company
to commute the entire reinsurance treaty under which the Enron claim was made.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

8. COMMITMENTS AND CONTINGENCIES

At December 31, 2005 the future minimum commitments under operating leases
are as follows: 2006 -- $1.9 million; 2007 -- $1.8 million; 2008 -- $1.6
million; 2009 -- $1.6 million; 2010 -- $1.6 million and thereafter -- $2.3
million. Total rental expense for 2005, 2004 and 2003 was $5.0 million, $5.1
million and $4.6 million, respectively.

The Company is party to various lawsuits arising in the normal course of
business. The Company believes the resolution of these lawsuits will not have a
material adverse effect on its financial condition or its results of operations.

9. INCOME TAXES

The components of deferred income taxes as of December 31, 2005 and 2004
were as follows (dollars in thousands):

2005 2004
------- -------

Deferred tax assets related to:
Unearned premium reserve.............................. $16,639 $14,416
Loss and loss adjustment expense reserve.............. 4,618 4,286
Accrued expenses...................................... 1,952 1,663
Other................................................. 7,911 8,632
------- -------
Total deferred tax assets.......................... 31,120 28,997
------- -------
Deferred tax liabilities related to:
Deferred policy acquisition costs..................... 35,991 35,745
Intangible assets..................................... 5,650 5,650
Unrealized gains on securities........................ 4,063 10,527
Other................................................. 4,236 4,099
------- -------
Total deferred tax liabilities..................... 49,940 56,021
------- -------
Net deferred tax liability.............................. $18,820 $27,024
======= =======

CNA Surety and its subsidiaries file a consolidated federal income tax
return. The income tax allocation between the Company and its subsidiaries is
subject to written agreement, approved by the Board of Directors. Allocation is
based upon separate return calculations in accordance with the Internal Revenue
Code of 1986 with current credit being given to separate company net losses. The
Company and its subsidiaries remit their estimated tax payments at such times as
would be required to be made to the Internal Revenue Service. Inter-company tax
balances are generally settled in full in the third quarter of the following
year.

The income tax provisions consisted of the following (dollars in
thousands):

YEARS ENDED DECEMBER 31,
--------------------------
2005 2004 2003
------- ------- --------

Federal current.................................. $13,208 $15,672 $(16,218)
Federal deferred................................. (1,740) (1,667) (1,872)
State............................................ 276 292 78
------- ------- --------
Total income tax expense (benefit)............... $11,744 $14,297 $(18,012)
======= ======= ========

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

A reconciliation from the federal statutory tax rate to the effective tax
rate is as follows:

YEARS ENDED
DECEMBER 31,
------------------
2005 2004 2003
----- ---- -----

Federal statutory rate................................. 35.0% 35.0% (35.0)%
Tax-exempt income deduction............................ (11.5) (9.4) (14.9)
Non-deductible expenses................................ 0.3 0.3 0.5
State income tax, net of federal income tax benefit.... 0.6 0.5 0.2
Other.................................................. (1.0) 0.1 (6.8)
----- ---- -----
Total income tax expense (benefit)..................... 23.4% 26.5% (56.0)%
===== ==== =====

10. EMPLOYEE BENEFITS

CNA Surety sponsors a tax deferred savings plan ("401(k) plan") covering
substantially all of its employees. Prior to December 31, 1999, the Company
matched 70% of the participating employee's contribution up to 6% of eligible
compensation (4.2% maximum matching). Effective January 1, 2000, the Company
match was increased to 100% of the participating employee's contribution up to
3% of eligible compensation and 50% of the participating employee's contribution
between 3% and 6% of eligible compensation (4.5% maximum matching). Effective
January 1, 2004, the Company implemented an additional basic contribution for
eligible 401(k) plan participants of 3% (if under age 45) or 5% (if 45 or older)
of eligible compensation. In addition, the Company may also make an annual
discretionary profit sharing contribution to the 401(k) plan, subject to the
approval of the Company's Board of Directors. The profit sharing contribution
may be restricted by plan and regulatory limitations. The Company contribution,
including profit sharing, to the 401(k) plan was $4.1 million, $3.5 million and
$2.3 million for the years ended December 31, 2005, 2004 and 2003, respectively.

Effective April 1, 2000, CNA Surety established the CNA Surety Corporation
Deferred Compensation Plan which is an unfunded, nonqualified deferred
compensation plan for a select group of management or highly compensated
employees. The purpose of the CNA Surety Corporation Deferred Compensation 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. There were no plan assets for
either of the postretirement benefit plans.

The postretirement benefit plan that provides medical benefits has been
determined to be actuarially equivalent to Medicare Part D on an estimated basis
under the rules provided in final regulations issued January 21, 2005. As such,
the federal subsidiary to plan sponsors under the Medicare Modernization Act
("MMA") has been recognized in the accounting for that plan.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The measurement date for each of the plans is December 31. The following
table sets forth the plans' combined accumulated postretirement benefit
obligation at the beginning and end of the last two fiscal years (dollars in
thousands):

2005 2004
------- -------

Reconciliation of benefit obligation
Benefit obligation at beginning of the year............ $ 5,185 $ 5,992
Service cost........................................... 242 149
Interest cost.......................................... 511 339
Effect of Medicare Modernization Act................... -- (1,241)
Actuarial loss......................................... 4,814 129
Benefits and expenses paid............................. (182) (183)
------- -------
Benefit obligation at end of year...................... $10,570 $ 5,185
======= =======

The following table sets forth the plans' combined funded status reconciled
with the amount shown in the Company's statement of financial position at
December 31, 2005 and December 31, 2004 (dollars in thousands):

2005 2004
-------- -------

Reconciliation of funded status
Funded status......................................... $(10,570) $(5,185)
Unrecognized prior service cost....................... (834) (996)
Unrecognized net loss................................. 4,250 (372)
-------- -------
Accrued benefit cost.................................. $ (7,154) $(6,553)
======== =======

The Company expects to contribute $0.2 million to the postretirement
benefit plans to pay benefits in 2006. The following benefit payments, which
reflect expected future service, as appropriate, are expected to be paid. These
amounts are shown both gross and net of the federal subsidy to plan sponsors
under the MMA.

BEFORE IMPACT OF FEDERAL SUBSIDY NET OF FEDERAL SUBSIDY
-------------------------------- ----------------------

2006................................. $ 278 $ 249
2007................................. 317 285
2008................................. 376 338
2009................................. 432 391
2010................................. 435 387
2011-2015............................ 2,757 2,444

The Company's postretirement health care plan is unfunded; the accumulated
postretirement benefit obligation and plan assets for that plan as of December
31, 2005 are $9.9 million and $0, respectively.

The Company's postretirement sick leave plan is unfunded; the accumulated
postretirement benefit obligation and plan assets for that plan as of December
31, 2005 are $0.7 million and $0, respectively.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The plans' combined net periodic postretirement benefit cost for the last
three fiscal years included the following components (dollars in thousands):

2005 2004 2003
----- ----- -----

Net periodic benefit cost
Service cost at end of year........................ $ 241 $ 149 $ 195
Interest cost...................................... 511 340 337
Prior service cost................................. (162) (162) (154)
Recognized net actuarial loss (gain)............... 193 (4) (8)
----- ----- -----
Net periodic benefit cost.......................... $ 783 $ 323 $ 370
===== ===== =====

The 2006 benefit cost is expected to be reduced by approximately $0.2
million as a result of the MMA.

2005 2004 2003
---- ----- ----

Key Assumptions
Discount rate........................................ 5.50% 5.875% 6.5%
Rate of compensation increase (postretirement sick
leave plan only).................................. 5.0% 5.0% 5.0%
Initial health care cost trend, pre-Medicare......... 10.0% 8.0% 8.0%
Initial health care cost trend, post-Medicare........ 10.0% 10.0% 10.0%
Ultimate health care cost trend...................... 5.0% 5.0% 5.0%
Year in which ultimate trend is reached.............. 2011 2010 2009

The Company selected a discount rate of 5.50% to measure the accumulated
postretirement benefit obligation. This rate generates approximately the same
liability as discounting projected cash flows using the Citigroup Pension
Discount Curve. The health care cost trend rate assumption has an effect on the
amounts reported. To illustrate, increasing the assumed health care cost trend
rates by 1 percentage point in each year would increase the benefit obligation
as of December 31, 2005 by $2.0 million and increase the aggregate of service
cost and interest cost for the year then ended by $0.2 million. Decreasing the
assumed health care cost trend rates by 1 percentage point in each year would
decrease the benefit obligation as of December 31, 2005 by $1.6 million and
decrease the aggregate of service cost and interest cost for the year then ended
by $0.1 million.

11. STOCKHOLDERS' EQUITY

The Company has reserved shares of its common stock for issuance to
directors, officers, employees and certain advisors of the Company through
incentive stock options, non-qualified stock options and stock appreciation
rights ("SARs") to be granted under the CNA Surety 1997 Long-Term Equity
Compensation Plan ("CNA Surety Plan"). The Company has also reserved shares of
its common stock for issuance to Capsure option holders under the CNA Surety
Corporation Replacement Stock Option Plan ("Replacement Plan"). The CNA Surety
Plan and Replacement Plan are collectively referred to as the "Plan". The
aggregate number of shares initially available for which options may be granted
under the Plan is 3,000,000.

Options issued under the Replacement Plan have the same exercise price,
rights, benefits, terms and conditions as the Capsure options replaced. The
number of unexercised and outstanding Capsure options issued to the holders
under the Replacement Plan on September 30, 1997 was 335,235. The exercise
prices of the replacement options ranged between $0.05 and $8.00 per share on
September 30, 1997.

The Compensation Committee (the "Committee") of the Board of Directors,
consisting of independent members of the Board of Directors, administers the
Plan. The Committee determines the option prices. Prices may not be less than
the fair market value of the Company's common stock on the date of grant for
incentive stock options and may not be less than the par value of the Company's
common stock for non-qualified stock options.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Plan provides for the granting of incentive stock options as defined
under Section 382 of the Internal Revenue Code of 1986, as amended. All non-
qualified stock options and incentive stock options granted under the Plan
expire ten years after the date of grant and vest ratably over the four-year
period following the date of grant. In the case of the Replacement Plan, the
options expire ten years from the original Capsure grant date. At December 31,
2005, there were no outstanding options issued under the Replacement Plan. At
December 31, 2004, there were 3,950 outstanding options issued under the
Replacement Plan.

The following table summarizes stock option activity for 2005, 2004 and
2003.

WEIGHTED
AVERAGE OPTION
SHARES SUBJECT PRICE PER
TO OPTION SHARE
-------------- --------------

Balance at December 31, 2002...................... 1,669,943 $12.76
Options granted................................. 344,500 $ 9.52
Options forfeited/expired....................... (277,051) $12.96
Options exercised............................... (3,000) $ 2.56
---------
Balance at December 31, 2003...................... 1,734,392 $12.11
Options granted................................. 356,425 $12.04
Options forfeited/expired....................... (369,263) $12.23
Options exercised............................... (22,313) $ 9.73
---------
Balance at December 31, 2004...................... 1,699,241 $12.09
Options granted................................. 354,775 $13.07
Options forfeited/expired....................... (155,275) $13.77
Options exercised............................... (310,832) $10.75
---------
Balance at December 31, 2005...................... 1,587,909 $12.41
=========

As of December 31, 2005, the number of shares available for granting of
options under the Plan was 542,002.

The following table summarizes information about stock options outstanding
at December 31, 2005:

OPTIONS OUTSTANDING
------------------------------------------------- OPTIONS EXERCISABLE
WEIGHTED AVERAGE ------------------------------
RANGE OF EXERCISE NUMBER REMAINING WEIGHTED AVERAGE NUMBER WEIGHTED AVERAGE
PRICES OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
----------------- ----------- ---------------- ---------------- ----------- ----------------

$9.35 to $11.50........ 504,725 6.6 years $ 9.98 319,900 $10.26
$12.06 to $15.875...... 1,083,184 7.3 years $13.54 482,164 $14.65

The weighted average fair market value (at grant date) per option granted
was $5.17, $3.82 and $3.72 respectively, for options granted during 2005, 2004
and 2003. The fair value of these options was estimated at grant date using a
Black-Scholes option pricing model with the following weighted average
assumptions for the year ended December 31, 2005: risk free interest rate of
4.4%; dividend yield of 0.0%; expected option life of 6 years; and volatility of
30.2%. These assumptions for the year ended December 31, 2004 were: risk free
interest rate of 1.1%; dividend yield of 0.0%; expected option life of 6 years;
and volatility of 30.4%. For the year ended December 31, 2003, these assumptions
were: risk free interest rate of 1.1%; dividend yield of 0.0%; expected option
life of 6 years; and volatility of 39.8%.

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

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 123 to stock based compensation under the Company's stock-based
compensation plan.

YEARS ENDED DECEMBER 31,
--------------------------
2005 2004 2003
------- ------- --------
(IN THOUSANDS, EXCEPT PER
SHARE DATA)

Net income (loss)................................ $38,431 $39,710 $(14,151)
Less: Total stock based compensation cost
determined under the fair value method, net of
tax............................................ (758) (616) (118)
------- ------- --------
Pro forma net income (loss)...................... $37,673 $39,094 $(14,269)
======= ======= ========
Basic and diluted earnings (loss) per share, as
reported....................................... $ 0.89 $ 0.92 $ (0.33)
======= ======= ========
Basic and diluted earnings (loss) per share, pro
forma.......................................... $ 0.87 $ 0.91 $ (0.33)
======= ======= ========

In December of 2004, the FASB issued Statement of Financial Accounting
Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), that
amends Statement of Financial Accounting Standard 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
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, modifies, repurchases or cancels 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, 1994) 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. The
Company plans to use the modified prospective transition method. SFAS 123R was
effective for the Company on January 1, 2006. The above pro forma disclosure of
the effect of SFAS 123 on results generally reflects the expected impact of
adoption of SFAS 123R on the Company, which is not expected to have a material
impact on the results of operations and/or equity of the Company.

Effective January 1, 1998, the Company established the CNA Surety
Corporation Non-Employee Directors Deferred Compensation Plan. Under this plan,
each director who is not a full-time employee of the Company or any of its
affiliates may defer all or a portion of the annual retainer fee that would
otherwise be paid to such director. The deferral amount, which must be in
multiples of 10% of the retainer fee, will be credited to a deferred
compensation account and will be deemed invested in Common Stock Units equal to
the deferred fees divided by the fair market value of CNA Surety common stock as
of each quarterly meeting date. Each director will be fully vested in his or her
deferred compensation amount. Aggregate common stock units outstanding as of
December 31, 2005 and 2004 were 14,709 and 15,079, respectively. Common Stock
Units are convertible into CNA Surety common stock at the election of the
director.

12. SEGMENT INFORMATION

The Company is a leading provider of surety and fidelity bonds in the
United States. According to the Surety Association of America ("SAA"), the
surety and fidelity segment of the domestic property and casualty insurance

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

industry aggregates approximately $5.7 billion in direct written premiums,
comprised of approximately $4.3 billion in surety premiums and $1.4 billion in
fidelity premiums.

Surety bonds are three-party agreements in which the issuer of the bond
(the surety) joins with a second party (the principal) in guaranteeing to a
third party (the owner/obligee) the fulfillment of some obligation on the part
of the principal. The surety is the party who guarantees fulfillment of the
principal's obligation to the obligee. There are two broad types of surety
products -- contract surety and commercial surety bonds.

Contract surety bonds secure a contractor's performance and/or payment
obligation generally with respect to a construction project. Contract surety
bonds are generally required by federal, state, and local governments for public
works projects. Commercial surety bonds include all surety bonds other than
contract and cover obligations typically required by law or regulation. Fidelity
bonds cover losses arising from employee dishonesty.

GROSS WRITTEN PREMIUMS FOR THE YEARS ENDED
-------------------------------------------------
% OF % OF % OF
2005 TOTAL 2004 TOTAL 2003 TOTAL
-------- ----- -------- ----- -------- -----

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NET WRITTEN PREMIUMS FOR THE YEARS ENDED
-------------------------------------------------
% OF % OF % OF
2005 TOTAL 2004 TOTAL 2003 TOTAL
-------- ----- -------- ----- -------- -----

Contract....................... $202,798 55.4% $172,274 54.1% $184,449 57.8%
Commercial..................... 128,022 35.0 115,454 36.3 106,899 33.5
Fidelity and other............. 35,128 9.6 30,556 9.6 27,862 8.7
-------- ----- -------- ----- -------- -----
$365,948 100.0% $318,284 100.0% $319,210 100.0%
======== ===== ======== ===== ======== =====
Domestic....................... $363,940 99.5 $311,620 97.9 $311,125 97.5%
International.................. 2,008 0.5 6,664 2.1 8,085 2.5
-------- ----- -------- ----- -------- -----
$365,948 100.0% $318,284 100.0% $319,210 100.0%
======== ===== ======== ===== ======== =====

Approximately $61.4 million, or 14.7%, of gross written premiums were
generated from national insurance brokers in 2005 with the single largest
national broker production comprising $13.3 million, or 3.2%, of gross written
premiums. In 2004, approximately $68.1 million, or 17.5%, of gross written
premiums were generated from national insurance brokers with the single largest
national broker production comprising $18.5 million, or 4.7%, of gross written
premiums. In 2003, approximately $61.2 million, or 16.5%, of gross written
premiums were generated from national insurance brokers with the single largest
national broker production comprising $19.2 million, or 5.2%, of gross written
premiums.

13. STATUTORY FINANCIAL DATA (UNAUDITED)

CNA Surety's insurance subsidiaries file financial statements prepared in
accordance with statutory accounting practices prescribed or permitted by
applicable insurance regulatory authorities. Prescribed statutory accounting
practices include state laws, regulations and general administrative rules, as
well as guidance provided in a variety of publications of the National
Association of Insurance Commissioners ("NAIC"). Permitted statutory accounting
practices encompass all accounting practices that are not prescribed. The
Company's insurance subsidiaries follow three permitted accounting practices
which did not have a material effect on reported statutory surplus or income.
The Company's insurance subsidiaries were given permission to report activity in
the Small Business Administration's Surety Bond Guarantee program as a
reinsurance program and to report all salvage and subrogation recoveries as
recoveries of loss rather than allocating recoveries between loss and loss
adjustment expenses. Also, Surety Bonding has been given permission to report
ceding commissions received from Western Surety that exceed the acquisition
costs related to the business ceded as a reduction to commission expense.
Historically, the principal differences between statutory financial statements
and financial statements prepared in accordance with generally accepted
accounting principles are that statutory financial statements do not reflect
deferred policy acquisition costs or intangible assets, deferred income taxes
are recorded but there are limitations as to the amount of deferred tax assets
that may be reported as "admitted" assets and fixed income securities are
generally carried at amortized cost in statutory financial statements.

The following table reconciles consolidated stockholders' equity at
December 31, 2005 and 2004 as reported herein in conformity with GAAP with total
statutory capital and surplus of CNA Surety's insurance subsidiaries,

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

determined in accordance with statutory accounting practices prescribed or
permitted by insurance regulatory authorities (dollars in thousands):

2005 2004
--------- ---------

Consolidated equity per GAAP.......................... $ 476,575 $ 446,371
Less: Impact of non-insurance companies and
eliminations........................................ (34,426) (53,151)
--------- ---------
Insurance company equity per GAAP..................... 511,001 499,522
Intangible assets..................................... (133,361) (133,361)
Net unrealized gain on fixed income securities........ (12,044) (28,412)
Deferred policy acquisition costs..................... (102,833) (102,128)
Deferred income taxes, net............................ 34,437 40,478
Non-admitted assets................................... (22,617) (23,453)
Other................................................. 573 (232)
--------- ---------
Total statutory capital and surplus per statutory
accounting practices................................ $ 275,156 $ 252,414
========= =========

The NAIC has promulgated Risk Based Capital ("RBC") requirements for
property and casualty insurance companies to evaluate the adequacy of statutory
capital and surplus in relation to investment and insurance risks such as asset
quality, loss reserve adequacy, and other business factors. The RBC information
is used by state insurance regulators as an early warning mechanism to identify
insurance companies that potentially are inadequately capitalized. In addition,
the formula defines new minimum capital standards that supplement the current
system of fixed minimum capital and surplus requirements on a state-by-state
basis. Regulatory compliance is determined by a ratio (the "Ratio") of the
enterprise's regulatory total adjusted capital, as defined by the NAIC, to its
authorized control level RBC, as defined by the NAIC. Generally, a Ratio in
excess of 200% of authorized control level RBC requires no corrective actions by
a company or regulators. As of December 31, 2005 each of CNA Surety's insurance
subsidiaries had a Ratio that was in compliance with the minimum RBC
requirements.

CNA Surety's insurance subsidiaries are subject to regulation and
supervision by the various state insurance regulatory authorities in which they
conduct business. Such regulation is generally designed to protect policyholders
and includes such matters as maintenance of minimum statutory surplus and
restrictions on the payment of dividends. Generally, statutory surplus of each
insurance subsidiary in excess of a statutorily prescribed minimum is available
for payment of dividends to the parent company. However, such distributions as
dividends may be subject to prior regulatory approval. Without prior regulatory
approval in 2006, CNA Surety's insurance subsidiaries may pay dividends of $39.1
million in the aggregate. Combined statutory surplus for the insurance
subsidiaries at December 31, 2005 was $275.2 million.

14. RELATED PARTY TRANSACTIONS

The Company has the following related party transactions not previously
described in Note 6. Reinsurance.

Effective July 1, 2004, CNA Surety entered into an Administrative Services
Agreement with CCC. This agreement, that replaced an agreement originally
effective January 1, 2001, allows the Company to purchase and/or have access to
certain services provided by CNAF. The Company will also pay CNAF a management
fee for its proportionate share of administrative and overhead costs incurred in
supporting the services provided pursuant to this agreement. The management fee
for the year 2006 is $2.0 million that shall be paid by CNA Surety to CNAF in
equal monthly installments by the last day of each month. The amounts paid were
$1.9 million, $1.8 million and $1.7 million for 2005, 2004 and 2003,
respectively. The management fee shall be increased as of January 1, the
"adjustment date", of each year this Administrative Services Agreement is in
force by the greater of 5% or the amount of the increase in the Consumer Price
Index for All Urban Consumers for the Chicago, Illinois area as reported by the
Bureau of Labor Statistics for the 12 month period immediately preceding the
adjustment date. The

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

agreement also allows CCC to purchase services from the Company. In 2005, 2004
and 2003, CCC paid the Company $0.8 million, $0.5 million and $0.5 million,
respectively, for services in connection with licensing and appointing CCC's
insurance producers as required by state insurance laws. This agreement shall be
effective so long as CNAF or their affiliates or shareholders shall continue to
own a majority interest in CNA Surety. This agreement may be terminated by
either party upon the provision of 30 days prior notice of such termination to
the other party.

The Company was charged $6.9 million, $7.4 million and $6.1 million for the
years ended December 31, 2005, 2004 and 2003, respectively, for rents and
services provided under the Administrative Services Agreement. In 2005, the
Company received $0.1 million for direct costs incurred by CCC on the Company's
behalf. This credit resulted from the release of certain prior year expenses
allocated to the Company during 2005. In 2004 and 2003, the Company was charged
$0.8 million and $1.4 million, respectively, for direct costs incurred by CCC on
the Company's behalf. The Company had no payable balance to CCC related to the
Administrative Services Agreement as of December 31, 2005 and 2004.

Western Surety has entered into a series of business transactions with
entities in which an affiliate of CCC had an interest. The first series involves
five separate real estate residual value insurance policies issued by R.V.I.
America Insurance Company ("RVI -- America") reinsured by Western Surety through
the Quota Share Treaty. RVI America is a wholly owned subsidiary of R.V.I.
America Corporation, which is a wholly owned subsidiary of R.V.I. Guaranty
Company Ltd. of Bermuda ("RVI -- Bermuda"), an unconsolidated affiliate of CCC.
The transactions involve policies with limits totaling approximately $11.5
million. CCC reinsured the full extent of RVI -- America's exposure on the
policies. Pursuant to the Quota Share Treaty, Western Surety was, in turn,
reinsuring all of CCC's exposures on the policies. Western Surety reinsured all
of its exposure on the policies with RVI-Bermuda, a non-admitted reinsurer. The
policy limits range from $1.7 million to $3.0 million with an average policy
limit of approximately $2.3 million and total limits of all policies of $11.5
million. Net premium amounts retained in 2000 relative to these reinsurance
transactions totaled $0.5 million as follows: RVI -- America, $0.1 million; CCC,
$0.1 million; Western Surety, $0.1 million; and RVI -- Bermuda, $0.2 million.
CCC's ownership interest of RVI -- Bermuda was disposed of in December 2005.

In addition, from time to time Western Surety provided surety bonds
guaranteeing insurance payments of certain companies to CCC and its affiliates
under retrospectively rated insurance policies underwritten by CCC and its
affiliates. Under the terms of these bonds, referred to as insurance program
bonds, if the principal, the insured company, failed to make required a required
premium payment, CCC and its affiliates would have a claim against the Company
under the bond. The Company now has a policy not to issue such bonds to
companies insured by CCC and its affiliates. The last such bond was written in
2001 and currently bonds with $2.6 million of total penal sums remain as of
December 31, 2005.

Western Surety from time to time provides license and permit bonds and
appeal bonds to CCC and its affiliates and to clients of CCC and its affiliates.
Under procedures established by the Audit Committee, the Company may issue
appeal bonds for CCC and its affiliates and their clients with penal sums of
$10.0 million or less without prior Audit Committee approval as long as those
bonds meet the Company's normal underwriting standards, the rates charged are
market rates and that the Company has received the indemnity of CCC. Bonds
greater than $10.0 million require the prior approval of the Audit Committee. As
of December 31, 2005, the total amount of the outstanding appeal and license and
permit bonds written on behalf of CCC and its affiliates was approximately $99.7
million, which was comprised of 49 bonds. Western Surety has entered into
indemnity agreements with CCC and its

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

affiliates indemnifying Western Surety for any loss arising from the issuance of
appeal bonds for CCC and its affiliates. The premium for these bonds was
approximately $0.6 million in 2005, $0.5 million in 2004 and $0.4 million in
2003.

15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

The following is a summary of the quarterly results of operations for the
years ended December 31, 2005, 2004 and 2003 (dollars in thousands, except per
share amounts):

FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
------- -------- -------- --------

2005
Revenues................................. $90,545 $ 93,316 $ 99,850 $100,371
======= ======== ======== ========
Income (loss) before income taxes........ $19,535 $(20,344) $ 27,045 $ 23,939
Income tax expense (benefit)............. 5,460 (8,409) 7,262 7,431
------- -------- -------- --------
Net income (loss)........................ $14,075 $(11,935) $ 19,783 $ 16,508
======= ======== ======== ========
Basic earnings (loss) per common share... $ 0.33 $ (0.28) $ 0.46 $ 0.38
======= ======== ======== ========
Diluted earnings (loss) per common
share.................................. $ 0.33 $ (0.28) $ 0.46 $ 0.38
======= ======== ======== ========
2004
Revenues................................. $84,404 $ 84,667 $ 90,950 $ 90,768
======= ======== ======== ========
Income before income taxes............... $ 8,119 $ 13,884 $ 15,194 $ 16,810
Income tax expense....................... 1,745 3,699 4,220 4,633
------- -------- -------- --------
Net income............................... $ 6,374 $ 10,185 $ 10,974 $ 12,177
======= ======== ======== ========
Basic and diluted earnings per common
share.................................. $ 0.15 $ 0.24 $ 0.25 $ 0.28
======= ======== ======== ========
2003
Revenues................................. $78,635 $ 84,596 $ 84,162 $ 85,183
======= ======== ======== ========
Income (loss) before income taxes........ $15,380 $ 15,966 $(77,507) $ 13,998
Income tax expense (benefit)............. 4,391 4,283 (30,088) 3,402
------- -------- -------- --------
Net income (loss)........................ $10,989 $ 11,683 $(47,419) $ 10,596
======= ======== ======== ========
Basic and diluted earnings (loss) per
common share........................... $ 0.26 $ 0.27 $ (1.10) $ 0.24
======= ======== ======== ========

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

As of December 31, 2005, the Company's management, including the Company's
Chief Executive Officer (CEO) and Chief Financial Officer (CFO) have conducted
an evaluation of the effectiveness of its disclosure controls and procedures (as
such term is defined in Rules 13a-15 (e) and 15d-15 (e) under the Securities
Exchange Act of 1934, as amended ("the Exchange Act"). Based on their
evaluation, the CEO and CFO concluded that the Company's disclosure controls and
procedures are effective in ensuring that all material information required to
be filed in this Annual Report has been made to them in a timely manner.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, the Company
included a report of management's assessment of the design and effectiveness of
its internal controls as part of this Annual Report on Form 10-K for the fiscal
year ended December 31, 2005. The independent registered public accounting firm
of the Company also attested to, and reported on, management's assessment of the
effectiveness of internal control over financial reporting. Management's report
and the independent registered public accounting firm's attestation report are
included in the Company's 2005 Financial Statements under the captions entitled
"Management's Report on Internal Control Over Financial Reporting" and "Report
of Independent Registered Public Accounting Firm on Internal Control Over
Financial Reporting" and are incorporated herein by reference.

There were no changes in the Company's internal control over financial
reporting (as defined in Rules 13a-15 (f) and 15d-15 (f) under the Exchange Act)
during the quarter ended December 31, 2005 that has materially affected, or is
reasonably likely to materially affect, the Company's internal control over
financial reporting.

ITEM 9B. OTHER INFORMATION

None.

PART III.

ITEMS 10, 11, 12, 13, AND 14. DIRECTORS AND EXECUTIVE OFFICERS OF THE
REGISTRANT, EXECUTIVE COMPENSATION, SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS,
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS,
AND PRINCIPAL ACCOUNTANT FEES AND SERVICES

The Company will file a definitive proxy statement with the Securities and
Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act
of 1934 (the "Proxy Statement") relating to the Company's Annual Meeting of
Stockholders to be held on April 25, 2006, not later than 120 days after the end
of the fiscal year covered by this Form 10-K. Information required by Items 10
through 14 will appear in the Proxy Statement and is incorporated herein by
reference.

PART IV.

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

PAGE
----

Financial Statement
Schedules:
Schedule
I -- Summary of
Investments....... 78
Schedule
II -- Condensed
Financial
Information of
Registrant........ 79
Schedule
III -- Supplemen-
ary Insurance
Information....... 83
Schedule
IV -- Reinsur-
nce............... 84
Schedule
V -- Valuation and
Qualifying
Accounts.......... 85
Schedule
VI -- Supplemental
Information
Concerning
Property -- Ca-
ualty Insurance
Operations........ 86
(a) (3) Exhibits.... 87

SCHEDULE I

CNA SURETY CORPORATION AND SUBSIDIARIES

SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
AS OF DECEMBER 31, 2005 AND 2004

AS OF DECEMBER 31, 2005
-----------------------------
COST OR
AMORTIZED FAIR CARRYING
COST VALUE VALUE
--------- -------- --------
(AMOUNTS IN THOUSANDS)

Fixed Income Securities:
U.S. Government and government agencies and
authorities..................................... $119,995 $118,856 $118,856
States, municipalities and political subdivisions.. 464,417 477,084 477,084
All other corporate bonds.......................... 123,363 123,211 123,211
Redeemable preferred stock......................... 3,000 3,128 3,128
-------- -------- --------
Total fixed income securities................... 710,775 722,279 722,279
-------- ======== --------
Equity securities.................................... 1,201 1,306 1,306
Short-term investments............................... 65,041 65,041
Other investments.................................... 965 965
-------- --------
Total investments............................... $777,982 $789,591
======== ========

AS OF DECEMBER 31, 2004
-----------------------------
COST OR
AMORTIZED FAIR CARRYING
COST VALUE VALUE
--------- -------- --------
(AMOUNTS IN THOUSANDS)

Fixed Income Securities:
U.S. Government and government agencies and
authorities..................................... $135,350 $136,108 $136,108
States, municipalities and political subdivisions.. 431,624 454,617 454,617
All other corporate bonds.......................... 126,044 131,316 131,316
Redeemable preferred stock......................... 5,356 6,297 6,297
-------- -------- --------
Total fixed income securities................... 698,374 728,338 728,338
-------- ======== --------
Equity securities.................................... 1,084 1,198 1,198
Short-term investments............................... 28,457 28,457
Other investments.................................... 1,058 1,058
-------- --------
Total investments............................... $728,973 $759,051
======== ========

SCHEDULE II

CNA SURETY CORPORATION

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY)
BALANCE SHEETS

DECEMBER 31,
------------------
2005 2004
-------- --------
(AMOUNTS IN
THOUSANDS)

ASSETS
Investments in and advances to subsidiaries.................. $505,301 $495,929
Fixed income securities (amortized cost: $1,000 and $4,803).. 1,000 6,358
Equity investments (cost: $1,201 and $1,080)................. 1,306 1,198
Short-term investments, at cost (which approximates fair
value)..................................................... 16,551 5,798
Cash (restricted: $2,565 and $1,761)......................... 2,566 1,762
Other assets................................................. 1,418 2,383
-------- --------
Total assets............................................... $528,142 $513,428
======== ========

LIABILITIES
Debt......................................................... $ 50,589 $ 65,488
Other liabilities............................................ 978 1,569
-------- --------
Total liabilities.......................................... 51,567 67,057
-------- --------

STOCKHOLDERS' EQUITY
Common stock................................................. 447 444
Additional paid-in capital................................... 259,684 255,997
Retained earnings............................................ 223,927 185,495
Accumulated other comprehensive income....................... 7,546 19,551
Treasury stock, at cost...................................... (15,029) (15,116)
-------- --------
Total stockholders' equity................................. 476,575 446,371
-------- --------
Total liabilities and stockholders' equity.............. $528,142 $513,428
======== ========

The accompanying notes are an integral part of these condensed financial
statements.

SCHEDULE II

CNA SURETY CORPORATION

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) -- (CONTINUED)
STATEMENTS OF INCOME

YEARS ENDED DECEMBER 31,
--------------------------
2005 2004 2003
------- ------- --------
(AMOUNTS IN THOUSANDS)

Revenues:
Net investment income................................ $ 774 $ 1,262 $ 923
Net realized investment gains........................ 2,227 40 81
------- ------- --------
Total revenues.................................... 3,001 1,302 1,004
------- ------- --------
Expenses:
Interest expense..................................... 3,545 2,248 1,491
Corporate expense.................................... 5,648 6,419 6,781
------- ------- --------
Total expenses.................................... 9,193 8,667 8,272
------- ------- --------
Loss from operations before income taxes and equity in
net income of subsidiaries........................... (6,192) (7,365) (7,268)
Income tax benefit..................................... (2,069) (2,573) (2,867)
------- ------- --------
Net loss before equity in net income of subsidiaries... (4,123) (4,792) (4,401)
Equity in net income (loss) of subsidiaries............ 42,554 44,502 (9,750)
------- ------- --------
Net income (loss)...................................... $38,431 $39,710 $(14,151)
======= ======= ========

The accompanying notes are an integral part of these condensed financial
statements.

SCHEDULE II

CNA SURETY CORPORATION

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) -- (CONTINUED)
STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31,
----------------------------
2005 2004 2003
-------- -------- --------
(AMOUNTS IN THOUSANDS)

OPERATING ACTIVITIES:
Net income (loss)................................... $ 38,431 $ 39,710 $(14,151)
Cash dividends from subsidiaries................. 20,465 -- 28,496
Tax payments received from (paid to)
subsidiaries................................... 11,764 (6,172) 7,362
Federal and state income tax (payments)
receipts....................................... (10,000) 8,988 (5,816)
Depreciation and amortization.................... 101 63 --
Net realized investment (gains) losses........... (2,227) (40) 4
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating
activities:
Equity in net (income) loss of subsidiaries.... (42,554) (44,502) 9,750
Deferred income taxes, net..................... (650) -- --
Accrued expenses............................... (373) 549 685
Change in other assets and liabilities......... (253) (3,415) (3,355)
-------- -------- --------
Net cash provided by (used in) operating activities... 14,704 (4,819) 22,975
-------- -------- --------
INVESTING ACTIVITIES:
Net advances from (to) subsidiaries................. 731 (3,207) (1,206)
Capital contributions to subsidiaries............... -- (20,350) (4,861)
Net sales of fixed income securities................ 7,860 180 68
Net purchases of equity securities.................. (38) (51) (145)
Changes in short-term investments................... (10,753) 8,291 (5,328)
-------- -------- --------
Net cash (used in) investing activities............... (2,200) (15,137) (11,472)
-------- -------- --------
FINANCING ACTIVITIES:
Proceeds from debt.................................. -- 30,930 --
Principal payments on debt.......................... (15,000) (15,000) (10,000)
Debt issuance costs................................. (125) (506) --
Issuance of treasury stock to employee stock
purchase plan.................................... 82 106 190
Employee stock option exercises and other........... 3,346 214 52
-------- -------- --------
Net cash provided by (used in) financing activities... (11,700) 15,745 (9,758)
-------- -------- --------
Increase (decrease) in cash........................... 804 (4,211) 1,745
Cash at beginning of period........................... 1,762 5,973 4,228
-------- -------- --------
Cash at end of period................................. $ 2,566 $ 1,762 $ 5,973
======== ======== ========

The accompanying notes are an integral part of these condensed financial
statements.

SCHEDULE II

CNA SURETY CORPORATION

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) -- (CONTINUED)

NOTES TO CONDENSED FINANCIAL INFORMATION

1. RESTRICTED CASH AND SHORT TERM INVESTMENTS

As of December 31, 2005 and 2004, short-term investments and cash included
$6.6 million and $5.1 million, respectively, of restricted cash primarily
related to premium receipt collections ultimately due to the Company's insurance
subsidiaries.

2. RECLASSIFICATIONS

Certain amounts in 2004 and 2003 have been reclassified to conform with the
current year presentation.

SCHEDULE III

CNA SURETY CORPORATION AND SUBSIDIARIES

SUPPLEMENTARY INSURANCE INFORMATION
AS OF AND FOR THE YEARS ENDED
DECEMBER 31, 2005, 2004 AND 2003

YEARS ENDED DECEMBER 31,
----------------------------
2005 2004 2003
-------- -------- --------
(AMOUNTS IN THOUSANDS)

Deferred policy acquisition costs.................... $102,833 $102,128
======== ========
Unpaid losses and loss adjustment expense reserves... $424,449 $363,387
======== ========
Unearned premiums.................................... $241,047 $226,019
======== ========
Net premium revenue.................................. $348,361 $317,857 $304,449
======== ======== ========
Net investment income................................ $ 33,747 $ 30,181 $ 26,301
======== ======== ========
Benefits, claims, losses and settlement expenses..... $127,841 $ 87,356 $172,476
======== ======== ========
Amortization of deferred policy acquisition costs.... $156,642 $150,471 $141,650
======== ======== ========
Other operating expenses............................. $ 45,879 $ 56,695 $ 49,090
======== ======== ========
Net premiums written................................. $365,948 $318,284 $319,210
======== ======== ========

SCHEDULE IV

CNA SURETY CORPORATION AND SUBSIDIARIES

REINSURANCE
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003

PERCENTAGE
CEDED TO ASSUMED OF AMOUNT
GROSS OTHER FROM OTHER NET ASSUMED
AMOUNT COMPANIES COMPANIES(1) AMOUNT TO NET
-------- --------- ------------ -------- ----------
(AMOUNTS IN THOUSANDS)

YEAR ENDED DECEMBER 31, 2005
Premiums written:
Property and casualty insurance... $311,435 $51,582 $106,095 $365,948 29.0%
-------- ------- -------- -------- ----
Total premiums written......... $311,435 $51,582 $106,095 $365,948 29.0%
======== ======= ======== ======== ====
Premiums earned:
Property and casualty insurance... $288,994 $54,141 $113,508 $348,361 32.6%
-------- ------- -------- -------- ----
Total premiums earned.......... $288,994 $54,141 $113,508 $348,361 32.6%
======== ======= ======== ======== ====
YEAR ENDED DECEMBER 31, 2004
Premiums written:
Property and casualty insurance... $267,371 $71,133 $122,046 $318,284 38.3%
-------- ------- -------- -------- ----
Total premiums written......... $267,371 $71,133 $122,046 $318,284 38.3%
======== ======= ======== ======== ====
Premiums earned:
Property and casualty insurance... $238,309 $69,610 $149,158 $317,857 46.9%
-------- ------- -------- -------- ----
Total premiums earned.......... $238,309 $69,610 $149,158 $317,857 46.9%
======== ======= ======== ======== ====
YEAR ENDED DECEMBER 31, 2003
Premiums written:
Property and casualty insurance... $195,786 $52,165 $175,589 $319,210 55.0%
-------- ------- -------- -------- ----
Total premiums written......... $195,786 $52,165 $175,589 $319,210 55.0%
======== ======= ======== ======== ====
Premiums earned:
Property and casualty insurance... $168,510 $59,065 $195,004 $304,449 64.1%
-------- ------- -------- -------- ----
Total premiums earned.......... $168,510 $59,065 $195,004 $304,449 64.1%
======== ======= ======== ======== ====

--------------

(1) Primarily from affiliates.

SCHEDULE V

CNA SURETY CORPORATION AND SUBSIDIARIES

VALUATION AND QUALIFYING ACCOUNTS
AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003

ADDITIONS
----------------------
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING COSTS AND OTHER END OF
OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS(1) PERIOD
---------- ---------- ---------- ------------- ----------
(AMOUNTS IN THOUSANDS)

YEAR ENDED DECEMBER 31, 2005
Allowance for possible losses on
premiums receivable............ $2,153 $(168) $-- $495 $1,490
====== ===== ==== ==== ======
Allowance for possible losses on
reinsurance receivable......... $ -- $ -- $-- $-- $ --
====== ===== ==== ==== ======
YEAR ENDED DECEMBER 31, 2004
Allowance for possible losses on
premiums receivable............ $1,575 $ 910 $-- $332 $2,153
====== ===== ==== ==== ======
Allowance for possible losses on
reinsurance receivable......... $ -- $ -- $-- $-- $ --
====== ===== ==== ==== ======
YEAR ENDED DECEMBER 31, 2003
Allowance for possible losses on
premiums receivable............ $1,365 $ 963 $-- $753 $1,575
====== ===== ==== ==== ======
Allowance for possible losses on
reinsurance receivable......... $ -- $ -- $-- $-- $ --
====== ===== ==== ==== ======

--------------

(1) Write-offs charged against allowance.

SCHEDULE VI

CNA SURETY CORPORATION AND SUBSIDIARIES

SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY
INSURANCE OPERATIONS
AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003

YEARS ENDED DECEMBER 31,
----------------------------
2005 2004 2003
-------- -------- --------
(AMOUNTS IN THOUSANDS)

Deferred policy acquisition costs.................... $102,833 $102,128
======== ========
Reserves for unpaid claims and claim adjustment
expenses........................................... $424,449 $363,387
======== ========
Discount (if any) deducted........................... $ -- $ --
======== ========
Unearned premiums.................................... $241,047 $226,019
======== ========
Net premium revenue.................................. $348,361 $317,857 $304,449
======== ======== ========
Net investment income................................ $ 33,747 $ 30,181 $ 26,301
======== ======== ========
Net claims and claim expenses incurred related to:
Current year....................................... $151,174 $ 87,969 $133,186
======== ======== ========
Prior years........................................ $(23,333) $ (613) $ 39,290
======== ======== ========
Amortization of deferred policy acquisition costs.... $156,642 $150,471 $141,650
======== ======== ========
Net paid claims and claim adjustment expenses........ $ 97,383 $ 95,982 $ 83,426
======== ======== ========
Net premiums written................................. $365,948 $318,284 $319,210
======== ======== ========

(A)(3) EXHIBITS

EXHIBIT
NUMBER DESCRIPTION
------- -----------

2(1) Reorganization Agreement dated as of December 19, 1996 among Capsure
Holdings Corp., Continental Casualty Company, CNA Surety Corporation,
Surety Acquisition Company and certain affiliates of Continental
Casualty Company (filed on December 27, 1996 as Exhibit 2 to Capsure
Holdings Corp.'s Form 8-K, and incorporated herein by reference.)

2(2) First Amendment to the Reorganization Agreement dated as of July 14,
1997 among Capsure Holdings Corp., Continental Casualty Company, CNA
Surety Corporation, Surety Acquisition Company and certain affiliates
of Continental Casualty Company (filed on July 16, 1997 as Exhibit 2
to Capsure Holdings Corp.'s Form 8-K, and incorporated herein by
reference.)

3(1) Certificate of Incorporation of CNA Surety Corporation dated December
10, 1996 (filed on August 15, 1997 as Exhibit 3(1)to CNA Surety
Corporation's Registration Statement on Form S-4 (Registration No.
333-33753), and incorporated herein by reference.)

3(2) Amendment to Certificate of Incorporation of CNA Surety Corporation
dated May 27, 1997 (filed on August 15, 1997 as Exhibit 3(2) to CNA
Surety Corporation's Registration Statement on Form S-4 (Registration
No. 333-33753), and incorporated herein by reference.)

3(3) Bylaws of CNA Surety Corporation (filed on August 15, 1997 as Exhibit
3(3) to CNA Surety Corporation's Registration Statement on Form S-4
(Registration No. 333-33753), and incorporated herein by reference.)

3(4) Amendment to Bylaws of CNA Surety Corporation (filed on September 23,
1998 as Exhibit 4(3) to CNA Surety Corporation's Registration
Statement on Form S-8 (Registration No. 333-64135), and incorporated
herein by reference.)

4(1) Specimen certificate of CNA Surety Corporation (filed on August 15,
1997 as Exhibit 4(1) to CNA Surety Corporation's Registration
Statement on Form S-4 (Registration No. 333-33753), and incorporated
herein by reference.)

9 Not applicable.

10(1) Form of The CNA Surety Corporation Replacement Stock Option Plan
(filed on August 15, 1997 as Exhibit 10(12) to CNA Surety
Corporation's Registration Statement on Form S-4 (Registration No.
333-33753), and incorporated herein by reference.)

10(2) Form of CNA Surety Corporation 1997 Long-Term Equity Compensation Plan
(filed on August 15, 1997 as Exhibit 10(13) to CNA Surety
Corporation's Registration Statement on Form S-4 (Registration No.
333-33753), and incorporated herein by reference.)

10(3) Form of Aggregate Stop Loss Reinsurance Contract by and between
Western Surety Company, Universal Surety of America, Surety Bonding
Company of America and Continental Casualty Company (filed on December
27, 1996 as Exhibit 2 to Capsure Holdings Corp.'s Form 8-K, and
incorporated herein by reference.)

10(4) Form of Surety Excess of Loss Reinsurance Contract by and between
Western Surety Company, Universal Surety of America, Surety Bonding
Company of America and Continental Casualty Company (filed on December
27, 1996 as Exhibit 2 to Capsure Holdings Corp.'s Form 8-K, and
incorporated herein by reference.)

10(5) Surety Second Excess of Loss Reinsurance Contract by and between
Western Surety Company, Universal Surety of America, Surety Bonding
Company of America and Continental Casualty Company (filed on July 9,
1998 as Exhibit 10(14) to CNA Surety Corporation's Registration
Statement on Form S-1(Registration No. 333-56063), and incorporated
herein by reference.)

10(6) Form of 10% Quota Share Treaty by and between Western Surety Company
and Continental Casualty Company (filed on November 14, 2002 as
Exhibit 10(1) to CNA Surety Corporation's Form 10-Q, and incorporated
herein by reference.)

10(7) Form of Surety Quota Share Treaty by and between Western Surety
Company and Continental Casualty Company (filed on November 14, 2002
as Exhibit 10(2) to CNA Surety Corporation's Form 10-Q, and
incorporated herein by reference.)

EXHIBIT
NUMBER DESCRIPTION
------- -----------

10(8) Revised Form of Surety Excess of Loss Reinsurance Contract by and
between Western Surety Company, Universal Surety of America, Surety
Bonding Company of America and Continental Casualty Company (filed on
May 14, 2003 as Exhibit 10(1) to CNA Surety Corporation's Form 10-Q,
and incorporated herein by reference.)

10(9) Placement Slip for Surety Excess of Loss Reinsurance Contract by and
between Western Surety Company, Universal Surety of America, Surety
Bonding Company of America and Continental Casualty Company (filed on
March 26, 2003 as Exhibit 10(12) to CNA Surety Corporation's Form 10-
K, and incorporated herein by reference.)

10(10) Endorsement No. 1 to the Surety Excess of Loss Reinsurance Contract by
and between Western Surety Company, Universal Surety of America,
Surety Bonding Company of America and Continental Casualty Company
(filed on November 13, 2003 to CNA Surety Corporation's Form 10-Q, and
incorporated herein by reference.)

10(11) Form of Surety Excess of Loss Reinsurance Contract by and between
Western Surety Company, Universal Surety of America, Surety Bonding
Company of America and Continental Casualty Company (filed on March
15, 2004 as Exhibit 10(12) to CNA Surety Corporation's Form 10-K, and
incorporated herein by reference.)

10(12) Endorsement to 10(11) Form of Surety Excess of Loss Reinsurance
Contract by and between Western Surety Company, Universal Surety of
America, Surety Bonding Company of America and Continental Casualty
Company (filed on March 15, 2004 as Exhibit 10(12) to CNA Surety
Corporation's Form 10-K, and incorporated herein by reference.)

10(13) Form of Surety Excess of Loss Reinsurance Contract by and between
Western Surety Company, Universal Surety of America, Surety Bonding
Company of America and Continental Casualty Company (filed on March
15, 2004 as Exhibit 10(13) to CNA Surety Corporation's Form 10-K, and
incorporated herein by reference.)

10(14) Form of Surety Excess of Loss Reinsurance Contract by and between
Western Surety Company, Universal Surety of America, Surety Bonding
Company of America and Continental Casualty Company (filed on March
15, 2004 as Exhibit 10(14) to CNA Surety Corporation's Form 10-K, and
incorporated herein by reference.)

10(15) Credit Agreement between CNA Surety Corporation and LaSalle Bank
National Association (filed on November 14, 2002 as Exhibit 10(3) to
CNA Surety Corporation's Form 10-Q, and incorporated herein by
reference.)

10(16) Amendment to Credit Agreement between CNA Surety Corporation and
LaSalle Bank National Association (filed on March 26, 2003 as Exhibit
10(9) to CNA Surety Corporation's Form 10-K, and incorporated herein
by reference.)

10(17) Second Amendment to Credit Agreement between CNA Surety Corporation
and LaSalle Bank National Association (filed on November 13, 2003 as
Exhibit 10(2) to CNA Surety Corporation's Form 10-Q, and incorporated
herein by reference.)

10(18) Third Amendment to Credit Agreement between CNA Surety Corporation and
LaSalle Bank National Association (filed on November 13, 2003 as
Exhibit 10(2) to CNA Surety Corporation's Form 10-Q, and incorporated
herein by reference.)

10(19) Form of Services and Indemnity Agreement by and between Western Surety
Company and Continental Casualty Company (filed on November 14, 2002
as Exhibit 10(5) to CNA Surety Corporation's Form 10-Q, and
incorporated herein by reference.)

10(20) Employment Agreement dated as of June 30, 2003 by and between CNA
Surety Corporation and John F. Welch (filed on August 12, 2003 as
Exhibit 10(1) to CNA Surety Corporation's Form 10-Q, and incorporated
herein by reference.)

10(21) Form of CNA Surety Corporation Non-Employee Directors Deferred
Compensation Plan (filed on July 9, 1998 as Exhibit 10(15) to CNA
Surety Corporation's Registration Statement on Form S-1 (Registration
No. 333-56063), and incorporated herein by reference.)

EXHIBIT
NUMBER DESCRIPTION
------- -----------

10(22) Form of CNA Surety Corporation Deferred Compensation Plan (filed on
March 24, 2000 as Exhibit 10(18) to CNA Surety Corporation's Annual
Report on Form 10-K, and incorporated herein by reference.)

10(23) Form of CNA Surety Corporation 2000 Employee Stock Purchase Plan
(filed on January 26, 2001 (incorporated by reference) to CNA Surety
Corporation's Registration Statement on Form S-8 (Registration No.
333-54440), and incorporated herein by reference.)

10(24) Deferred Bonus Agreement dated as of January 13, 2003 by and between
CNA Surety Corporation and Michael Dougherty (filed on March 26, 2003
as Exhibit 10(9) to CNA Surety Corporation's Form 10-K, and
incorporated herein by reference.)

10(25) Deferred Bonus Agreement dated as of December 19, 2002 by and between
CNA Surety Corporation and Enid Tanenhaus (filed on March 26, 2003 as
Exhibit 10(9) to CNA Surety Corporation's Form 10-K, and incorporated
herein by reference.)

10(26) Deferred Bonus Agreement dated as of January 13, 2003 by and between
CNA Surety Corporation and Thomas Pottle (filed on March 15, 2004 as
Exhibit 10(26) to CNA Surety Corporation's Form 10-K, and incorporated
herein by reference).

10(27) Form of CNA Surety Corporation 2005 Deferred Compensation Plan (filed
on May 2, 2005 as Exhibit 10(27) to CNA Surety Corporation's Form 10-
Q, and incorporated herein by reference).

10(28) Form of CNA Surety Corporation 2005 Deferred Compensation Plan Trust
(filed on May 2, 2005 as Exhibit 10(28) to CNA Surety Corporation's
Form 10-Q, and incorporated herein by reference).

10(29) Form of Third Amendment to CNA Surety Corporation 2005 Deferred
Compensation Plan (filed on May 2, 2005 as Exhibit 10(29) to CNA
Surety Corporation's Form 10-Q, and incorporated herein by reference).

10(30) Form of Employment Agreement dated as of January 1, 2006 by and
between CNA Surety Corporation and John F. Welch (filed on December
14, 2005 as Exhibit 10(30) to CNA Surety Corporation's Form 8-K, and
incorporated herein by reference.)

10(31) Amendment to Form of Surety Excess of Loss Reinsurance Contract by and
between Western Surety Company, Universal Surety of America, Surety
Bonding Company of America and Continental Casualty Company (filed on
August 2, 2005 as Exhibit 10(30) to CNA Surety Corporation's Form 10-
Q, and incorporated herein by reference).

10(32) Amendment to Form of Surety Excess of Loss Reinsurance Contract by and
between Western Surety Company, Universal Surety of America, Surety
Bonding Company of America and Continental Casualty Company (filed on
August 2, 2005 as Exhibit 10(31) to CNA Surety Corporation's Form 10-
Q, and incorporated herein by reference).

10(33) Amendment to Form of Surety Quota Share Reinsurance Contract by and
between Western Surety Company and Continental Casualty Company (filed
on August 2, 2005 as Exhibit 10(32) to CNA Surety Corporation's Form
10-Q, and incorporated herein by reference).

10(34) Form of CNA Surety Corporation 2006 Long-Term Equity Compensation
Plan.

11 Not Applicable.

12 Not Applicable.

13 Not Applicable.

16 Not Applicable.

18 Not Applicable.

21 Subsidiaries of the Registrant.

22 Not Applicable.

23 Consent of Deloitte & Touche LLP dated February 24, 2006.

24 Not Applicable.

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.

EXHIBIT
NUMBER DESCRIPTION
------- -----------

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.

32(2) Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.

CNA SURETY CORPORATION

/s/ JOHN F. WELCH
----------------------------------------
John F. Welch
President and Chief Executive Officer
(Principal Executive Officer)

/s/ JOHN F. CORCORAN
----------------------------------------
John F. Corcoran
Senior Vice President and Chief
Financial Officer
(Principal Financial and Accounting
Officer)

Dated February 27, 2006

Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed below by the following persons on behalf of
the Registrant and in the capacities and on the dates indicated.

DATE TITLE SIGNATURE
---- ----- ---------

February 27, 2006 Chairman of the Board /s/ JAMES LEWIS
and Director -------------------------------------
James Lewis

February 27, 2006 Director /s/ PHILIP H. BRITT
-------------------------------------
Philip H. Britt

February 27, 2006 Director /s/ ROBERT TINSTMAN
-------------------------------------
Robert Tinstman

February 27, 2006 Director /s/ LORI KOMSTADIUS
-------------------------------------
Lori Komstadius

February 27, 2006 Director /s/ ROY E. POSNER
-------------------------------------
Roy E. Posner

February 27, 2006 Director /s/ ADRIAN M. TOCKLIN
-------------------------------------
Adrian M. Tocklin

February 27, 2006 Director /s/ JOHN F. WELCH
-------------------------------------
John F. Welch