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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ________________________to_______________________
Commission file number: 1-13277
CNA SURETY CORPORATION
(Exact name of Registrant as specified in its Charter)
DELAWARE 36-4144905
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
CNA CENTER, CHICAGO, ILLINOIS 60685
(Address of principal executive offices) (Zip Code)
(312) 822-5000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer 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 in
Rule 12b-2 of the Exchange Act). [ ] Yes [X] No
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Sections 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. [ ]Yes [ ] No
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
43,575,029 shares of Common Stock, $.01 par value as of April 21, 2006.
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CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
PAGE
PART I. FINANCIAL INFORMATION:
Item 1. Condensed Consolidated Financial Statements (Unaudited): 3
Report of Independent Registered Public Accounting Firm................................................................. 3
Condensed Consolidated Balance Sheets at March 31, 2006 and at December 31, 2005........................................ 4
Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2006 and 2005.......................... 5
Condensed Consolidated Statements of Stockholders' Equity for the Three Months Ended March 31, 2006 and 2005............ 6
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2006 and 2005...................... 7
Notes to Condensed Consolidated Financial Statements.................................................................... 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............................. 17
Item 3. Quantitative and Qualitative Disclosures About Market Risk........................................................ 30
Item 4. Controls and Procedures ........................................................................................ 31
PART II. OTHER INFORMATION:
Item 1. Legal Proceedings................................................................................................. 31
Item 1A. Risk Factors..................................................................................................... 31
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds....................................................... 31
Item 3. Defaults Upon Senior Securities................................................................................... 31
Item 4. Submission of Matters to a Vote of Security Holders............................................................... 32
Item 5. Other Information................................................................................................. 32
Item 6. Exhibits.......................................................................................................... 33
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois
We have reviewed the accompanying condensed consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of March 31, 2006, and the related
condensed consolidated statements of income, of stockholders' equity, and of
cash flows for the three-month periods ended March 31, 2006 and 2005. These
interim financial statements are the responsibility of the Corporation's
management.
We conducted our reviews in accordance with the standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with standards
of the Public Company Accounting Oversight Board (United States), the objective
of which is the expression of an opinion regarding the financial statements
taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to such condensed consolidated interim financial statements for them to
be in conformity with accounting principles generally accepted in the United
States of America.
We have previously audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheet of CNA Surety Corporation and subsidiaries as of December 31, 2005, and
the related consolidated statements of income, stockholders' equity, and cash
flows for the year then ended (not presented herein); and in our report dated
February 25, 2006, we expressed an unqualified opinion on those consolidated
financial statements. In our opinion, the information set forth in the
accompanying condensed consolidated balance sheet as of December 31, 2005 is
fairly stated, in all material respects, in relation to the consolidated balance
sheet from which it has been derived.
/s/ Deloitte & Touche LLP
Chicago, Illinois
May 1, 2006
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
MARCH 31, DECEMBER 31,
2006 2005
----------- -----------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $704,987 and $710,775) .......... $ 707,048 $ 722,279
Equity securities, at fair value (cost: $1,323 and $1,201) .............................. 1,464 1,306
Short-term investments, at cost (approximates fair value) .............................. 84,038 65,041
Other investments, at cost .............................................................. 963 965
----------- -----------
Total invested assets ................................................................... 793,513 789,591
Cash ...................................................................................... 9,869 8,323
Deferred policy acquisition costs ......................................................... 105,682 102,833
Insurance receivables:
Premiums, including $11,242 and $7,947 from affiliates, (net of allowance for doubtful
accounts: $1,145 and $1,490) ........................................................... 40,899 33,359
Reinsurance, including $56,149 and $53,025 from affiliates .............................. 122,857 119,670
Deposit with affiliated ceding company .................................................... 32,136 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: $21,200 and $24,887) .................................................. 20,312 19,674
Prepaid reinsurance premiums .............................................................. 5,609 5,396
Accrued investment income ................................................................. 9,135 9,522
Other assets .............................................................................. 2,917 3,174
----------- -----------
Total assets ............................................................................ $ 1,281,714 $ 1,262,614
=========== ===========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses .............................................. $ 426,181 $ 424,449
Unearned premiums ....................................................................... 251,278 241,047
----------- -----------
Total reserves .......................................................................... 677,459 665,496
Debt ...................................................................................... 50,614 50,589
Deferred income taxes, net ................................................................ 17,780 18,820
Current income taxes payable .............................................................. 8,138 6,459
Reinsurance and other payables to affiliates .............................................. 176 174
Accrued expenses .......................................................................... 10,890 16,532
Other liabilities ......................................................................... 24,646 27,969
----------- -----------
Total liabilities ....................................................................... $ 789,703 $ 786,039
Commitments and contingencies (See Notes 4, 5, 6, & 7)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,965 shares issued and
43,569 shares outstanding at March 31, 2006 and 44,734 shares issued and 43,334 shares
outstanding at December 31, 2005 ........................................................ 449 447
Additional paid-in capital ................................................................ 263,188 259,684
Retained earnings ......................................................................... 41,928 223,927
Accumulated other comprehensive income .................................................... 1,431 7,546
Treasury stock, at cost ................................................................... (14,985) (15,029)
----------- -----------
Total stockholders' equity .............................................................. 492,011 476,575
----------- -----------
Total liabilities and stockholders' equity .............................................. $ 1,281,714 $ 1,262,614
=========== ===========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31
-----------------------
2006 2005
--------- ---------
Revenues:
Net earned premium.............................................................. $ 91,888 $ 80,563
Net investment income........................................................... 9,154 7,971
Net realized investment gains................................................... 18 2,011
--------- ---------
Total revenues................................................................. 101,060 90,545
--------- ---------
Expenses:
Net losses and loss adjustment expenses......................................... 23,596 21,591
Net commissions, brokerage and other underwriting expenses...................... 50,913 48,645
Interest expense................................................................ 952 774
--------- ---------
Total expenses................................................................. 75,461 71,010
--------- ---------
Income before income taxes........................................................ 25,599 19,535
Income tax expense................................................................ 7,598 5,460
--------- ---------
Net income........................................................................ $ 18,001 $ 14,075
========= =========
Earnings per common share......................................................... $ 0.41 $ 0.33
========= =========
Earnings per common share, assuming dilution...................................... $ 0.41 $ 0.33
========= =========
Weighted average shares outstanding............................................... 43,450 43,076
========= =========
Weighted average shares outstanding, assuming dilution............................ 43,692 43,304
========= =========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
COMMON
STOCK ADDITIONAL
SHARES COMMON PAID-IN COMPREHENSIVE
OUTSTANDING STOCK CAPITAL INCOME (LOSS)
----------- ------- ----------- -------------
Balance, December 31, 2004............................................ 43,015 $ 444 $ 255,996
Comprehensive income:
Net income.......................................................... -- -- -- $ 14,075
Other comprehensive income:
Change in unrealized gains on securities, after income taxes
of $5,109, net of reclassification adjustment of ($103),
after income tax benefit of $55 -- -- -- (9,489)
---------
Total comprehensive income.......................................... $ 4,586
=========
Stock options exercised and other..................................... 112 1 1,128
------- ------- -----------
Balance, March 31, 2005............................................... 43,127 $ 445 $ 257,124
======= ======= ===========
Balance, December 31, 2005. 43,334 $ 447 $ 259,684
Comprehensive income:
Net income.......................................................... -- -- -- $ 18,001
Other comprehensive income:
Change in unrealized gains on securities, after income tax benefit
of $3,293 (net of reclassification adjustment of $8, after income
tax expense of $4)................................................ -- -- -- (6,115)
---------
Total comprehensive income.......................................... $ 11,886
=========
Stock-based compensation.............................................. -- -- 259
Stock options exercised and other..................................... 235 2 3,245
------- ------- -----------
Balance, March 31, 2006............................................... 43,569 $ 449 $ 263,188
======= ======= ===========
ACCUMULATED
OTHER TREASURY TOTAL
RETAINED COMPREHENSIVE STOCK STOCKHOLDERS'
EARNINGS INCOME AT COST EQUITY
-------- ------------- ---------- -------------
Balance, December 31, 2004.......................................... $ 185,496 $ 19,551 $ (15,116) $ 446,371
Comprehensive income:
Net income........................................................ 14,075 -- -- 14,075
Other comprehensive income:
Change in unrealized gains on securities, after income tax
benefit of $5,109 (net of reclassification adjustment of
($103), after income tax benefit of $55)........................ -- (9,489) -- (9,489)
Stock options exercised and other................................... -- 50 1,179
--------- -------- ----------- -----------
Balance, March 31, 2005............................................. $ 199,571 $ 10,062 $ (15,066) $ 452,136
========= ======== =========== ===========
Balance, December 31, 2005.......................................... $ 223,927 $ 7,546 $ (15,029) $ 476,575
Comprehensive income:
Net income........................................................ 18,001 -- -- 18,001
Other comprehensive income:
Change in unrealized gains on securities, after income tax
benefit of $3,293 (net of reclassification adjustment of
$8, after income tax expense of $4).............................. -- (6,115) -- (6,115)
Stock-based compensation............................................. -- -- -- 259
Stock options exercised and other.................................... -- -- 44 3,291
--------- -------- ----------- -----------
Balance, March 31, 2006............................................. $ 241,928 $ 1,431 $ (14,985) $ 492,011
========= ======== =========== ===========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
---------------------
2006 2005
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ...................................................................... $ 18,001 $ 14,075
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization ................................................. 1,298 1,138
Accretion of bond discount, net ............................................... 244 760
Loss on disposal of property and equipment .................................... 144 --
Net realized investment gains ................................................. (18) (2,011)
Stock-based compensation ...................................................... 259 --
Changes in:
Insurance receivables ......................................................... (10,727) (3,720)
Reserve for unearned premiums ................................................. 10,230 9,044
Reserve for unpaid losses and loss adjustment expenses ........................ 1,733 (6,037)
Deposits with affiliated ceding company ....................................... 491 --
Deferred policy acquisition costs ............................................. (2,850) (1,368)
Deferred income taxes, net .................................................... 300 519
Reinsurance and other payables to affiliates .................................. (174) (302)
Prepaid reinsurance premiums .................................................. (212) (4,898)
Accrued expenses .............................................................. (5,641) (4,843)
Other assets and liabilities .................................................. 1,127 175
-------- --------
Net cash provided by operating activities ................................... 14,205 $ 2,532
CASH FLOWS FROM INVESTING ACTIVITIES:
Fixed income securities:
Purchases ..................................................................... (45,000) (4,751)
Maturities .................................................................... 4,945 15,818
Sales ......................................................................... 45,000 41,338
Purchases of equity securities .................................................. (292) (41)
Proceeds from the sale of equity securities ..................................... 194 9
Changes in short-term investments ............................................... (18,737) (51,266)
Purchases of property and equipment, net ........................................ (2,055) (1,042)
Changes in receivables/payables for securities sold/purchased ................... -- 92
Other, net ...................................................................... (5) 1,503
-------- --------
Net cash (used in) provided by investing activities ........................... (15,950) 1,660
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Principal payments on debt ...................................................... -- (5,000)
Employee stock option exercises and other ....................................... 3,291 1,179
-------- --------
Net cash (used in) provided by financing activities ........................... 3,291 (3,821)
-------- --------
Increase in cash .................................................................. 1,546 371
Cash at beginning of period ....................................................... 8,323 7,336
-------- --------
Cash at end of period ............................................................. $ 9,869 $ 7,707
======== ========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest ........................................................................ 1,021 738
Income taxes .................................................................... 3,371 2,112
The accompanying notes are an integral part of these condensed consolidated
financial statements.
7
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
(UNAUDITED)
1. SIGNIFICANT ACCOUNTING POLICIES
FORMATION OF CNA SURETY CORPORATION AND MERGER
In December 1996, CNA Financial Corporation ("CNAF") and Capsure agreed to
merge (the "Merger") the surety business of CNAF with Capsure's insurance
subsidiaries, Western Surety Company ("Western Surety"), Surety Bonding Company
of America ("Surety Bonding") and Universal Surety of America ("USA"), into CNA
Surety. CNAF, through its operating subsidiaries, writes multiple lines of
property and casualty insurance, including surety business that is reinsured by
Western Surety. CNAF owns approximately 63% of the outstanding common stock of
CNA Surety. Loews Corporation ("Loews") owns approximately 91% of the
outstanding common stock of CNAF. The principal operating subsidiaries of CNAF
that wrote the surety line of business for their own account prior to the Merger
were Continental Casualty Company and its property and casualty affiliates
(collectively, "CCC") and The Continental Insurance Company and its property and
casualty affiliates (collectively, "CIC"). CIC was acquired by CNAF on May 10,
1995.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of CNA Surety and
all majority-owned subsidiaries.
ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles ("GAAP") requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
BASIS OF PRESENTATION
These unaudited Condensed Consolidated Financial Statements should be read
in conjunction with the Consolidated Financial Statements and Notes thereto
included in the Company's 2005 Form 10-K. Certain financial information that is
included in annual financial statements prepared in accordance with GAAP is not
required for interim reporting and has been condensed or omitted. The
accompanying unaudited Condensed Consolidated Financial Statements reflect, in
the opinion of management, all adjustments necessary for a fair presentation of
the interim financial statements. All such adjustments are of a normal and
recurring nature. The financial results for interim periods may not be
indicative of financial results for a full year. Certain reclassifications have
been made to the 2005 financial statements to conform with the presentation in
the 2006 Condensed Consolidated Financial Statements.
EARNINGS PER SHARE
Basic earnings per common share is computed by dividing income available to
common stockholders by the weighted average number of common shares outstanding
for the period. Diluted earnings per common share is computed based on the
weighted average number of shares outstanding plus the dilutive effect of common
stock equivalents which is computed using the treasury stock method.
8
The computation of earnings per common share is as follows (amounts in
thousands, except for per share data):
THREE MONTHS ENDED
MARCH 31,
-----------------------
2006 2005
--------- ---------
Net income.............................................................................................. $ 18,001 $ 14,075
========= =========
Shares:
Weighted average shares outstanding................................................................... 43,334 43,015
Weighted average shares of options exercised and additional stock issuance............................ 116 61
--------- ---------
Total weighted average shares outstanding............................................................... 43,450 43,076
Effect of dilutive options............................................................................ 242 228
--------- ---------
Total weighted average shares outstanding, assuming dilution............................................ 43,692 43,304
========= =========
Earnings per share...................................................................................... $ 0.41 $ 0.33
========= =========
Earnings per share, assuming dilution................................................................... $ 0.41 $ 0.33
========= =========
No adjustments were made to reported net income in the computation of
earnings per share. There were no options excluded from the calculation of
diluted earnings per share for the three months ended March 31, 2006. Options to
purchase shares of common stock of 0.5 million were excluded from the
calculation of diluted earnings per share for the three months ended March 31,
2005 because the exercise price of these options was greater than the average
market price of CNA Surety's common stock.
As discussed below, the Company adopted Statement of Accounting Standards
("SFAS") No. 123 (revised 2004), "Share-based Payment" ("SFAS No. 123R") on
January 1, 2006. Prior to 2006, the Company applied the intrinsic value method
under Accounting Principles Board ("APB") Opinion No. 25 ("APB 25"), and related
interpretations, in accounting for its stock-based compensation plan as allowed
under the provisions of SFAS No. 123, "Accounting for Stock-based Compensation"
("SFAS No. 123"). Under the recognition and measurement principles of APB 25, no
stock-based compensation cost was recognized, as the exercise price of the
granted options equaled the market price of the underlying stock 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 (amounts in thousands, except for per share data):
THREE MONTHS ENDED
MARCH 31, 2005
------------------
Net
income.............................................................................................. $ 14,075
Less: Total stock-based compensation cost determined under the fair value method, net of tax............ (168)
--------
Pro forma net income.................................................................................... $ 13,907
========
Basic and diluted earnings per share, as reported....................................................... $ 0.32
========
Basic and diluted earnings per share, pro forma......................................................... $ 0.32
========
ACCOUNTING PRONOUNCEMENTS
In December of 2004, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 123 (revised 2004) ("SFAS No. 123R"), that amends SFAS No. 123,
as originally issued in May of 1995. SFAS No. 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 No. 123R supercedes APB 25. Under SFAS No. 123R, 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 SFAS No.
123R using either the modified prospective method or the modified retrospective
method. The modified prospective method requires a company to (a) record
compensation expense for all awards it grants after the date it adopts SFAS No.
123R 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 No. 123 was effective (i.e. for all fiscal
years beginning after December 15, 2004) or (b) only to prior interim periods in
the year of initial adoption if the effective date of SFAS No. 123R does not
coincide with the beginning of the fiscal year. SFAS No. 123R was effective for
the Company January 1, 2006. The Company applied the modified prospective
transition method. The Company accounted for graded vesting using the
accelerated method. Adoption of SFAS No. 123R decreased net income by $0.2
million for the quarter ended March 31, 2006.
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
9
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 standard was effective for fiscal years beginning after December 15, 2005,
and was adopted by the Company as of January 1, 2006. Adoption of this standard
did not have a material impact on the Company's results of operations and/or
equity.
In November of 2005, the FASB issued 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 No. 115") and equity securities that are accounted for using
the cost method specified in APB 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. FSP 115-1 and 124-1 replaces
guidance set forth in EITF 03-1 with references to existing other-than-temporary
impairment guidance and clarifies 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. FSP 115-1 and 124-1 were effective for fiscal years
beginning after December 15, 2005 and was adopted by the Company on January 1,
2006. Adoption of FSP 115-1 and 124-1 of did not have a material impact on the
Company's results of operations and/or equity.
2. INVESTMENTS
The estimated fair value and amortized cost or cost of fixed income and
equity securities held by CNA Surety at March 31, 2006 and December 31, 2005, by
investment category, were as follows (dollars in thousands):
GROSS UNREALIZED LOSSES
AMORTIZED GROSS --------------------------- ESTIMATED
COST OR UNREALIZED LESS THAN 12 MORE THAN 12 FAIR
MARCH 31, 2006 COST GAINS MONTHS MONTHS VALUE
-------------- --------- ---------- ------------ ------------ ---------
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury ........................................... $ 15,623 $ -- $ (318) $ (188) $ 15,117
U.S. Agencies ........................................... 40,047 10 (403) (111) 39,543
Collateralized mortgage obligations ..................... 18,163 303 (439) -- 18,027
Mortgage pass-through securities ........................ 43,650 55 (886) (771) 42,048
Obligations of states and political subdivisions .. 462,045 10,397 (2,731) (820) 468,891
Corporate bonds ........................................... 68,725 1,434 (1,337) (530) 68,292
Non-agency collateralized mortgage obligations ............ 22,197 -- (1,277) -- 20,920
Other asset-backed securities:
Second mortgages/home equity loans ...................... 25,924 -- (226) (53) 25,645
Other ................................................... 5,613 73 (216) -- 5,470
Redeemable preferred stock ................................ 3,000 95 -- -- 3,095
--------- --------- --------- --------- ---------
Total fixed income securities ........................... 704,987 12,367 (7,833) (2,473) 707,048
Equity securities ......................................... 1,323 141 -- -- 1,464
--------- --------- --------- --------- ---------
Total ................................................... $ 706,310 $ 12,508 $ (7,833) $ (2,473) $ 708,512
========= ========= ========= ========= =========
10
GROSS UNREALIZED LOSSES
AMORTIZED GROSS --------------------------- ESTIMATED
COST OR UNREALIZED LESS THAN 12 MORE THAN 12 FAIR
DECEMBER 31, 2005 COST GAINS MONTHS MONTHS VALUE
----------------- ----------- ---------- ------------ ------------ ---------
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury....................................... $ 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
=========== ========== ========= ========= =========
The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk, with investments
concentrated in high quality fixed income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
CNA Surety classifies its fixed income securities and its equity securities
as available-for-sale, and as such, they are carried at fair value. The
amortized cost of fixed income securities is adjusted for amortization of
premiums and accretion of discounts to maturity, which is included in net
investment income. Changes in fair value are reported as a component of other
comprehensive income, exclusive of other-than-temporary impairment losses, if
any.
As of March 31, 2006, 107 securities held by the Company were in an
unrealized loss position. The Company believes that 106 of these securities are
in an unrealized loss position because of changes in interest rates and
therefore expects these securities will recover in value at or before maturity.
Of these 106 securities, 80 were rated "AAA" by Standard & Poor's ("S&P") and
"Aaa" by Moody's Investor Services ("Moody's"). Only fourteen of these 106
securities were in a loss position that exceeded 5% of its book value, with the
largest unrealized loss, $0.5 million, being approximately 5.6% of that
security's book value. The largest percentage unrealized loss was approximately
8.5% of that security's book value resulting in an unrealized loss of $0.1
million.
The remaining security that was in an unrealized loss position was issued by
the financing subsidiary of a large domestic automaker. The security was in an
unrealized loss position of approximately 9% ($0.3 million) of its book value
and was rated below investment grade by S&P and 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 at maturity.
Based on the foregoing information, the Company believes there are no
other-than-temporary impairments at March 31, 2006.
Invested assets are exposed to various risks, such as interest rate, market
and credit risks. Due to the level of risk associated with certain of these
invested assets and the level of uncertainty related to changes in the value of
these assets, it is possible that changes in risks in the near term may
significantly affect the amounts reported in the Condensed Consolidated Balance
Sheets and Condensed Consolidated Statements of Income.
11
3. REINSURANCE
The effect of reinsurance on the Company's written and earned premium was as
follows (dollars in thousands):
THREE MONTHS ENDED MARCH 31,
--------------------------------------------------
2006 2005
------------------------ ------------------------
WRITTEN EARNED WRITTEN EARNED
----------- --------- -------- ----------
Direct..................................................... $ 85,758 $ 75,221 $ 77,929 $ 65,260
Assumed.................................................... 26,971 27,277 25,364 28,988
Ceded...................................................... (10,823) (10,610) (18,583) (13,685)
------------ --------- --------- ----------
Net premiums............................................... $ 101,906 $ 91,888 $ 84,710 $ 80,563
=========== ========= ========= ==========
Assumed premiums primarily include all surety business written or renewed,
net of reinsurance, by CCC and CIC, which is reinsured by Western Surety
pursuant to reinsurance and related agreements.
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):
THREE MONTHS ENDED MARCH 31,
-----------------------------------------
2006 2005
------------------- -------------------
$ RATIO $ RATIO
--------- ----- --------- -----
Gross losses and loss adjustment expenses............................ $ 26,854 26.2% $ 28,611 30.4%
Ceded amounts........................................................ (3,258) 30.7% (7,020) 51.3%
--------- ---------
Net losses and loss adjustment expenses.............................. $ 23,596 25.7% $ 21,591 26.8%
========= =========
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 difference between the 2006 Excess
of Loss Treaty and the Company's 2005 Excess of Loss Treaty is 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 $41.5 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.
RELATED PARTY REINSURANCE
Reinsurance agreements together with the Services and Indemnity Agreement
that are described below provide for the transfer of the surety business written
by CCC and CIC to Western Surety.
The Services and Indemnity Agreement provides the Company's insurance
subsidiaries the authority to perform various administrative, management,
underwriting and claim functions in order to conduct the business of CCC and CIC
and to be reimbursed by CCC for services rendered. In consideration for
providing the foregoing services, CCC has agreed to pay Western Surety a
quarterly fee of $50,000. This agreement was renewed on January 1, 2006 and
expires on December 31, 2006 and is annually renewable thereafter.
Through a surety quota share treaty ("the Quota Share Treaty"), CCC and CIC
transfer to Western Surety all surety business written or renewed by CCC and CIC
after September 30, 1997 ("the Merger Date"). The Quota Share Treaty was renewed
on January 1, 2006 and expires on December 31, 2006 and is annually renewable
thereafter. CCC and CIC transfer the related liabilities of such business and
pay to Western Surety an amount in cash equal to CCC's and CIC's net written
premiums written on all such business, minus a quarterly ceding commission to be
retained by CCC and CIC equal to $50,000 plus 25% of net written premiums
written on such business. This contemplates an approximate 4% override
commission for fronting fees to CCC and CIC on their actual direct acquisition
costs.
12
Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and
loss adjustment expense reserves transferred to Western Surety as of September
30, 1997 by agreeing to pay Western Surety, within 30 days following the end of
each calendar quarter, the amount of any adverse development on such reserves,
as re-estimated as of the end of such calendar quarter. There was no adverse
reserve development for the period from September 30, 1997 (date of inception)
through March 31, 2006.
Through a stop loss contract entered into at the Merger Date (the "Stop Loss
Contract"), the Company's insurance subsidiaries were protected from adverse
loss experience on certain business underwritten after the Merger Date. The Stop
Loss Contract between the insurance subsidiaries and CCC limited the insurance
subsidiaries' prospective net loss ratios with respect to certain accounts and
lines of insured business for three full accident years following the Merger
Date. In the event the insurance subsidiaries' accident year net loss ratio
exceeded 24% in any of the accident years 1997 through 2000 on certain insured
accounts (the "Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end
of each calendar quarter following the Merger Date, to pay the insurance
subsidiaries a dollar amount equal to (i) the amount, if any, by which their
actual accident year net loss ratio exceeds the applicable Loss Ratio Cap,
multiplied by (ii) the applicable net earned premiums. As of March 31, 2006 and
December 31, 2005, the Company had billed and received $45.9 million under the
Stop Loss Contract.
The Company and CCC previously participated in a $40 million excess of $60
million reinsurance contract effective from January 1, 2005 to December 31, 2005
providing coverage exclusively for the one large national contractor 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. 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 was from January 1, 2005 to December 31,
2005. 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.
As of March 31, 2006 and December 31, 2005, the Company has ceded losses of
$50.0 million under the terms of this contract.
The Company and CCC entered into a $50 million excess of $100 million
contract for the period of January 1, 2005 to December 31, 2005. The premium for
this contract was $4.8 million plus an additional premium of $14.0 million if a
loss was 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
was not renewed for 2006.
As of March 31, 2006 and December 31, 2005, CNA Surety had an insurance
receivable balance from CCC and CIC of $67.4 million and $61.0 million,
respectively. CNA Surety had no reinsurance payables to CCC and CIC as of March
31, 2006 and December 31, 2005.
4. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the reserves for unpaid losses and loss adjustment expenses was
as follows (dollars in thousands):
THREE MONTHS ENDED
MARCH 31,
-------------------------
2006 2005
----------- -----------
Reserves at beginning of period:
Gross........................................................................... $ 424,449 $ 363,387
Ceded reinsurance............................................................... 147,435 116,831
----------- -----------
Net reserves at beginning of period........................................... 277,014 246,556
----------- -----------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period................................ 23,637 21,591
Decrease in provision for insured events of prior periods..................... (41) --
------------ -----------
Total net incurred............................................................ 23,596 21,591
----------- -----------
Net payments attributable to:
Current period events......................................................... 410 162
Prior period events........................................................... 24,022 29,795
----------- -----------
Total net payments............................................................ 24,432 29,957
----------- -----------
Net reserves at end of period................................................... 276,178 238,190
Ceded reinsurance at end of period.............................................. 150,003 119,160
----------- -----------
Gross reserves at end of period............................................... $ 426,181 $ 357,350
=========== ===========
13
5. DEBT
On July 27, 2005, the Company refinanced $30.0 million in outstanding
borrowings under its previous credit facility with a new credit facility (the
"2005 Credit Facility"). The 2005 Credit Facility provides an aggregate of up to
$50.0 million in borrowings under a revolving credit facility. At March 31, 2006
and December 31, 2005, the outstanding 2005 Credit Facility balance was $20.0
million. The 2005 Credit Facility matures on June 30, 2008. No other debt
matures in the next five years.
The term of borrowings under the 2005 Credit Facility may be fixed, at the
Company's option, for a period of one, two, three, or six months. The interest
rate is based on, among other rates, the London Interbank Offered Rate ("LIBOR")
plus the applicable margin. The margin, including a facility fee and utilization
fee, can vary based on the Company's leverage ratio (debt to total
capitalization) from 1.15% to 1.45%. The margin was 1.25% at March 31, 2006. As
of March 31, 2006, the weighted average interest rate on the 2005 Credit
Facility was 6.125% on the $20.0 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 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 for the quarter ended March 31, 2006.
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 Condensed 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 March 31, 2006 the interest
rate on the junior subordinated debenture was 8.12%.
6. EMPLOYEE BENEFITS
CNA Surety established the CNA Surety Corporation Deferred Compensation Plan
("2000 Plan"), effective April 1, 2000. The Company established and maintains
the 2000 Plan as an unfunded, nonqualified deferred compensation plan for a
select group of management or highly compensated employees. The purpose of the
2000 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 "2005 Plan") and
the CNA Surety Corporation 2005 Deferred Compensation Plan Trust (the "2005
Trust"). The 2005 Plan and 2005 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
2005 Plan and 2005 Trust will be used in lieu of the 2000 Plan and the CNA
Surety Corporation Deferred Compensation Plan Trust (the "2000 Trust") for all
amounts deferred on or after January 1, 2005. Amounts deferred under the 2000
Plan prior to January 1, 2005 will continue to be covered by and paid out in
accordance with the terms of the 2000 Plan, the 2000 Trust and the elections
made by participants under the 2000 Plan.
Western Surety sponsors two postretirement benefit plans covering certain
employees. One plan provides medical benefits, and the other plan provides sick
leave termination payments. The postretirement health care plan is contributory
and the sick leave plan is non-contributory. Western Surety uses a December 31
measurement date for both of its postretirement benefit plans. There were no
plan assets for either of the postretirement benefit plans.
The plans' combined net periodic postretirement benefit cost included the
following components (amounts in thousands):
14
THREE MONTHS ENDED
MARCH 31,
-------------------
2006 2005
------ ------
Net periodic benefit cost:
Service cost................................................................................ $ 74 $ 37
Interest cost............................................................................... 143 75
Prior service cost.......................................................................... (41) (41)
Recognized net actuarial loss............................................................... 63 --
------ ------
Net periodic benefit cost................................................................... $ 239 $ 71
====== ======
The Company expects to contribute $0.2 million to the postretirement benefit
plans to pay benefits in 2006. As of March 31, 2006, $0.1 million of
contributions have been made to the postretirement benefit plans.
7. COMMITMENTS AND CONTINGENCIES
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.
8. STOCK-BASED COMPENSATION
The compensation expense recorded for the Company's stock-based compensation
plan was $0.3 million in the current quarter. The total income tax benefit
recognized in the income statement for stock-based compensation arrangements was
$0.1 million in the current quarter. The amount of cash received from the
exercise of stock options was $3.2 million and $1.3 million during the quarters
ended March 31, 2006 and March 31, 2005, respectively.
1997 LONG-TERM EQUITY COMPENSATION PLAN
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 ("the 1997 Plan"). The aggregate number of shares initially
available for which options may be granted under the 1997 Plan is 3,000,000.
The Compensation Committee (the "Committee") of the Board of Directors,
consisting of independent members of the Board of Directors, administers the
1997 Plan. The Committee determines the option exercise prices. Exercise 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.
The 1997 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 1997
Plan expire ten years after the date of grant and vest ratably over the
four-year period following the date of grant.
No options were granted under the 1997 Plan during the quarters ended March
31, 2006 and March 31, 2005.
The Company's 2006 Long-Term Equity Compensation Plan ("the 2006 Plan"),
which replaces the 1997 Plan, was approved by shareholders on April 25, 2006.
A summary of option activity as of March 31, 2006 is presented below:
WEIGHTED
AVERAGE OPTION
SHARES SUBJECT PRICE PER
TO OPTION SHARE
-------------- ----------------
Outstanding options at January 1, 2006.......................................... 1,587,909 $ 12.41
Options granted................................................................ -- $ --
Options forfeited/expired...................................................... (23,775) $ 13.54
Options exercised.............................................................. (230,200) $ 12.78
----------
Outstanding options at March 31, 2006........................................... 1,333,934 $ 12.32
==========
15
A summary of the status of the Company's non-vested options as of March 31,
2006 and changes during the quarter ended March 31, 2006 is presented below:
WEIGHTED
AVERAGE
SHARES SUBJECT GRANT-DATE
TO OPTION FAIR VALUE
-------------- ----------
Non-vested options at January 1, 2006........................................... 785,845 $ 11.91
Options granted................................................................ -- --
Options vested................................................................. -- --
Options forfeited.............................................................. (4,100) $ 11.84
--------
Non-vested options at March 31, 2006............................................ 781,745 $ 11.91
========
As of March 31, 2006, the number of shares available for granting of options
under the 1997 Plan was 566,077.
The following table summarizes information about stock options outstanding
at March 31, 2006:
OPTIONS OUTSTANDING
--------------------------------------------------- OPTIONS EXERCISABLE
WEIGHTED AVERAGE ------------------------------
NUMBER REMAINING WEIGHTED AVERAGE NUMBER WEIGHTED AVERAGE
RANGE OF EXERCISE PRICES OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
------------------------ ----------- ---------------- ---------------- ----------- ----------------
$9.35 to $11.50...................... 397,750 6.6 years $ 9.88 214,050 $ 10.21
$12.06 to $15.875.................... 936,184 7.4 years $ 13.36 338,139 $ 14.62
The aggregate intrinsic value of options outstanding and exercisable at
March 31, 2006 were $5.9 million and $2.1 million, respectively. The total
intrinsic value of options exercised during the quarter ended March 31, 2006 was
$0.8 million.
As of March 31, 2006, there was $1.7 million of total unrecognized
compensation cost related to non-vested stock-based compensation arrangements
granted under the 1997 Plan. That cost is expected to be recognized as follows:
2006 - $0.9 million; 2007 - $0.5 million; 2008 - $0.2 million; and 2009 - $0.1
million.
16
CNA SURETY CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
The following is a discussion and analysis of CNA Surety Corporation and its
subsidiaries' (collectively, "CNA Surety" or the "Company") operating results,
liquidity and capital resources, and financial condition. This discussion should
be read in conjunction with the Condensed Consolidated Financial Statements in
Item 1 of Part 1 of this Quarterly Report on Form 10-Q and the Company's Annual
Report on Form 10-K for the year ended December 31, 2005.
CRITICAL ACCOUNTING POLICIES
Management believes the most significant accounting policies and related
disclosures for purposes of understanding the Company's results of operations
and financial condition pertain to reserves for unpaid losses and loss
adjustment expenses and reinsurance, investments, intangible assets, 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 March 31, 2006
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................................................................... $ 127,101 $ 127,271 $ 254,372
Commercial................................................................. 105,889 54,189 160,078
Fidelity and other......................................................... 4,391 7,340 11,731
---------- ---------- -----------
Total...................................................................... $ 237,381 $ 188,800 $ 426,181
========== ========== ===========
17
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 Condensed Consolidated Balance Sheets includes estimated
liabilities for unpaid losses and loss adjustment expenses of $426.2 million and
$424.4 million and reinsurance receivables related to unpaid losses of $150.0
million and $147.4 million at March 31, 2006 and December 31, 2005,
respectively. Due to the inherent uncertainties in the process of establishing
the liabilities for unpaid losses and loss adjustment expenses, the actual
ultimate claims amounts will differ from the currently recorded amounts. This
difference could have a material effect on reported earnings and financial
condition. Future effects from changes in these estimates will be recorded in
the period such changes are determined to be needed.
INVESTMENTS
Management believes the Company has the ability to hold all fixed income
securities to maturity. However, the Company may dispose of securities prior to
their scheduled maturity due to changes in interest rates, prepayments, tax and
credit considerations, liquidity or regulatory capital requirements, or other
similar factors. As a result, the Company classifies all of its fixed income
securities (bonds and redeemable preferred stocks) and equity securities as
available-for-sale. These securities are reported at fair value, with unrealized
gains and losses, net of deferred income taxes, reported as a separate component
of other comprehensive income. Cash flows from purchases, sales and maturities
are reported gross in the investing activities section of the Condensed
Consolidated Statements of Cash Flows.
The amortized cost of fixed income securities is determined based on cost
and the cumulative effect of amortization of premiums and accretion of discounts
to maturity. Such amortization and accretion are included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective-yield method based on estimated cash flows. All
securities transactions are recorded on the trade date. Investment gains or
losses realized on the sale of securities are determined using the specific
identification method. Investments with an other-than-temporary decline in value
are written down to fair value, resulting in losses that are included in
realized investment gains and losses.
Short-term investments, which generally include U.S. Treasury bills,
corporate notes, money market funds, and investment grade commercial paper
equivalents, are carried at amortized cost that approximates fair value.
Invested assets are exposed to various risks, such as interest rate risk, market
risk and credit risk. Due to the level of risk associated with invested assets
and the level of uncertainty related to changes in the value of these assets, it
is possible that changes in risks in the near term may significantly affect the
amounts reported in the Condensed Consolidated Balance Sheets and Condensed
Consolidated Statements of Income.
INTANGIBLE ASSETS
CNA Surety's Condensed Consolidated Balance Sheet as of March 31, 2006 and
December 31, 2005 includes intangible assets of approximately $138.8 million.
These amounts represent goodwill and identified intangibles arising from the
acquisition of Capsure Holdings Corp. ("Capsure").
A significant amount of judgment is required in performing intangible assets
impairment tests. Such tests are performed annually on October 1, or more
frequently if events or changes indicate that the estimated fair value of CNA
Surety's reporting units might be impaired. Under 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 intangible assets. The excess of the recorded
amount of intangible assets over the implied value of intangible assets is
recorded as an impairment loss.
18
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 accounting principles generally
accepted in the United States of America ("GAAP") and non-GAAP financial
measures in order to provide information used by management to monitor the
Company's operating performance. Management utilizes various financial measures
to monitor the Company's insurance operations and investment portfolio.
Underwriting results, which are derived from certain income statement amounts,
are considered a non-GAAP financial measure and are used by management to
monitor performance of the Company's insurance operations. The Company's
investment portfolio is monitored through analysis of various quantitative and
qualitative factors and certain decisions related to the sale or impairment of
investments that produce realized gains and losses, which is also a component
used in the calculation of net income and is a non-GAAP financial measure.
Underwriting results are computed as net earned premiums less net loss and
loss adjustment expenses and net commissions, brokerage and other underwriting
expenses. Management uses underwriting results to monitor its insurance
operations' results without the impact of certain factors, including net
investment income, net realized investment gains (losses) and interest expense.
Management excludes these factors in order to analyze the direct relationship
between net earned premiums and the related net loss and loss adjustment
expenses along with net commissions, brokerage and other underwriting expenses.
Operating ratios are calculated using insurance results and are widely used
by the insurance industry and regulators such as state departments of insurance
and the National Association of Insurance Commissioners for financial regulation
and as a basis of comparison among companies. The ratios discussed in the
Company's MD&A are calculated using GAAP financial results and include the net
loss and loss adjustment expense ratio ("loss ratio") as well as the net
commissions, brokerage and other underwriting expense ratio ("expense ratio")
and combined ratio. The loss ratio is the percentage of net incurred losses and
loss adjustment expenses to net earned premiums. The expense ratio is the
percentage of net commissions, brokerage and other underwriting expenses,
including the amortization of deferred acquisition costs, to net earned
premiums. The combined ratio is the sum of the loss and expense ratios.
The Company's investment portfolio is monitored by management through
analysis of various factors including unrealized gains and losses on securities,
portfolio duration and exposure to interest rates, and market and credit risk.
Based on such analyses, the Company may impair an investment security in
accordance with its policy, or sell a security. Such activities will produce net
realized investment gains and losses.
While management uses various GAAP and non-GAAP financial measures to
monitor various aspects of the Company's performance, net income is the most
directly comparable GAAP measure and represents a more comprehensive measure of
operating performance. Management believes that its process of evaluating
performance through the use of these non-GAAP financial measures provides a
basis for enhanced understanding of the operating performance and the impact to
net income as a whole. Management also believes that investors may find these
widely used financial measures described above useful in interpreting the
underlying trends and performance, as well as to provide visibility into the
significant components of net income.
19
COMPARISON OF CNA SURETY RESULTS FOR THE THREE MONTHS ENDED MARCH 31, 2006
AND 2005
ANALYSIS OF NET INCOME
Net income for the three months ended March 31, 2006 was $18.0 million,
compared to a net income of $14.1 million for the same period in 2005. This
increase is primarily a result of higher net earned premium, higher net
investment income, and the impacts of lower loss and expense ratios. The
components of net income are discussed in the following sections.
RESULTS OF INSURANCE OPERATIONS
Underwriting components for the Company for the three months ended March 31,
2006 and 2005 are summarized in the following table (dollars in thousands):
THREE MONTHS
ENDED
MARCH 31,
2006 2005
----------- -----------
Gross written premiums............................................................................... $ 112,729 $ 103,293
=========== ===========
Net written premiums................................................................................. $ 101,906 $ 84,710
=========== ===========
Net earned premiums.................................................................................. $ 91,888 $ 80,563
=========== ===========
Net losses and loss adjustment expenses.............................................................. $ 23,596 $ 21,591
=========== ===========
Net commissions, brokerage and other expenses........................................................ $ 50,913 $ 48,645
=========== ===========
Loss ratio........................................................................................... 25.7% 26.8%
Expense ratio........................................................................................ 55.4 60.4
----------- -----------
Combined ratio....................................................................................... 81.1% 87.2%
=========== ===========
PREMIUMS WRITTEN
CNA Surety primarily markets contract and commercial surety bonds. Contract
surety bonds generally secure a contractor's performance and/or payment
obligation with respect to a construction project. Contract surety bonds are
generally required by federal, state and local governments for public works
projects. The most common types include bid, performance and payment bonds.
Commercial surety bonds include all surety bonds other than contract and cover
obligations typically required by law or regulation. The commercial surety
market includes numerous types of bonds categorized as court judicial, court
fiduciary, public official, license and permit and many miscellaneous bonds that
include guarantees of financial performance. The Company also writes fidelity
bonds that cover losses arising from employee dishonesty and other insurance
products.
The Company assumes significant amounts of premiums primarily from
affiliates. This includes all surety business written or renewed, net of
reinsurance, by CCC and CIC, and their affiliates, after the Merger Date that is
reinsured by Western Surety pursuant to reinsurance and related agreements.
Because of certain regulatory restrictions that limit the Company's ability to
write business on a direct basis, the Company continues to utilize the
underwriting capacity available through these agreements. The Company is in full
control of all aspects of the underwriting and claim management of the assumed
business.
Gross written premiums are summarized in the following table (dollars in
thousands):
THREE MONTHS
ENDED
MARCH 31,
2006 2005
----------- -----------
Contract.............................................................................................. $ 67,444 $ 56,271
Commercial............................................................................................ 35,855 37,213
Fidelity and other.................................................................................... 9,430 9,809
----------- -----------
Total................................................................................................. $ 112,729 $ 103,293
=========== ===========
Gross written premiums increased 9.1% to $112.7 million, for the three
months ended March 31, 2006 as compared with the same period in 2005. Contract
surety gross written premiums increased 19.9% to $67.4 million due primarily to
increased demand as a result of the strong construction economy as well as
increased volume resulting from growth over the last several years in the number
of targeted accounts serviced. Commercial surety gross written premiums
decreased 3.6% to $35.9 million primarily due to declining premium volume on
large commercial accounts. Fidelity and other premiums decreased by 3.9%
primarily due to a decline in notary errors and omissions policies associated
with a reduction in notary bond business of a large producer.
20
Net written premiums are summarized in the following table (dollars in
thousands):
THREE MONTHS ENDED
MARCH 31,
2006 2005
--------- ---------
Contract......................................................... $ 57,712 $ 40,052
Commercial....................................................... 34,764 34,849
Fidelity and other............................................... 9,430 9,809
--------- ---------
Total............................................................ $ 101,906 $ 84,710
========= =========
Net written premiums increased 20.3% or $17.2 million, for the three months
ended March 31, 2006 as compared with the same period in 2005, primarily due to
the increase in gross written premiums as described above and a decrease in
ceded written premiums. Ceded written premiums decreased $7.8 million for the
three months ended March 31, 2006 as compared with the same period in 2005,
resulting from the Company's decision not to renew a high-level excess of loss
reinsurance treaty and cost savings on the Company's core reinsurance program.
EXCESS OF LOSS REINSURANCE
The Company's reinsurance program is predominantly comprised of excess of
loss reinsurance contracts that limit the Company's retention on a per principal
basis. The Company's reinsurance coverage is provided by third party reinsurers
and related parties.
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 difference between the 2006 Excess
of Loss Treaty and the Company's 2005 Excess of Loss Treaty is 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 $41.5 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.
RELATED PARTY REINSURANCE
Reinsurance agreements together with the Services and Indemnity Agreement
that are described below provide for the transfer of the surety business written
by CCC and CIC to Western Surety.
The Services and Indemnity Agreement provides the Company's insurance
subsidiaries the authority to perform various administrative, management,
underwriting and claim functions in order to conduct the business of CCC and CIC
and to be reimbursed by CCC for services rendered. In consideration for
providing the foregoing services, CCC has agreed to pay Western Surety a
quarterly fee of $50,000. This agreement was renewed on January 1, 2006 and
expires on December 31, 2006 and is annually renewable thereafter.
Through a surety quota share treaty ("the Quota Share Treaty"), CCC and CIC
transfer to Western Surety all surety business written or renewed by CCC and CIC
after September 30, 1997 ("the Merger Date"). The Quota Share Treaty was renewed
on January 1, 2006 and expires on December 31, 2006 and is annually renewable
thereafter. CCC and CIC transfer the related liabilities of such business and
pay to Western Surety an amount in cash equal to CCC's and CIC's net written
premiums written on all such business, minus a quarterly ceding commission to be
retained by CCC and CIC equal to $50,000 plus 25% of net written premiums
written on such business. This contemplates an approximate 4% override
commission for fronting fees to CCC and CIC on their actual direct acquisition
costs.
Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and
loss adjustment expense reserves transferred to Western Surety as of September
30, 1997 by agreeing to pay Western Surety, within 30 days following the end of
each calendar quarter, the amount of any adverse development on such reserves,
as re-estimated as of the end of such calendar quarter. There was no adverse
reserve development for the period from September 30, 1997 (date of inception)
through March 31, 2006.
21
Through a stop loss contract entered into at the Merger Date (the "Stop Loss
Contract"), the Company's insurance subsidiaries were protected from adverse
loss experience on certain business underwritten after the Merger Date. The Stop
Loss Contract between the insurance subsidiaries and CCC limited the insurance
subsidiaries' prospective net loss ratios with respect to certain accounts and
lines of insured business for three full accident years following the Merger
Date. In the event the insurance subsidiaries' accident year net loss ratio
exceeded 24% in any of the accident years 1997 through 2000 on certain insured
accounts (the "Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end
of each calendar quarter following the Merger Date, to pay the insurance
subsidiaries a dollar amount equal to (i) the amount, if any, by which their
actual accident year net loss ratio exceeds the applicable Loss Ratio Cap,
multiplied by (ii) the applicable net earned premiums. As of March 31, 2006 and
December 31, 2005, the Company had billed and received $45.9 million under the
Stop Loss Contract.
The Company and CCC previously participated in a $40 million excess of $60
million reinsurance contract effective from January 1, 2005 to December 31, 2005
providing coverage exclusively for the one large national contractor 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. 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 was from January 1, 2005 to December 31,
2005. 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.
As of March 31, 2006 and December 31, 2005, the Company has ceded losses of
$50.0 million under the terms of this contract.
The Company and CCC entered into a $50 million excess of $100 million
contract for the period of January 1, 2005 to December 31, 2005. The premium for
this contract was $4.8 million plus an additional premium of $14.0 million if a
loss was 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
was not renewed for 2006.
NET LOSS RATIO
The net loss ratio was 25.7% for the three months ended March 31, 2006 as
compared with 26.8% for the same period in 2005. The lower loss ratio reflects
improved claim experience and the increase in net earned premium that resulted
from the Company's decision not to renew a high-level excess of loss reinsurance
treaty and cost savings on the Company's core reinsurance program.
EXPOSURE MANAGEMENT
The Company's business is subject to certain risks and uncertainties
associated with the current economic environment and corporate credit
conditions. In response to these risks and uncertainties, the Company continues
with various exposure management initiatives. These initiatives are particularly
focused on exposure to large commercial accounts. Large commercial accounts are
defined as accounts with exposures in excess of $10.0 million. "Exposure" is
defined as the face amount of the bond. As the following table depicts, the
Company has reduced its exposure, before the effects of reinsurance, to large
commercial accounts with exposures in excess of $25.0 million. However, total
large commercial account exposure has increased slightly in the first quarter of
2006.
NUMBER OF ACCOUNTS TOTAL EXPOSURE (DOLLARS IN MILLIONS)
AS OF AS OF
------------------------- ---------------------------------------------
MARCH 31, DECEMBER 31, MARCH 31, DECEMBER 31, % REDUCTION
COMMERCIAL ACCOUNT EXPOSURE 2006 2005 2006 2005 (INCREASE)
--------------------------- --------- ----------- ----------- ------------- -----------
$100 million and larger............. 2 2 $ 238.2 $ 246.6 3.4%
$50 to $100 million................. 2 2 134.5 137.6 2.3%
$25 to $50 million.................. 8 9 266.3 307.7 13.5%
$10 to $25 million.................. 36 32 502.8 445.6 (12.8)%
--- --- -------- --------
Total............................... 48 45 $1,141.8 $1,137.5 (0.4)%
=== === ======== ========
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.
22
The Company continues to manage its exposure to any one contract credit and
aggressively looks for co-surety, shared accounts and other means to support or
reduce larger exposures. Reinsurance, indemnification and subrogation rights,
including rights to contract proceeds on construction projects in the event of
default, exist that substantially reduce CNA Surety's exposure to loss.
EXPENSE RATIO
The expense ratio was 55.4% for the three months ended March 31, 2006 as
compared with 60.4% for the same period in 2005. Approximately 1.3 percentage
points of this improvement resulted from the impact of the reduction in cost of
the Company's 2006 reinsurance program. The remaining improvement reflects the
strong premium growth accomplished with only a minimal increase in underwriting
expenses.
INVESTMENT INCOME AND REALIZED INVESTMENT GAINS/LOSSES
Net investment income was $9.2 million for the three months ended March 31,
2006, as compared with $8.0 million for the same period in 2005. This is due to
the significant increase in invested assets. The annualized pre-tax yield was
4.5% and 4.4% for the three months ended March 31, 2006 and 2005, respectively.
The annualized after-tax yield was 3.8% and 3.7% for the three months ended
March 31, 2006 and 2005, respectively. Net realized investment gains were
negligible for the three months ended March 31, 2006 compared to $2.0 million
for the three months ended March 31, 2005. This decrease was due to the absence
of the realized investment gain in 2005 from the Company's sale of its interest
in De Montfort Group, Ltd.
The following summarizes net realized investment gains (losses) activity
(dollars in thousands):
THREE MONTHS ENDED
MARCH 31,
----------------------
2006 2005
-------- --------
Gross realized investment gains........................... $ 19 $ 2,165
Gross realized investment losses.......................... (1) (154)
-------- --------
Net realized investment gains............................. $ 18 $ 2,011
======== ========
The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality fixed income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
Invested assets are exposed to various risks, such as interest rate, market
and credit. Due to the level of risk associated with certain of these invested
assets and the level of uncertainty related to changes in the value of these
assets, it is possible that changes in risks in the near term may significantly
affect the amounts reported in the Condensed Consolidated Balance Sheets and
Condensed Consolidated Statements of Income.
INTEREST EXPENSE
Interest expense increased by 23.0% for the three months ended March 31,
2006 as compared with the same period in 2005, due to higher interest rates
associated with the Credit Facility and the subordinated debentures, partially
offset by a reduction in weighted average debt outstanding. Weighted average
debt outstanding was $50.9 million for the three months ended March 31, 2006 as
compared with $65.9 million for the same period in 2005. The weighted average
interest rate for the three months ended March 31, 2006 was 7.1% as compared
with 4.5% for the same period in 2005.
INCOME TAXES
For the three months ended March 31, 2006, the Company's effective tax rate
differs from the statutory tax rate due primarily to tax-exempt investment
income. The impact of tax-exempt securities on taxable income was $4.3 million
for the three months ended March 31, 2006. The impact of tax-exempt securities
on taxable income was $3.9 million for the three months ended March 31, 2005.
23
LIQUIDITY AND CAPITAL RESOURCES
It is anticipated that the liquidity requirements of CNA Surety will be met
primarily with funds generated from its insurance operations. The principal
sources of consolidated cash flows are premiums, investment income, sales and
maturities of investments, and reinsurance recoveries. CNA Surety also may
generate funds from additional borrowings under the credit facility described
below. The primary cash flow uses are payments for claims, operating expenses,
reinsurance premiums, federal income taxes, and debt service. In general, surety
operations generate premium collections from customers in advance of cash
outlays for claims. Premiums are invested until such time as funds are required
to pay claims and claims adjusting expenses.
The Company believes that total invested assets, including cash and
short-term investments, are sufficient in the aggregate and have suitably
scheduled maturities to satisfy all policy claims and other operating
liabilities, including dividend and income tax sharing payments of its insurance
subsidiaries. At March 31, 2006, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $706.2 million of fixed income
securities, $71.8 million of short-term investments, $1.0 million of other
investments and $10.7 million of cash. 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.
During the first quarter of 2006, the Company paid an additional $12.0
million related to the surety losses of the large national contractor discussed
in the Company's Annual Report on Form 10-K for the year ended December 31,
2005. The Company's exposure, net of expected reinsurance recoveries from CCC,
of $60.0 million was previously fully reserved.
Cash flow at the parent company level is derived principally from dividend
and tax sharing payments from its insurance subsidiaries. The principal
obligations at the parent company level are to service debt and pay operating
expenses, including income taxes. At March 31, 2006, the parent company's
invested assets consisted of $0.8 million of fixed income securities, $1.5
million of equity securities, and $9.8 million of short-term investments and
cash. 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, and
$19.2 million of short-term investments and cash. At March 31, 2006 and December
31, 2005 respectively, parent company short-term investments and cash included
$1.5 million and $6.6 million of restricted cash primarily related to premium
receipt collections ultimately due to the Company's insurance subsidiaries.
The Company's consolidated net cash flow provided by operating activities
was $14.2 million for the three months ended March 31, 2006 compared to net cash
flow provided by operating activities of $2.5 million for the comparable period
in 2005. The increase in net cash flow provided by operating activities
primarily relates to higher premiums received and lower loss payments.
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. At March 31, 2006
and December 31, 2005, the outstanding 2005 Credit Facility balance was $20.0
million. The 2005 Credit Facility matures on June 30, 2008. No other debt
matures in the next five years.
The term of the borrowings under the 2005 Credit Facility may be fixed, at
the Company's option, for a period of one, two, three, or six months. The
interest rate is based on, among other rates, the London Interbank Offered Rate
("LIBOR") plus the applicable margin. The margin, including a facility fee and
utilization fee, can vary based on the Company's leverage ratio (debt to total
capitalization) from 1.15% to 1.45%. The margin was 1.25% at March 31, 2006. As
of March 31, 2006, the weighted average interest rate on the 2005 Credit
Facility was 6.125% on the $20.0 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 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 is
in compliance with all covenants during the quarter ended March 31, 2006.
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 Condensed 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
24
Company has also guaranteed the dividend payments and redemption of the
preferred securities issued by the Issuer Trust. The maximum amount of
undiscounted future payments the Company could make under the guarantee is $75.0
million, consisting of annual dividend payments of $1.5 million over 30 years
and the redemption value of $30.0 million. Because payment under the guarantee
would only be required if the Company does not fulfill its obligations under the
debentures held by the Issuer Trust, the Company has not recorded any additional
liabilities related to this guarantee.
The subordinated debenture bears interest at a rate of LIBOR plus 337.5
basis points and matures in April of 2034. As of March 31, 2006 the interest
rate on the junior subordinated debenture was 8.12%.
A summary of the Company's commitments as of March 31, 2006 is presented in
the following table (in millions):
MARCH 31, 2006 2006 2007 2008 2009 2010 THEREAFTER TOTAL
-------------- -------- ------- ------- ------- ------ ---------- -------
Debt (a)........................................ $ 3.1 $ 3.7 $ 23.3 $ 2.5 $ 2.5 $ 89.8 $ 124.9
Operating leases................................ 1.4 1.8 1.6 1.7 1.7 2.3 10.5
Loss and loss adjustment expense reserves....... 152.0 172.1 45.7 12.2 10.0 34.2 426.2
Other long-term liabilities (b)................. 0.3 0.8 0.7 0.5 0.5 6.0 8.8
-------- ------- ------- ------- ------ ------- ------
Total........................................... $ 156.8 $ 178.4 $ 71.3 $ 16.9 $ 14.7 $ 132.3 $570.4
======== ======= ======= ======= ====== ======= ======
(a) Reflects expected principal and interest payments.
(b) Reflects unfunded postretirement benefit plans and long-term incentive plan
payments to certain executives.
As an insurance holding company, CNA Surety is dependent upon dividends and
other permitted payments from its insurance subsidiaries to pay operating
expenses, meet debt service requirements, as well as to pay cash dividends. The
payment of dividends by the insurance subsidiaries is subject to varying degrees
of supervision by the insurance regulatory authorities in South Dakota and
Texas. In South Dakota, where Western Surety and Surety Bonding are domiciled,
insurance companies may only pay dividends from earned surplus excluding surplus
arising from unrealized capital gains or revaluation of assets. In Texas, where
USA is domiciled, an insurance company may only declare or pay dividends to
stockholders from the insurer's earned surplus. The insurance subsidiaries may
pay dividends without obtaining prior regulatory approval only if such dividend
or distribution (together with dividends or distributions made within the
preceding 12-month period) is less than, as of the end of the immediately
preceding year, the greater of (i) 10% of the insurer's surplus to policyholders
or (ii) statutory net income. In South Dakota, net income includes net realized
capital gains in an amount not to exceed 20% of net unrealized capital gains.
All dividends must be reported to the appropriate insurance department prior to
payment.
The dividends that may be paid without prior regulatory approval are
determined by formulas established by the applicable insurance regulations, as
described above. The formulas that determine dividend capacity in the current
year are dependent on, among other items, the prior year's ending statutory
surplus and statutory net income. Dividend capacity for 2006 is based on
statutory surplus and income at and for the year ended December 31, 2005.
Without prior regulatory approval, CNA Surety's insurance subsidiaries may pay
stockholder dividends of $39.1 million in the aggregate in 2006. CNA Surety
received no dividends from its insurance subsidiaries during the first three
months of 2006 or 2005. CNA Surety received no dividends from its non-insurance
subsidiaries during the first three months of 2006. CNA Surety received $1.5
million in dividends, including $0.5 million in cash, from its non-insurance
subsidiaries during the first three months of 2005.
Combined statutory surplus totaled $292.1 million at March 31, 2006,
resulting in a net written premium to statutory surplus ratio of 1.3 to 1.
Insurance regulations restrict Western Surety's maximum net retention on a
single surety bond to 10 percent of statutory surplus. Under the 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 March 31,
2006, Western Surety's statutory surplus was $292.1 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. Intercompany
tax payments are made at such times when estimated tax payments would be
required by (or refunds received from) the Internal Revenue Service ("IRS"). CNA
Surety received $3.1 million and $0.7 million from its subsidiaries for the
three months ended March 31, 2006 and March 31, 2005, respectively.
25
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, January 1, 2004, January 1, 2005, and January 1, 2006 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 obligations and capital needs.
26
FINANCIAL CONDITION
INVESTMENT PORTFOLIO
The estimated fair value and amortized cost or cost of fixed income and
equity securities held by CNA Surety at March 31, 2006 and December 31, 2005, by
investment category, were as follows (dollars in thousands):
GROSS
UNREALIZED LOSSES
AMORTIZED GROSS LESS MORE ESTIMATED
COST OR UNREALIZED THAN THAN FAIR
MARCH 31, 2006 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................................................ $ 15,623 $ -- $ (318) $ (188) $ 15,117
U.S. Agencies................................................ 40,047 10 (403) (111) 39,543
Collateralized mortgage obligations.......................... 18,163 303 (439) -- 18,027
Mortgage pass-through securities............................. 43,650 55 (886) (771) 42,048
Obligations of states and political subdivisions............... 462,045 10,397 (2,731) (820) 468,891
Corporate bonds................................................ 68,725 1,434 (1,337) (530) 68,292
Non-agency collateralized mortgage obligations................. 22,197 -- (1,277) -- 20,920
Other asset-backed securities:
Second mortgages/home equity loans........................... 25,924 -- (226) (53) 25,645
Other........................................................ 5,613 73 (216) -- 5,470
Redeemable preferred stock..................................... 3,000 95 -- -- 3,095
----------- ---------- ---------- --------- ----------
Total fixed income securities................................ 704,987 12,367 (7,833) (2,473) 707,048
Equity securities.............................................. 1,323 141 -- -- 1,464
----------- ---------- ---------- --------- ----------
Total........................................................ $ 706,310 $ 12,508 $ (7,833) $ (2,473) $ 708,512
=========== ========== ========== ========= ==========
GROSS
UNREALIZED LOSSES
AMORTIZED GROSS LESS MORE ESTIMATED
COST OR UNREALIZED THAN THAN FAIR
DECEMBER 31, 2005 COST GAINS 12 MONTHS 12 MONTHS VALUE
----------------- ---------- ---------- ----------- ---------- ----------
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government
and agencies:
U.S. Treasury................................................ $ 15,637 $ -- $ (32) $ (153) $ 15,542
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
Credit card receivables...................................... --
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
=========== ========== ========== ========= ==========
27
The following table summarizes for fixed income securities in an unrealized
loss position at March 31, 2006 and 2005, 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):
MARCH 31, 2006 DECEMBER 31, 2005
----------------------------- ------------------------------
ESTIMATED GROSS ESTIMATED GROSS
UNREALIZED LOSS AGING FAIR VALUE UNREALIZED LOSS FAIR VALUE UNREALIZED LOSS
--------------------- ----------- --------------- ------------ ---------------
Fixed income securities:
0-6 months............................................ $ 124,923 $ 1,403 $ 224,117 $ 3,468
7-12 months........................................... 176,786 6,429 32,630 1,049
13-24 months.......................................... 37,416 1,380 32,429 1,105
Greater than 24 months................................ 18,538 1,094 1,089 75
----------- --------- ----------- ---------
Total ................................................ $ 357,663 $ 10,306 $ 290,265 $ 5,697
=========== ========= =========== =========
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 other-than-temporary 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 other-than-temporary impairment loss has been
recorded, the security is written down to fair value and the resulting losses
are recognized in realized gains/losses in the Condensed Consolidated Statements
of Operations.
As of March 31, 2006, 107 securities held by the Company were in an
unrealized loss position. The Company believes that 106 of these securities are
in an unrealized loss position because of changes in interest rates and
therefore expects these securities will recover in value at or before maturity.
Of these 106 securities, 80 were rated "AAA" by Standard & Poor's ("S&P") and
"Aaa" by Moody's Investor Services ("Moody's"). Only fourteen of these 106
securities were in a loss position that exceeded 5% of its book value, with the
largest unrealized loss, $0.5 million, being approximately 5.6% of that
security's book value. The largest percentage unrealized loss was approximately
8.5% of that security's book value resulting in an unrealized loss of $0.1
million.
The remaining security that was in an unrealized loss position was issued by
the financing subsidiary of a large domestic automaker. The security was in an
unrealized loss position of approximately 9% of its book value and was rated
below investment grade by S&P and 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 at maturity.
Based on the foregoing information, the Company believes there are no
other-than-temporary impairments at March 31, 2006.
IMPACT OF PENDING ACCOUNTING STANDARDS
In January 2006, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 155, "Accounting for Certain
Hybrid Financial Instruments" ("SFAS 155"). SFAS 155 amends FASB Statements No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133"), and No. 140, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities". SFAS 155 also resolves issues addressed in
SFAS 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial
Interests in Securitized Financial Assets. SFAS 155 will improve financial
reporting by eliminating the exemption from applying SFAS 133 to interests in
securitized financial assets so that similar instruments are accounted for in
the same manner regardless of the form of the instruments. SFAS 155 will also
improve financial reporting by allowing a preparer to elect fair value
28
measurement at acquisition, at issuance, or when a previously recognized
financial instrument is subject to a re-measurement (new basis) event, on an
instrument-by-instrument basis. SFAS 155 is effective for all financial
instruments acquired or issued after the beginning of an entity's first fiscal
year that begins after September 15, 2006. The fair value election provided for
in paragraph 4(c) of SFAS 155 may also be applied upon adoption of SFAS 155 for
hybrid financial instruments that had been bifurcated under paragraph 12 of SFAS
133 prior to the adoption of this Statement. Provisions of SFAS 155 may be
applied to instruments that an entity holds at the date of adoption on an
instrument-by-instrument basis. Adoption of this standard is not expected to
have a material impact on the Company's results of operations 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 losses and loss
reserves; the impact of routine ongoing insurance reserve reviews being
conducted by the Company; the routine state regulatory examinations of the
Company's primary insurance company subsidiaries, and the Company's responses to
the results of those reviews and examinations; the Company's expectations
concerning its revenues, earnings, expenses and investment activities; expected
cost savings and other results from the Company's expense reduction and
restructuring activities; and the Company's proposed actions in response to
trends in its business.
Forward-looking statements, by their nature, are subject to a variety of
inherent risks and uncertainties that could cause actual results to differ
materially from the results projected. Many of these risks and uncertainties
cannot be controlled by the Company. Some examples of these risks and
uncertainties are:
- general economic and business conditions;
- changes in financial markets such as fluctuations in interest rates,
long-term periods of low interest rates, credit conditions and
currency, commodity and stock prices;
- the ability of the Company's contract principals to fulfill their
bonded obligations;
- the effects of corporate bankruptcies on surety bond claims, as well as
on capital markets;
- changes in foreign or domestic political, social and economic
conditions;
- regulatory initiatives and compliance with governmental regulations,
judicial decisions, including interpretation of policy provisions,
decisions regarding coverage, trends in litigation and the outcome of
any litigation involving the Company, and rulings and changes in tax
laws and regulations;
- regulatory limitations, impositions and restrictions upon the Company,
including the effects of assessments and other surcharges for guaranty
funds and other mandatory pooling arrangements;
- the impact of competitive products, policies and pricing and the
competitive environment in which the Company operates, including
changes in the Company's books of business;
- product and policy availability and demand and market responses,
including the level of ability to obtain rate increases and decline or
non-renew underpriced accounts, to achieve premium targets and
profitability and to realize growth and retention estimates;
- development of claims and the impact on loss reserves, including
changes in claim settlement practices;
- the performance of reinsurance companies under reinsurance contracts
with the Company;
- results of financing efforts, including the availability of bank credit
facilities;
- changes in the Company's composition of operating segments;
29
- the sufficiency of the Company's loss reserves and the possibility of
future increases in reserves;
- the risks and uncertainties associated with the Company's loss
reserves; and,
- the possibility of further changes in the Company's ratings by ratings
agencies, including the inability to access certain markets or
distribution channels and the required collateralization of future
payment obligations as a result of such changes, and changes in rating
agency policies and practices.
Any forward-looking statements made in this report are made by the Company
as of the date of this report. The Company does not have any obligation to
update or revise any forward-looking statement contained in this report, even if
the Company's expectations or any related events, conditions or circumstances
change.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
CNA Surety's investment portfolio is subject to economic losses due to
adverse changes in the fair value of its financial instruments, or market risk.
Interest rate risk represents the largest market risk factor affecting the
Company's consolidated financial condition due to its significant level of
investments in fixed income securities. Increases and decreases in prevailing
interest rates generally translate into decreases and increases in the fair
value of the Company's fixed income portfolio. The fair value of these interest
rate sensitive instruments may also be affected by the credit-worthiness of the
issuer, prepayment options, relative value of alternative investments, the
liquidity of the instrument, income tax considerations and general market
conditions. The Company manages its exposure to interest rate risk primarily
through an asset/liability matching strategy. The Company's exposure to interest
rate risk is mitigated by the relative short-term nature of its insurance and
other liabilities. The targeted effective duration of the Company's investment
portfolio is approximately 5 years, consistent with the expected duration of its
insurance and other liabilities.
The tables below summarize the estimated effects of certain hypothetical
increases and decreases in interest rates. It is assumed that the changes occur
immediately and uniformly across each investment category. The hypothetical
changes in market interest rates selected reflect the Company's expectations of
the reasonably possible best or worst case scenarios over a one-year period. The
hypothetical fair values are based upon the same prepayment assumptions that
were utilized in computing fair values as of March 31, 2006. Significant
variations in market interest rates could produce changes in the timing of
repayments due to prepayment options available. The fair value of such
instruments could be affected and therefore actual results might differ from
those reflected in the following tables.
HYPOTHETICAL
ESTIMATED FAIR PERCENTAGE
HYPOTHETICAL VALUE AFTER INCREASE
FAIR VALUE AT CHANGE IN HYPOTHETICAL (DECREASE) IN
MARCH 31, INTEREST RATE CHANGE IN STOCKHOLDERS'
2006 (BP=BASIS POINTS) INTEREST RATE EQUITY
------------- ----------------- --------------- -------------
(DOLLARS IN THOUSANDS)
U.S. Government and government agencies and authorities...... $ 114,735 200 bp increase $ 104,193 (1.4)%
100 bp increase 109,660 (0.7)
100 bp decrease 118,429 0.5
200 bp decrease 120,942 0.8
States, municipalities and political subdivisions............ 468,891 200 bp increase 417,758 (6.8)
100 bp increase 443,210 (3.4)
100 bp decrease 495,721 3.5
200 bp decrease 524,575 7.4
Corporate bonds and all other................................ 123,422 200 bp increase 110,270 (1.7)
------------
100 bp increase 115,163 (1.1)
100 bp decrease 125,807 0.3
200 bp decrease 131,530 1.1
Total fixed income securities available-for-sale............. $ 707,048 200 bp increase 632,221 (9.9)
============
100 bp increase 668,033 (5.2)
100 bp decrease 739,957 4.3
200 bp decrease 777,047 9.2
30
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
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains a system of disclosure controls and procedures which
are designed to ensure that information required to be disclosed by the Company
in reports that it files or submits to the Securities and Exchange Commission
under the Securities and Exchange Act of 1934, including this report, is
recorded, processed, summarized and reported on a timely basis. These disclosure
controls and procedures include controls and procedures designed to ensure that
information required to be disclosed under the Exchange Act is accumulated and
communicated to the Company's management on a timely basis to allow decisions
regarding required disclosure.
The Company's principal executive officer and its principal financial
officer undertook an evaluation of the Company's disclosure controls and
procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d - 15(e)) as of
the end of the period covered by this report and concluded that the Company's
controls and procedures were effective.
There were no changes in the Company's internal control over financial
reporting that occurred during the Company's last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS - Information on the Company's legal proceedings is
set forth in Note 7 of the Condensed Consolidated Financial Statements
included under Part 1, Item 1.
ITEM 1A. RISK FACTORS - Information on the Company's risk factors is set forth
in Item 1A "Risk Factors" in the Company's Annual Report on Form 10-K for
the year-ended December 31, 2005.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS - None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES - None.
31
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS -
At the Annual Meeting of Shareholders of CNA Surety Corporation held on
April 25, 2006, the Company's shareholders voted on the following proposals.
The numbers of shares issued, outstanding and eligible to vote as of the
record date of March 1, 2006 were 43,489,474. Proxies representing
42,648,125 shares or approximately 98 percent of the eligible voting shares
were tabulated.
PROPOSAL I
Election of Directors.
NUMBER OF SHARES/VOTES
-------------------------------
FOR AUTHORITY WITHHELD
---------- ------------------
Philip H. Britt............................. 42,098,310 549,815
Roy E. Posner............................... 41,899,710 748,415
Adrian M. Tocklin........................... 41,898,678 749,447
James R. Lewis.............................. 39,242,914 3,405,211
Lori Komstadius............................. 39,241,298 3,406,827
Robert Tinstman............................. 42,099,027 549,098
John F. Welch............................... 39,242,514 3,405,611
PROPOSAL II
To approve the Company's proposed 2006 Long-Term Equity Compensation Plan.
For............................................................... 34,220,932
Against........................................................... 7,111,281
Abstain........................................................... 1,315,912
PROPOSAL III
To ratify the Board of Directors' appointment of the Company's independent
registered public accounting firm, Deloitte & Touche LLP, for fiscal year
2006.
For............................................................... 42,284,857
Against........................................................... 92,276
Abstain........................................................... 270,992
ITEM 5. OTHER INFORMATION - Reports on Form 8-K:
February 16, 2006; CNA Surety Corporation Earnings Press Release issued on
February 16, 2006
February 16, 2006; CNA Surety Corporation adoption of a new 2006 Long-Term
Equity Compensation Plan
32
ITEM 6. EXHIBITS
EXHIBIT NUMBER
--------------
Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 302 of the 31.1
Sarbanes-Oxley Act of 2002...................................................................................
Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 302 of the 31.2
Sarbanes-Oxley Act of 2002...................................................................................
Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the 32.1 *
Sarbanes-Oxley Act of 2002...................................................................................
Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the 32.2 *
Sarbanes-Oxley Act of 2002...................................................................................
* Exhibits 32.1 and 32.2 are being furnished and shall not be deemed "filed"
for the purpose of Section 18 of the Securities Exchange Act of 1934, as
amended, or otherwise subject to the liabilities of that Section. These
Exhibits shall not be incorporated by reference into any registration
statement or other document pursuant to the Securities Act of 1933, as
amended.
33
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized.
CNA SURETY CORPORATION (Registrant)
/s/ John F. Welch
-----------------------------------------------------
John F. Welch
President and Chief Executive Officer
/s/ John F. Corcoran
-----------------------------------------------------
John F. Corcoran
Senior Vice President and Chief Financial Officer
Date: May 1, 2006
34
EXHIBIT INDEX
31(1) Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act
of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002-Chief Executive Officer.
31(2) Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act
of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002 -- Chief Financial Officer.
32(1) Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002- Chief Executive
Officer.
32(2) Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002- Chief Financial
Officer.
35