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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 September 30, 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
incorporation or organization) Identification No.)
333 S. WABASH AVE., CHICAGO, ILLINOIS 60604
(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:
43,750,467 shares of Common Stock, $.01 par value as of October 20, 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 September 30, 2006 and at December 31, 2005.................................... 4
Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2006 and 2005............. 5
Condensed Consolidated Statements of Stockholders' Equity for the Nine Months Ended September 30, 2006 and 2005......... 6
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 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........................................................ 34
Item 4. Controls and Procedures........................................................................................... 36
PART II. OTHER INFORMATION:................................................................................................. 36
Item 1. Legal Proceedings................................................................................................. 36
Item 1A. Risk Factors..................................................................................................... 36
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds....................................................... 36
Item 3. Defaults Upon Senior Securities................................................................................... 36
Item 4. Submission of Matters to a Vote of Security Holders............................................................... 36
Item 5. Other Information................................................................................................. 36
Item 6. Exhibits.......................................................................................................... 37
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 (the "Corporation") as of September 30,
2006, and the related condensed consolidated statements of income for the
three-month and nine-month periods ended September 30, 2006 and 2005, and the
related condensed consolidated statements of stockholders' equity and of cash
flows for the nine-month periods ended September 30, 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 the
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 24, 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
October 31, 2006
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2006 2005
--------------- ------------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $775,891 and $710,775).................... $ 787,849 $ 722,279
Equity securities, at fair value (cost: $1,447 and $1,201)........................................ 1,572 1,306
Short-term investments, at cost (approximates fair value)......................................... 58,277 65,041
Other investments, at cost (approximates fair value).............................................. 174 965
------------- ------------
Total invested assets............................................................................. 847,872 789,591
Cash................................................................................................ 6,469 8,323
Deferred policy acquisition costs................................................................... 106,590 102,833
Insurance receivables:
Premiums, including $11,415 and $7,947 from affiliates, (net of allowance for doubtful accounts:
$1,427 and $1,490).............................................................................. 46,133 33,359
Reinsurance, including $55,428 and $53,025 from affiliates........................................ 116,280 119,670
Deposit with affiliated ceding company.............................................................. 32,731 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: $23,400 and
$24,887).......................................................................................... 24,135 19,674
Prepaid reinsurance premiums........................................................................ 3,174 5,396
Accrued investment income........................................................................... 9,907 9,522
Other assets........................................................................................ 3,004 3,174
------------- ------------
Total assets...................................................................................... $ 1,335,080 $ 1,262,614
============= ============
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses........................................................ $ 420,237 $ 424,449
Unearned premiums................................................................................. 263,268 241,047
------------- ------------
Total reserves.................................................................................... 683,505 665,496
Debt................................................................................................ 30,665 50,589
Deferred income taxes, net.......................................................................... 19,052 18,820
Current income taxes payable........................................................................ 3,063 6,459
Reinsurance and other payables to affiliates........................................................ 172 174
Accrued expenses.................................................................................... 16,228 16,532
Other liabilities................................................................................... 37,434 27,969
------------- ------------
Total liabilities................................................................................. $ 790,119 $ 786,039
Commitments and contingencies (See Notes 4, 5, 6 & 7)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 45,136 shares issued and 43,745
shares outstanding at September 30, 2006 and 44,734 shares issued and 43,334 shares outstanding
at December 31, 2005.............................................................................. 451 447
Additional paid-in capital.......................................................................... 266,559 259,684
Retained earnings................................................................................... 285,037 223,927
Accumulated other comprehensive income.............................................................. 7,854 7,546
Treasury stock, at cost............................................................................. (14,940) (15,029)
------------- ------------
Total stockholders' equity........................................................................ 544,961 476,575
------------- ------------
Total liabilities and stockholders' equity........................................................ $ 1,335,080 $ 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ----------------------
2006 2005 2006 2005
----------- ----------- ----------- ---------
Revenues:
Net earned premium......................................................... $ 102,798 $ 91,061 $ 291,727 $ 256,881
Net investment income...................................................... 9,850 8,681 29,021 24,706
Net realized investment gains (losses)..................................... (999) 108 (894) 2,124
------------ ----------- ------------ -----------
Total revenues............................................................. 111,649 99,850 319,854 283,711
----------- ----------- ----------- -----------
Expenses:
Net losses and loss adjustment expenses.................................... 21,133 19,976 69,674 104,330
Net commissions, brokerage and other underwriting expenses................. 56,527 51,891 160,954 150,593
Interest expense........................................................... 967 938 2,931 2,552
----------- ----------- ----------- -----------
Total expenses............................................................. 78,627 72,805 233,559 257,475
----------- ----------- ----------- -----------
Income before income taxes................................................... 33,022 27,045 86,295 26,236
Income tax expense........................................................... 9,402 7,262 25,185 4,313
----------- ----------- ----------- -----------
Net income................................................................... $ 23,620 $ 19,783 $ 61,110 $ 21,923
=========== =========== =========== ===========
Earnings per common share.................................................... $ 0.54 $ 0.46 $ 1.40 $ 0.51
=========== =========== =========== ===========
Earnings per common share, assuming dilution................................. $ 0.54 $ 0.46 $ 1.39 $ 0.51
=========== =========== =========== ===========
Weighted average shares outstanding.......................................... 43,558 43,168 43,602 43,174
=========== =========== =========== ===========
Weighted average shares outstanding, assuming dilution....................... 43,897 43,385 43,879 43,394
=========== =========== =========== ===========
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.......................................................... -- -- -- $ 21,923
Other comprehensive income:
Change in unrealized gains on securities, after income tax benefit
of $4,978 (net of reclassification adjustment of $1,113, after
income tax expense of $599)....................................... -- -- -- (9,246)
-----------
Total comprehensive income.......................................... $ 12,677
===========
Stock options exercised and other..................................... 244 3 2,549
------- ------- -----------
Balance, September 30, 2005........................................... 43,259 $ 447 $ 258,545
======= ======= ===========
Balance, December 31, 2005............................................ 43,334 $ 447 $ 259,684
Comprehensive income:
Net income.......................................................... -- -- -- $ 61,110
Other comprehensive income:
Change in unrealized gains on securities, after income tax expense
of $166 (net of reclassification adjustment of $892, after income
tax expense of $480).............................................. -- -- -- 308
-----------
Total comprehensive income.......................................... $ 61,418
===========
Stock-based compensation.............................................. -- -- 983
Stock options exercised and other..................................... 411 4 5,892
------- ------- -----------
Balance, September 30, 2006........................................... 43,745 $ 451 $ 266,559
======= ======= ===========
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........................................................ 21,923 -- -- 21,923
Other comprehensive income:
Change in unrealized gains on securities, after income tax benefit
of $4,978 (net of reclassification adjustment of $1,113, after
income tax expense of $599)..................................... -- (9,246) -- (9,246)
Stock options exercised and other................................... -- 87 2,639
----------- ------------ ----------- -----------
Balance, September 30, 2005......................................... $ 207,419 $ 10,305 $ (15,029) $ 461,687
=========== ============ =========== ===========
Balance, December 31, 2005.......................................... $ 223,927 $ 7,546 $ (15,029) $ 476,575
Comprehensive income:
Net income........................................................ 61,110 -- -- 61,110
Other comprehensive income:
Change in unrealized gains on securities, after income tax expense
of $166 (net of reclassification adjustment of $892, after
income tax expense of $480)..................................... -- 308 -- 308
Stock-based compensation............................................ -- -- -- 983
Stock options exercised and other................................... -- -- 89 5,985
----------- ----------- ---------- -----------
Balance, September 30, 2006......................................... $ 285,037 $ 7,854 $ (14,940) $ 544,961
=========== ============ ========== ===========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------
2006 2005
------------ -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................................................. $ 61,110 $ 21,923
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization............................................................ 3,911 3,372
Amortization of bond premium, net........................................................ 119 2,068
Loss on disposal of property and equipment............................................... 149 245
Net realized investment (gains) losses................................................... 894 (2,124)
Stock-based compensation................................................................. 983 --
Changes in:
Insurance receivables.................................................................... (9,384) 12,296
Reserve for unearned premiums............................................................ 22,221 26,101
Reserve for unpaid losses and loss adjustment expenses................................... (4,212) 42,560
Deposits with affiliated ceding company.................................................. 654 (32,332)
Deferred policy acquisition costs........................................................ (3,757) (4,614)
Deferred income taxes, net............................................................... (1,887) (886)
Reinsurance and other payables to affiliates............................................. (2) 8,533
Prepaid reinsurance premiums............................................................. 2,222 (449)
Accrued expenses......................................................................... (304) (3,306)
Other assets and liabilities............................................................. 7,808 (4,959)
------------ -----------
Net cash provided by operating activities.............................................. 80,525 68,428
------------ -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Fixed income securities:
Purchases................................................................................ (210,631) (119,603)
Maturities............................................................................... 18,730 30,071
Sales.................................................................................... 124,077 90,979
Purchases of equity securities............................................................. (1,117) (694)
Proceeds from the sale of equity securities................................................ 962 709
Changes in short-term investments.......................................................... 7,428 (62,985)
Purchases of property and equipment, net................................................... (8,444) (5,478)
Changes in receivables/payables for securities sold/purchased.............................. -- (6)
Other, net................................................................................. 631 1,522
------------ -----------
Net cash used in investing activities.................................................... (68,364) (65,485)
------------ -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Principal payments on debt................................................................. (20,000) (5,000)
Debt issuance costs........................................................................ -- (125)
Employee stock option exercises and other.................................................. 5,985 2,639
------------ -----------
Net cash used in financing activities.................................................... (14,015) (2,486)
Increase (decrease) in cash.................................................................. (1,854) 457
Cash at beginning of period.................................................................. 8,323 7,336
------------ -----------
Cash at end of period........................................................................ $ 6,469 $ 7,793
============ ===========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest................................................................................... $ 2,913 $ 2,180
Income taxes............................................................................... 27,938 10,077
The accompanying notes are an integral part of these condensed consolidated
financial statements.
7
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
1. SIGNIFICANT ACCOUNTING POLICIES
FORMATION OF CNA SURETY CORPORATION AND MERGER
In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings
Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF
with Capsure's insurance subsidiaries, Western Surety Company ("Western
Surety"), Surety Bonding Company of America ("Surety Bonding") and Universal
Surety of America ("USA"), into CNA Surety Corporation ("CNA Surety" or the
"Company"). CNAF, through its operating subsidiaries, writes multiple lines of
property and casualty insurance, including surety business that is reinsured by
Western Surety. CNAF owns approximately 63% of the outstanding common stock of
CNA Surety. Loews Corporation ("Loews") owns approximately 89% 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2006 2005 2006 2005
---------- ---------- ---------- ----------
Net income................................................. $ 23,620 $ 19,783 $ 61,110 $ 21,923
========== ========== ========== ==========
Shares:
Weighted average shares outstanding........................ 43,519 43,140 43,334 43,015
Weighted average shares of options exercised and
additional stock issuance.............................. 39 28 268 159
---------- ---------- ---------- ----------
Total weighted average shares outstanding.................. 43,558 43,168 43,602 43,174
Effect of dilutive options............................... 339 217 277 220
---------- ---------- ---------- ----------
Total weighted average shares outstanding, assuming
dilution................................................. 43,897 43,385 43,879 43,394
========== ========== ========== ==========
Earnings per share......................................... $ 0.54 $ 0.46 $ 1.40 $ 0.51
========== ========== ========== ==========
Earnings per share, assuming dilution...................... $ 0.54 $ 0.46 $ 1.39 $ 0.51
========== ========== ========== ==========
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 and nine months ended September 30,
2006. Options to purchase shares of common stock of 0.4 million were excluded
from the calculation of diluted earnings per share for the three and nine months
ended September 30, 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 Financial Accounting
Standards ("SFAS") No. 123 (revised 2004), "Share-based Payment" ("SFAS 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 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 NINE MONTHS ENDED
SEPTEMBER 30, 2005 SEPTEMBER 30, 2005
------------------ ------------------
Net income......................................................................... $ 19,783 $ 21,923
Less: Total stock-based compensation cost determined under the fair value method,
net of tax....................................................................... (94) (491)
------------ -----------
Pro forma net income............................................................... $ 19,689 $ 21,432
============ ===========
Basic and diluted earnings per share, as reported.................................. $ 0.46 $ 0.51
============ ===========
Basic earnings per share, pro forma................................................ $ 0.46 $ 0.50
============ ===========
Diluted earnings per share, pro forma.............................................. $ 0.45 $ 0.49
============ ===========
ACCOUNTING PRONOUNCEMENTS
In December of 2004, the Financial Accounting Standards Board ("FASB")
issued SFAS 123R, that amends SFAS 123, as originally issued in May of 1995.
SFAS 123R addresses the accounting for share-based payment transactions in which
an enterprise receives employee services in exchange for (a) equity instruments
of the enterprise or (b) liabilities that are based on the fair value of the
enterprise's equity instruments or that may be settled by the issuance of such
equity instruments. SFAS 123R supercedes APB 25. Under SFAS 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 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 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 123 was effective (i.e. for all
fiscal years beginning after December 15, 2004) or (b) only to prior interim
periods in the year of initial adoption if the effective date of SFAS 123R does
not coincide with the beginning of the fiscal year. SFAS 123R was effective for
the Company on January 1, 2006. The Company applied the modified prospective
transition method. The Company accounted for graded vesting using the
accelerated method. The Company applied the alternative transition method in
calculating its pool of excess tax benefits available to absorb future tax
deficiencies as provided by FSP FAS 123(R)-3, "Transition Election Related to
Accounting for
9
the Tax Effects of Share-Based Payment Awards". Adoption of SFAS 123R decreased
net income by $0.2 million and $0.6 million for the three and nine months ended
September 30, 2006.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Correction". This standard is a replacement of APB Opinion No. 20 and FASB
Standard No. 3. Under the new standard, any voluntary changes in accounting
principles should be adopted via a retrospective application of the accounting
principle in the financial statements presented in addition to obtaining an
opinion from the auditors that the new principle is preferred. In addition,
adoption of a change in accounting principle required by the issuance of a new
accounting standard would also require retroactive restatement, unless the new
standard includes explicit transition guidelines. This 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 an impact
on the Company's results of operations and/or equity.
In November of 2005, the FASB issued FASB Staff Position ("FSP") No. 115-1
and No. 124-1, "The Meaning of Other-than-Temporary Impairment and its
Application to Certain Investments" ("FSP 115-1 and 124-1"), as applicable to
debt and equity securities that are within the scope of SFAS No. 115,
"Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115")
and equity securities that are accounted for using the cost method specified in
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. FSP 115-1 and 124-1 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, FSP 115-1 and 124-1 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 was 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 did not have a material impact on the
Company's results of operations and/or equity.
In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for
Defined Benefit Pension and Other Postretirement Plans" (an amendment of FASB
Statements No. 87, 88, 106 and 132(R) ("SFAS 158"). SFAS 158 requires a company
who sponsors one or more single-employer defined benefit plans to recognize the
overfunded or underfunded status of a defined benefit postretirement plan as an
asset or liability in its statement of financial position and to recognize
changes in that funded status in the year in which the changes occur through
comprehensive income. SFAS 158 requires a company to measure benefit plan assets
and obligations as of the date of the company's fiscal year-end statement of
financial position. SFAS 158 also requires a company to disclose in the notes to
financial statements additional information about certain effects on net
periodic benefit cost for the next fiscal year that arise from delayed
recognition of the gains or losses, prior service costs or credits, and
transition asset or obligation. The requirement to recognize the funded status
of a benefit plan and the disclosure requirements are effective as of the end of
the fiscal year ending after December 15, 2006. The requirement to measure plan
assets and benefit obligations as of the date of the fiscal year-end statement
of financial position is effective for fiscal years ending after December 15,
2008. The Company is currently evaluating the impact that adopting SFAS 158 will
have on our financial condition.
2. INVESTMENTS
The estimated fair value and amortized cost or cost of fixed income and
equity securities held by CNA Surety at September 30, 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
COST GAINS MONTHS MONTHS VALUE
---------- --------- ------------ ------------ ----------
SEPTEMBER 30, 2006
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury.......................................... $ 14,846 $ -- $ (137) $ (151) $ 14,558
U.S. Agencies.......................................... 40,030 60 -- (273) 39,817
Collateralized mortgage obligations.................... 17,246 345 -- (339) 17,252
Mortgage pass-through securities....................... 40,446 76 -- (1,236) 39,286
Obligations of states and political subdivisions......... 515,553 13,982 (8) (4) 529,523
Corporate bonds.......................................... 66,936 1,465 (154) (1,061) 67,186
Non-agency collateralized mortgage obligations........... 37,068 242 -- (853) 36,457
Other asset-backed securities:
Second mortgages/home equity loans..................... 20,925 -- (38) (137) 20,750
Credit card receivables................................ 17,228 252 -- -- 17,480
Other.................................................. 5,613 70 -- (143) 5,540
---------- -------- ----------- --------- -----------
Total fixed income securities.......................... 775,891 16,492 (337) (4,197) 787,849
Equity securities........................................ 1,447 125 -- -- 1,572
---------- -------- ----------- --------- -----------
Total.................................................. $ 777,338 $ 16,617 $ (337) $ (4,197) $ 789,421
========== ======== =========== ========== ===========
10
GROSS UNREALIZED LOSSES
AMORTIZED GROSS ---------------------------- ESTIMATED
COST OR UNREALIZED LESS THAN 12 MORE THAN 12 FAIR
COST GAINS MONTHS MONTHS VALUE
---------- ---------- ------------ ------------ -----------
DECEMBER 31, 2005
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
========== ========= ========= ========== ===========
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 over the life of the security, 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.
During the third quarter of 2006, the Company recognized impairment losses
on 21 municipal fixed income securities that were in an unrealized loss
position. In response to the significant change in interest rates in the third
quarter, as well as a revised outlook on future interest rates, the Company does
not have the intention of holding these securities to their anticipated
recovery. The other-than-temporary impairment losses on these securities were
$0.9 million.
As of September 30, 2006, 65 securities held by the Company were in an
unrealized loss position. The Company believes that 64 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 65 securities, 44 were rated "AAA" by Standard & Poor's ("S&P") and
"Aaa" by Moody's Investor Services ("Moody's") and all were investment grade.
Two of these 65 securities were in a loss position that exceeded 5% of its book
value, with the largest percentage unrealized loss being approximately 6.8% of
that security's book value resulting in an unrealized loss of $0.1 million. The
largest unrealized loss was $0.4 million, which was approximately 4.7% of that
security's book value.
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 4.9% ($0.2 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.
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 SEPTEMBER 30,
------------------------------------------------
2006 2005
------------------------------------------------
WRITTEN EARNED WRITTEN EARNED
----------- ----------- ----------- -----------
Direct....................................................................... $ 85,663 $ 85,766 $ 83,428 $ 76,128
Assumed...................................................................... 30,241 28,933 30,054 28,490
Ceded........................................................................ (10,837) (11,901) (10,451) (13,557)
----------- ----------- ----------- ----------
$ 105,067 $ 102,798 $ 103,031 $ 91,061
=========== =========== =========== ==========
NINE MONTHS ENDED SEPTEMBER 30,
-----------------------------------------------
2006 2005
------------------------ ------------------------
WRITTEN EARNED WRITTEN EARNED
----------- ----------- ----------- -----------
Direct....................................................................... $ 259,015 $ 240,823 $ 242,912 $ 211,590
Assumed...................................................................... 88,932 84,903 80,407 85,628
Ceded........................................................................ (31,777) (33,999) (40,787) (40,337)
----------- ----------- ----------- -----------
$ 316,170 $ 291,727 $ 282,532 $ 256,881
=========== =========== =========== ===========
Assumed premiums primarily include all surety business written or renewed,
net of reinsurance, by CCC and CIC, which is reinsured by Western Surety
pursuant to reinsurance and related agreements.
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):
THREE MONTHS ENDED SEPTEMBER 30,
----------------------------------------
2006 2005
------------------- -------------------
$ RATIO $ RATIO
---------- ------ ---------- ------
Gross losses and loss adjustment expenses............................................ $ 9,900 8.6% $ 9,883 9.4%
Ceded amounts........................................................................ 11,233 (94.4%) 10,093 (74.4%)
---------- ----------
Net losses and loss adjustment expenses.............................................. $ 21,133 20.6% $ 19,976 21.9%
========== ==========
NINE MONTHS ENDED SEPTEMBER 30,
----------------------------------------
2006 2005
------------------ -------------------
$ RATIO $ RATIO
Gross losses and loss adjustment expenses............................................ $ 65,082 20.0% $ 106,682 35.9%
Ceded amounts........................................................................ 4,592 (13.5%) (2,352) 5.8%
---------- -----------
Net losses and loss adjustment expenses.............................................. $ 69,674 23.9% $ 104,330 40.6%
========== ===========
During the three months ended September 30, 2006 and 2005, the Company
recorded results based on independent actuarial reviews performed during the
respective quarters which indicated that gross reserves should be reduced by
approximately $17.0 million and $15.0 million, respectively. This adjustment
reflects changes in estimates of incurred-but-not-reported reserves. The
corresponding change in ceded reserves was such that net reserves were reduced
by $5.1 million and $3.4 million for the three months ended September 30, 2006
and 2005, respectively. These actions resulted in the unusual relationships in
the gross and ceded amounts shown above.
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 primary 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.
12
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 all 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 the
Merger Date 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 the Merger Date through
September 30, 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 September 30, 2006
and December 31, 2005, the Company had billed and received $45.9 million under
the Stop Loss Contract. As of September 30, 2006, the Company had an estimated
unpaid loss recoverable balance of approximately $2.0 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 September 30, 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 were ceded under this contract, which was not
renewed for 2006.
As of September 30, 2006 and December 31, 2005, CNA Surety had an
insurance receivable balance from CCC and CIC of $66.8 million and $61.0
million, respectively. CNA Surety had no reinsurance payables to CCC and CIC as
of September 30, 2006 and December 31, 2005.
13
4. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the reserves for unpaid losses and loss adjustment expenses
was as follows (dollars in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ---------------------
2006 2005 2006 2005
---------- ---------- ---------- ---------
Reserves at beginning of period:
Gross........................................................... $ 435,725 $ 402,769 $ 424,449 $ 363,387
Ceded reinsurance............................................... 155,237 114,212 147,435 116,831
---------- ---------- ---------- ---------
Net reserves at beginning of period......................... 280,488 288,557 277,014 246,556
---------- ---------- ---------- ---------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period.............. 26,266 23,403 74,974 107,630
Decrease in provision for insured events of prior periods... (5,133) (3,427) (5,300) (3,300)
---------- ---------- ---------- ---------
Total net incurred.......................................... 21,133 19,976 69,674 104,330
---------- ---------- ---------- ---------
Net payments attributable to:
Current period events....................................... 2,525 1,444 4,076 2,375
Prior period events......................................... 21,929 3,099 65,445 44,521
---------- ---------- ---------- ---------
Total net payments.......................................... 24,454 4,543 69,521 46,896
---------- ---------- ---------- ---------
Net reserves at end of period................................... 277,167 303,990 277,167 303,990
Ceded reinsurance at end of period.............................. 143,070 101,957 143,070 101,957
---------- ---------- ---------- ---------
Gross reserves at end of period............................. $ 420,237 $ 405,947 $ 420,237 $ 405,947
========== ========== ========== =========
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 provided an aggregate of up to
$50.0 million in borrowings under a revolving credit facility. In the third
quarter of 2006, the outstanding 2005 Credit Facility balance of $20.0 million
was paid. Also, in September 2006, the Company reduced the available aggregate
revolving credit facility to $25.0 million in borrowings. 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%. There was no outstanding balance under the
2005 Credit Facility at September 30, 2006. As such, there was no applicable
margin and the weighted average interest rate was 0.325% at September 30, 2006.
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 as of and for the period ended September 30,
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 September 30, 2006 the interest
rate on the junior subordinated debenture was 8.78%.
14
6. EMPLOYEE BENEFITS
CNA Surety established the CNA Surety Corporation Deferred Compensation
Plan (the "2000 Plan"), effective April 1, 2000. The Company established and
maintains the 2000 Plan as an unfunded, non-qualified 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 non-qualified
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):
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
--------------------------------- -----------------------------------
2006 2005 2006 2005
------------ ------------ ----------- ------------
Net periodic benefit cost:
Service cost...................... $ 46 $ 107 $ 194 $ 181
Interest cost..................... 152 233 438 382
Prior service cost................ (41) (40) (121) (121)
Recognized net actuarial loss..... 78 145 203 145
------------ ------------ ----------- ------------
Net periodic benefit cost......... $ 235 $ 445 $ 714 $ 587
============ ============ =========== ============
The Company expects to contribute $0.2 million to the postretirement
benefit plans to pay benefits in 2006. As of September 30, 2006, $0.2 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 and $1.0 million for the three and nine
months ended September 30, 2006. The total income tax benefit recognized in the
income statement for stock-based compensation arrangements was $0.1 million and
$0.3 million for the three and nine months ended September 30, 2006. The amount
of cash received from the exercise of stock options was $1.0 million and $0.4
million for the three months ended September 30, 2006 and September 30, 2005,
respectively, and $5.8 million and $2.8 million for the nine months ended
September 30, 2006 and September 30, 2005, respectively.
EQUITY COMPENSATION PLANS
The Company previously 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"). No options were granted under the 1997 Plan
during the three and nine months ended September 30, 2006.
15
The Company's 2006 Long-Term Equity Compensation Plan (the "2006 Plan"),
approved by shareholders on April 25, 2006, replaced the 1997 Plan. Incentive
stock options, non-qualified stock options, restricted stock, bonus shares, or
SARs may be granted to directors, officers, employees and certain advisors of
the Company under the 2006 Plan. The aggregate number of shares initially
available for which options may be granted under the 2006 Plan was 3,000,000.
The 2006 Plan is administered by a committee (the "Committee") of the
Board of Directors, consisting of two or more directors of the Company. Subject
to the provisions set forth in the 2006 Plan, all of the members of the
Committee shall be independent members of the Board of Directors. 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 2006 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 2006
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 2006 Plan during the three and nine
months ended September 30, 2006. As of September 30, 2006, the number of shares
available for granting of options under the 2006 Plan was 3,000,000.
A summary of the status of the Company's outstanding options as of
September 30, 2006 and changes during the nine months ended September 30, 2006
is presented below:
WEIGHTED
AVERAGE
SHARES OPTION
SUBJECT PRICE PER
TO OPTION SHARE
--------- ----------
Outstanding options at January 1, 2006............................ 1,587,909 $ 12.41
Options granted............................................... -- $ --
Options forfeited/expired..................................... (50,450) $ 13.05
Options exercised............................................. (401,859) $ 13.21
---------
Outstanding options at September 30, 2006......................... 1,135,600 $ 12.09
=========
A summary of the status of the Company's non-vested options as of
September 30, 2006 and changes during the nine months ended September 30, 2006
is presented below:
SHARES AVERAGE
SUBJECT GRANT-DATE
TO OPTION FAIR VALUE
--------- ----------
Non-vested options at January 1, 2006............................. 785,845 $ 11.91
Options granted............................................... -- --
Options vested................................................ (14,750) $ 9.93
Options forfeited............................................. (29,175) $ 12.32
---------
Non-vested options at September 30, 2006.......................... 741,920 $ 11.93
=========
The following table summarizes information about stock options outstanding
at September 30, 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......... 357,000 6.1 years $ 9.86 190,075 $ 10.22
$12.06 to $15.875....... 778,600 7.5 years $ 13.12 203,005 $ 14.44
The aggregate intrinsic value of options outstanding and options
exercisable at September 30, 2006 were $9.2 million and $3.1 million,
respectively. The total intrinsic value of options exercised during the three
and nine months ended September 30, 2006 was $0.3 million and $1.6 million,
respectively.
As of September 30, 2006, there was $1.0 million of total unrecognized
compensation cost related to non-vested stock-based compensation arrangements
granted under the Company's equity compensation plans. That cost is expected to
be recognized as follows: remainder of 2006 - $0.2 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, goodwill and other intangible
assets, recognition of premium revenue and the related unearned premium
liability, and deferred policy acquisition costs. The Company's accounting
policies related to reserves for unpaid losses and loss adjustment expenses and
related estimates of reinsurance recoverables are particularly critical to an
assessment of the Company's financial results. Given the nature of the surety
business, the determination of these balances is inherently a highly subjective
exercise, which requires management to analyze, weigh, and balance numerous
macroeconomic, customer specific, and claim specific factors and trends, most of
which, in themselves, are inherently uncertain and difficult to predict.
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 IBNR reserves include provisions for losses in excess of the current
case reserve for previously reported claims and for claims that may be reopened.
The IBNR reserves also include offsets for anticipated salvage and subrogation
recoveries. The following table shows the estimated liability as of September
30, 2006 for unpaid claims applicable to reported claims and to IBNR for each
sub-line of business (dollars in thousands):
17
GROSS CASE LOSS GROSS IBNR LOSS TOTAL GROSS
AND LAE RESERVES AND LAE RESERVES RESERVES
---------------- ------------------ --------------
Contract............. $ 120,781 $ 130,899 $ 251,680
Commercial........... 108,532 47,763 156,295
Fidelity and other... 5,156 7,106 12,262
---------------- ------------------ --------------
Total................ $ 234,469 $ 185,768 $ 420,237
================ ================== ==============
The Company retains an independent actuarial firm of national standing to
perform periodic actuarial analyses of the Company's loss reserves. These
analyses typically include a comprehensive review performed in the third quarter
based on data as of June 30 and an update of the comprehensive review performed
in January based on data as of December 31. In between these analyses,
management monitors claim activity against benchmarks prepared by the
independent actuarial firm based on expected claim activity and consults with
the actuarial firm as necessary.
The independent actuarial firm's analyses are based upon multiple
projection methodologies that involve detailed statistical analysis of past
claim reporting, settlement activity, and salvage and subrogation activity, as
well as claim frequency and severity data when sufficient information exists to
lend statistical credibility to the analysis. The analysis may be based upon
internal loss experience or industry experience. Methodologies may vary
depending on the type of claim being estimated. While methodologies may vary,
each employs significant judgments and assumptions.
In estimating the unpaid claim liabilities, the independent actuarial firm
employed the following projection methodologies:
- Historical development method, sometimes referred to as a link ratio
method;
- Bornhuetter-Ferguson method on both a paid and incurred basis;
- Average hindsight outstanding projection method;
- Frequency-severity method; and
- Loss ratio method.
The following provides a summary of these projection methodologies:
Historical Development Method
As a group of claims matures, their collective value changes. This change
in value over time is referred to as loss development. The loss development
method is a traditional actuarial approach which relies on the historical
changes in losses from one evaluation point to another to project the current
valuation of losses to ultimate settlement values. Development patterns which
have been exhibited by more mature (older) years are used to estimate the
expected development of the less mature (more recent) years. The strength of
this method is that it is very responsive to emerging loss experience for each
accident year. The weakness is that this method can become highly leveraged and
volatile for less mature accident years.
Bornhuetter-Ferguson Method
The incurred Bornhuetter-Ferguson ("B-F") method is commonly used to
provide a more stable estimate of ultimate losses in situations where loss
development is volatile, substantial and/or immature. The method calculates IBNR
(or unpaid loss when conducting a paid B-F projection) directly as the product
of:
Expected Ultimate Losses multiplied by IBNR (or Unpaid) Percentage.
The IBNR (or unpaid) percentage is derived from the incurred (or paid) loss
development patterns. Various approaches can be used to determine the expected
ultimate losses (e.g., prior year estimates, pricing assumptions, etc.). To
obtain an estimate of expected ultimate losses, the independent actuarial firm
utilized an expected loss ratio (ultimate losses divided by earned premium)
based on review of prior accident years' loss ratio experience. This estimate
was then applied to the more recent accident years' earned premium. The strength
of the B-F method is that it is less leveraged than the historical development
method and thus does not result in an overreaction to an unusual claim
occurrence (or an unusual lack of claims). The weakness of the method is that it
is reliant on an initial expectation of ultimate losses.
18
Average Hindsight Outstanding Method
This method relies on the older, more mature accident years' ultimate loss
estimates to restate what the outstanding losses should have been, with
hindsight, by accident year by stage of development. These restated hindsight
outstanding losses are then trended to the appropriate cost levels for the
accident years being projected and added to the paid to date losses in order to
generate indicated ultimate losses for the more recent accident years. The
strength of this method is that it is relatively unaffected by changes in a
company's case reserving practices. The weaknesses of this method are that it is
sensitive to payment pattern shifts and that the average hindsight severities
can become highly variable for certain datasets.
Frequency-Severity Method
This method first projects the expected number of claims for each accident
year and then multiplies this estimate by the expected average cost of claims
for the applicable accident year. The number of claims can be projected using
the historical development technique or other methodology. The average cost of
claims for the more recent accident years is estimated by observing the
estimated average cost of claims for the older more mature accident years and
trending those values to appropriate cost levels for the more recent accident
years. The strength of this method is that it is not reliant on loss development
factors for less mature accident years which can become highly leveraged and
volatile. The weakness is that this method is slow to react to an abrupt change
in claim severities.
Loss Ratio Method
This method relies on historical projected ultimate loss ratios for the
more mature accident years to estimate the more recent, less mature accident
years' ultimate losses. Applying a selected loss ratio (by reviewing more mature
years) to the more recent years' earned premium results in an indication of the
more recent years' ultimate losses. The strength of this method is that it can
be used in connection with a company's pricing targets and can be used when the
historical data has limited credibility. The weakness of this method is that it
is slow to react to the emerging loss experience for a particular accident year.
Each of the projection methodologies employed rely to varying degrees on
the basic assumption that the Company's historical claim experience is
indicative of the Company's future claim development. The amount of weight given
to any individual projection method is based on an assessment of the volatility
of the historical data and development patterns, an understanding of the changes
in the overall surety industry over time and the resultant potential impact of
these changes on the Company's prospective claims development, an understanding
of the changes to the Company's processes and procedures within its
underwriting, claims handling and data systems functions, among other things.
The decision as to how much weight to give to any particular projection
methodology is ultimately a matter of experience and professional judgment.
Surety results, especially for contract and certain commercial products
like insurance program bonds, workers compensation insurance bonds and
reclamation bonds, tend to be impacted by fewer, but more severe, losses. With
this type of loss experience, it is more difficult to estimate the required
reserves, particularly for the most current accident years which may have few
reported claims. Therefore, assumptions related to the frequency and magnitude
of severe loss are key in estimating surety loss reserves. The Company
experienced a period of unusually high frequency of severe loss in accident
years 2002 and 2003. In response to this activity, the independent actuarial
firm included higher expectations of severe losses in its analysis for 2004. The
Company's claim experience improved dramatically since 2004. As a result, the
independent actuarial firm's current analysis places less reliance on the severe
loss experience in accident years 2002 and 2003.
The indicated reserve was developed by reviewing the Company's claims
experience by accident year for several individual sub-lines of business. Within
each sub-line, the selection of the point estimate was made after consideration
of the appropriateness of the various projection methodologies in light of the
sub-line's loss characteristics and historical data. In general, for the older,
more mature, accident years the historical development method (i.e., link ratio
method) was relied upon more heavily. For the more recent years, the indicated
reserves were more heavily based on the Bornhuetter-Ferguson and loss ratio
methods since these are not as reliant on the Company's large (i.e., leveraged)
development factors and thus are believed to represent a more stable set of
methods from which to select indicated reserves for the more recent years.
The independent actuarial firm's analysis is the primary tool that
management utilizes in determining its best estimate of loss reserves. However,
the carried reserve may differ from the independent actuarial firm's point
estimate as a result of management's consideration of the impact of factors such
as the following, especially as they relate to the current accident year:
19
- Current claim activity, including the frequency and severity of
current claims;
- Changes in underwriting standards and business mix such as the
Company's efforts to reduce exposures to large commercial bonds;
- Changes in the claims handling process; and
- Current economic conditions, especially corporate default rates and
the condition of the construction economy.
Management believes that the impact of the factors listed above, and
others, may not be fully quantifiable through actuarial analysis. Accordingly,
management may apply its judgment of the impact of these factors, and others, to
its selection of the recorded loss reserves.
The following table shows the point estimate as determined by the
Company's independent actuarial firm at December 31, 2005 and as of their most
recent analysis, June 30, 2006, compared to the actual loss reserve established
by management, both gross and net of reinsurance (dollars in thousands):
Gross Basis:
Recorded loss reserves at December 31, 2005............. $ 424,449
Actuarial point estimate at December 31, 2005........... 428,238
----------
Difference at December 31, 2005......................... $ (3,789)
==========
Difference as a % of actuarial point estimate........... (0.9)%
Recorded loss reserves at June 30, 2006................. $ 435,725
Actuarial point estimate at June 30, 2006............... 419,080
----------
Difference at June 30, 2006............................. $ 16,645
==========
Difference as a % of actuarial point estimate........... 4.0%
Recorded loss reserves at September 30, 2006............ $ 420,237
==========
Net Basis:
Recorded loss reserves at December 31, 2005............. $ 277,015
Actuarial point estimate at December 31, 2005........... 278,617
----------
Difference at December 31, 2005......................... $ (1,602)
==========
Difference as a % of actuarial point estimate........... (0.6)%
Recorded loss reserves at June 30, 2006................. $ 280,488
Actuarial point estimate at June 30, 2006............... 276,110
----------
Difference at June 30, 2006............................. $ 4,378
==========
Difference as a % of actuarial point estimate........... 1.6%
Recorded loss reserves at September 30, 2006............ $ 277,167
==========
At December 31, 2005, management's recorded reserves were slightly lower
than the point estimates determined by the independent actuarial firm, with the
difference being somewhat larger on a gross basis. At December 31, 2005,
management believed that improved economic conditions, lower corporate default
rates, reduced exposure to large commercial bonds and fewer reported severe
claims indicated that a lower provision for severe losses was appropriate.
Management believed that the actuarial point estimates included provisions for
severe losses that were more heavily influenced by the Company's experience in
accident years 2002 and 2003 and did not fully reflect the favorable economic
conditions and changes in the Company's exposures. While there still is a
significant amount of uncertainty regarding the ultimate cost of claims for
accident years 2004 and prior, the independent actuarial firm's analyses
performed in 2005 did indicate improvement in those accident years which was
consistent with management's position concerning the recorded loss reserves at
December 31, 2004.
The conclusion of the independent actuarial firm's analyses conducted
during the third quarter with data as of June 30, 2006 resulted in lower point
estimates, confirming the positive loss trends noted by management. These
positive loss trends include improvement in the 2005 accident year primarily due
to fewer reported severe claims. During the third quarter, management recorded
favorable development on prior accident years of $5.1 million on a net basis
based on the redundancy indicated by the most recent actuarial analysis and the
continuation of positive loss experience in the third quarter.
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
20
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.
Casualty insurance loss reserves are subject to a significant amount of
uncertainty. Given the nature of surety losses with its low frequency, high
severity characteristics, this is particularly true for surety loss reserves. As
a result, the range of reasonable loss reserve estimates may be broader than
that associated with traditional property/casualty insurance products. While the
loss reserve estimates represent the best professional judgments, arrived at
after careful actuarial analysis of the available data, it is important to note
that variation from the estimates is not only possible but, in fact, probable.
The degree of such variation could be significant and in either direction from
the estimates and could result in actual losses outside of the estimated reserve
range. The sources of this inherent variability are numerous - future economic
conditions, court decisions, legislative actions, and individual large claim
impacts, for example.
The range of reasonable reserve estimates is not intended to reflect the
maximum and/or minimum possible outcomes; but rather reflects a range of
reasonable estimates given the uncertainty in estimating unpaid claim
liabilities for surety business. Further, there is no generally accepted method
to estimating reserve ranges, but rather many concepts are currently being
vetted within actuarial literature.
In developing the indicated range of reserve estimates for the Company,
the independent actuarial firm utilized the Mack methodology and their point
estimate analysis in order to estimate the requisite reserve distribution
parameters. The Mack methodology is premised on the idea that the volatility in
a company's historical paid loss development is representative of the
variability in a company's future payments and thus can be used to estimate the
variability within a company's reserve estimate. Given the dispersion of the
reserve indications, along with its experience and professional judgment, the
independent actuarial firm selected the 50th and 75th percentile as representing
a reasonable range of reserve estimates.
At December 31, 2005, the range of reasonable loss reserve estimates, net
of reinsurance receivables, calculated by the independent actuarial firm and
adopted by management was from $229 million to $325 million. The 2006 interim
review of loss reserves includes only a point estimate calculation and no update
of the reserve range. A new reserve range will be calculated as a part of the
December 31, 2006 actuarial review. Ranges of reasonable loss reserve estimates
are not calculated for the sub-lines of business. Management believes that the
range calculated over total reserves provides the most meaningful information
due to the importance of correlation of losses between the sub-lines of business
related to the impact of general economic conditions.
The primary factors that would result in the Company's actual losses being
closer to either end of the reserve range is the emergence of (or lack thereof)
a small number of large claims, as well as the recovery of (or lack thereof) a
small number of large salvage/subrogation amounts. In other words, the primary
factors that, if they were to occur, would result in the Company's actual
payments being at the high end of the indicated range are if the Company
experiences an unusually high number of large claims and/or an unusually low
number of large salvage and subrogation recoveries. Conversely, if the Company
were to experience an unusually low number of large claims and/or an unusually
high number of large salvage and subrogation recoveries, the Company's actual
payments would tend to be at the low end of the range. These variations in
outcomes could be driven by broader issues such as the state of the construction
economy or the level of corporate defaults, or by the specific facts and
circumstances surrounding individual claims. Again, it is important to note that
it is possible that the actual payments could fall outside of the estimated
range.
The Company's Condensed Consolidated Balance Sheets includes estimated
liabilities for unpaid losses and loss adjustment expenses of $420.2 million and
$424.4 million and reinsurance receivables related to unpaid losses of $143.0
million and $147.4 million at September 30, 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
21
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
over the life of the security. Such amortization and accretion are included in
investment income. For mortgage-backed and certain asset-backed securities, the
Company recognizes income using the effective-yield method based on estimated
cash flows. All securities transactions are recorded on the trade date.
Investment gains or losses realized on the sale of securities are determined
using the specific identification method. Investments with an
other-than-temporary decline in value are written down to fair value, resulting
in losses that are included in realized investment gains and losses.
Short-term investments, which generally include U.S. Treasury bills,
corporate notes, money market funds, and investment grade commercial paper
equivalents, are carried at amortized cost that approximates fair value.
Invested assets are exposed to various risks, such as interest rate risk, market
risk and credit risk. Due to the level of risk associated with invested assets
and the level of uncertainty related to changes in the value of these assets, it
is possible that changes in risks in the near term may significantly affect the
amounts reported in the Condensed Consolidated Balance Sheets and Condensed
Consolidated Statements of Income.
INTANGIBLE ASSETS
CNA Surety's Condensed Consolidated Balance Sheet as of September 30, 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
asset impairment tests. Such tests are performed annually on October 1, or more
frequently if events or changes indicate that the estimated fair value of an
intangible asset 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.
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
22
performance of the Company's insurance operations. The Company's investment
portfolio is monitored through analysis of various quantitative and qualitative
factors and certain decisions related to the sale or impairment of investments
that produce realized gains and losses, which is also a component used in the
calculation of net income and is a non-GAAP financial measure.
Underwriting results are computed as net earned premiums less net loss and
loss adjustment expenses and net commissions, brokerage and other underwriting
expenses. Management uses underwriting results to monitor its insurance
operations' results without the impact of certain factors, including net
investment income, net realized investment gains (losses) and interest expense.
Management excludes these factors in order to analyze the direct relationship
between net earned premiums and the related net loss and loss adjustment
expenses along with net commissions, brokerage and other underwriting expenses.
Operating ratios are calculated using insurance results and are widely
used by the insurance industry and regulators such as state departments of
insurance and the National Association of Insurance Commissioners for financial
regulation and as a basis of comparison among companies. The ratios discussed in
the Company's MD&A are calculated using GAAP financial results and include the
net loss and loss adjustment expense ratio ("loss ratio") as well as the net
commissions, brokerage and other underwriting expense ratio ("expense ratio")
and combined ratio. The loss ratio is the percentage of net incurred losses and
loss adjustment expenses to net earned premiums. The expense ratio is the
percentage of net commissions, brokerage and other underwriting expenses,
including the amortization of deferred acquisition costs, to net earned
premiums. The combined ratio is the sum of the loss and expense ratios.
The Company's investment portfolio is monitored by management through
analysis of various factors including unrealized gains and losses on securities,
portfolio duration and exposure to interest rates, and market and credit risk.
Based on such analyses, the Company may impair an investment security in
accordance with its policy, or sell a security. Such activities will produce net
realized investment gains and losses.
While management uses various GAAP and non-GAAP financial measures to
monitor various aspects of the Company's performance, net income is the most
directly comparable GAAP measure and represents a more comprehensive measure of
operating performance. Management believes that its process of evaluating
performance through the use of these non-GAAP financial measures provides a
basis for enhanced understanding of the operating performance and the impact to
net income as a whole. Management also believes that investors may find these
widely used financial measures described above useful in interpreting the
underlying trends and performance, as well as to provide visibility into the
significant components of net income.
COMPARISON OF CNA SURETY RESULTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER
30, 2006 AND 2005
ANALYSIS OF NET INCOME
Net income for the three months ended September 30, 2006 was $23.6
million, or $0.54 per share, compared to $19.8 million, or $0.46 per share, for
the same period in 2005. The increase in net income reflects higher earned
premium, higher investment income, and the impacts of lower loss and expense
ratios. The components of net income are discussed in the following sections.
Net income for the nine months ended September 30, 2006 was $61.1 million,
or $1.40 per share, compared to $21.9 million, or $0.51 per share, in 2005. The
increase in net income reflects the absence of a $40.0 million pre-tax ($26.0
million after-tax) charge in 2005 to establish a reserve for contract surety
losses related to the large national contractor described in the Company's
previous public filings. Other positive impacts included higher earned premium,
higher investment income, and a lower expense ratio.
RESULTS OF INSURANCE OPERATIONS
Underwriting components for the Company for the three and nine months
ended September 30, 2006 and 2005 are summarized in the following table (dollars
in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
2006 2005 2006 2005
---------- ---------- ---------- ----------
Gross written premiums.......................... $ 115,904 $ 113,482 $ 347,947 $ 323,319
========== ========== ========== ==========
Net written premiums............................ $ 105,067 $ 103,031 $ 316,170 $ 282,532
========== ========== ========== ==========
Net earned premiums............................. $ 102,798 $ 91,061 $ 291,727 $ 256,881
========== ========== ========== ==========
Net losses and loss adjustment expenses......... $ 21,133 $ 19,976 $ 69,674 $ 104,330
========== ========== ========== ==========
Net commissions, brokerage and other expenses... $ 56,527 $ 51,891 $ 160,954 $ 150,593
========== ========== ========== ==========
23
Loss ratio..................................... 20.6% 21.9% 23.9% 40.6%
Expense ratio.................................. 55.0 57.0 55.2 58.6
-------- -------- --------- ---------
Combined ratio................................. 75.6% 78.9% 79.1% 99.2%
======== ======== ========= =========
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 Continental Casualty Company ("CCC") and The Continental
Insurance Company ("CIC"), and their affiliates, after September 30, 1997 (the
"Merger Date") that is reinsured by Western Surety Company ("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 SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2006 2005 2006 2005
-------- -------- -------- --------
Contract .......................... $ 74,444 $ 71,044 $220,646 $194,179
Commercial ........................ 33,862 33,568 102,734 102,069
Fidelity and other................. 7,598 8,870 24,567 27,071
-------- -------- -------- --------
$115,904 $113,482 $347,947 $323,319
======== ======== ======== ========
For the quarter ended September 30, 2006, gross written premiums increased
2.1 percent to $115.9 million as compared to the quarter ended September 30,
2005. Gross written premiums for contract surety increased 4.8 percent to $74.4
million primarily due to increased demand as a result of the strong construction
economy and growth in contract size due to cost inflation within the
construction industry. Gross written premiums for commercial surety increased
0.9 percent to $33.9 million due to growth in large commercial products. Small
commercial premiums decreased slightly as a decline in production of notary
bonds resulting from a loss of a large notary program offset growth in other
commercial products. Fidelity and other premiums decreased by 14.3 percent, due
to a decline in production of notary errors and omissions policies related to
the notary program noted above.
For the nine months ended September 30, 2006, gross written premiums
increased 7.6 percent to $347.9 million as compared to the nine-month period
ended September 30, 2005. Gross written premiums for contract surety increased
13.6 percent to $220.6 million primarily due to increased demand as a result of
the strong construction economy and growth in contract size due to cost
inflation within the construction industry. Commercial surety and related
fidelity and other premiums decreased 1.4 percent to $127.3 million as a decline
in production of notary bonds and notary errors and omissions policies resulting
from the loss of a large notary program discussed above offset growth in other
commercial and related products.
Net written premiums are summarized in the following table (dollars in
thousands):
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------- -------------------------------
2006 2005 2006 2005
------------ ------------ ------------ ------------
Contract ....................... $ 64,896 $ 61,732 $ 192,299 $ 157,847
Commercial ..................... 32,573 32,429 99,304 97,614
Fidelity and other.............. 7,598 8,870 24,567 27,071
------------ ------------ ------------ ------------
$ 105,067 $ 103,031 $ 316,170 $ 282,532
============ ============ ============ ============
For the quarter ended September 30, 2006, net written premiums increased
2.0 percent to $105.1 million as compared to the third quarter of 2005,
primarily due to the increase in gross written premiums as described above.
24
For the nine months ended September 30, 2006, net written premiums
increased 11.9 percent to $316.2 million, primarily due to the increase in gross
written premiums described above and a decrease in ceded written premiums. Ceded
written premiums decreased $9.0 million to $31.8 million for the first nine
months of 2006 compared to the same period last year. This decrease reflects the
Company's decision not to renew a high-level excess of loss reinsurance treaty
and cost savings on the 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 primary 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 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 all 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 the Merger
Date by agreeing to pay Western Surety, within 30 days following the end of each
calendar quarter, the amount of any adverse development on such reserves, as
re-estimated as of the end of such calendar quarter. There was no adverse
reserve development for the period from September 30, 1997 (date of inception)
through September 30, 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 September 30, 2006
and December 31, 2005, the Company had billed and received $45.9 million under
the Stop Loss Contract. As of September 30, 2006, the Company had an estimated
unpaid loss recoverable balance of approximately $2.0 million under the Stop
Loss Contract.
25
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 September 30, 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 were ceded under this contract, which was not
renewed for 2006.
NET LOSS RATIO
The net loss ratio was 20.6% for the three months ended September 30, 2006
as compared with 21.9% for the same period in 2005. The improved loss ratio
includes favorable development on prior accident years, as confirmed by our
independent loss reserve review, of $5.1 million or approximately 5 percentage
points compared to $3.4 million or approximately 4 percentage points in the same
period last year. The favorable development was primarily due to decreased
severity of contract claims in the 2005 accident year.
The net loss ratio was 23.9% for the nine months ended September 30, 2006
as compared with 40.6% for the same period in 2005. The improved loss ratio
primarily reflects the absence of the reserve charge related to the large
national contractor and overall improved claim experience.
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 within certain exposure ranges. However, total large
commercial account exposure has increased 9.1 percent in the nine months ended
September 30, 2006.
NUMBER OF ACCOUNTS TOTAL EXPOSURE (DOLLARS IN MILLIONS)
AS OF AS OF
----------------------------- --------------------------------------------
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, DECEMBER 31, % INCREASE
COMMERCIAL ACCOUNT EXPOSURE 2006 2005 2006 2005 (REDUCTION)
----------------------------- ------------- ------------ ------------- ------------ ------------
$100 million and larger...... 2 2 $ 233.6 $ 246.6 (5.3)%
$50 to $100 million.......... 3 2 193.4 137.6 40.6%
$25 to $50 million........... 7 9 238.1 307.7 (22.6)%
$10 to $25 million........... 38 32 575.4 445.6 29.1%
-- -- ------------ -----------
Total........................ 50 45 $ 1,240.5 $ 1,137.5 9.1%
== == ============ ===========
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.
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.
26
EXPENSE RATIO
The expense ratio was 55.0% for the three months ended September 30, 2006 as
compared with 57.0% for the same period in 2005. The expense ratio was 55.2% for
the nine months ended September 30, 2006 as compared with 58.6% for the same
period in 2005. The improvement in both ratios reflects the impact of a decrease
in ceded earned premium and the strong premium growth accomplished with minimal
increases in underwriting expenses.
INVESTMENT INCOME AND REALIZED INVESTMENT GAINS/LOSSES
Net investment income was $9.8 million for the three months ended
September 30, 2006, as compared with $8.7 million for the same period in 2005.
This is due to the increase in invested assets in 2005 and 2006 and higher
yields. The annualized pre-tax yield was 4.5% and 4.3% for the three months
ended September 30, 2006 and 2005, respectively. The annualized after-tax yield
was 3.8% and 3.6% for the three months ended September 30, 2006 and 2005,
respectively. Net realized investment losses were $1.0 million for the quarter
ended September 30, 2006 compared to net realized investment gains of $0.1
million in the same period of 2005. This decrease was primarily due to the
recognition of impairment losses on certain fixed income securities, which are
discussed in detail later in the Financial Condition section of this MD&A.
Net investment income was $29.0 million for the nine months ended
September 30, 2006 as compared with $24.7 million for the same period in 2005.
The increase is due to the impact of higher overall invested assets and higher
yields. The annualized pre-tax yields were 4.5% and 4.3% for the nine months
ended September 30, 2006 and 2005, respectively. The annualized after-tax yields
were 3.7% and 3.6% for the nine months ended September 30, 2006 and 2005,
respectively. Net realized investment losses were $0.9 million for the first
nine months of 2006 compared to net realized investment gains of $2.1 million in
the same period of 2005. This decrease was primarily due to the recognition of
impairment losses on certain fixed income securities as noted above and the
absence of the realized investment gain from the Company's sale of its interest
in De Montfort Group, Ltd. in 2005.
The following summarizes net realized investment gains (losses) activity
(dollars in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- -----------------------
2006 2005 2006 2005
-------- -------- -------- ---------
Gross realized investment gains............................ $ 41 $ 109 $ 155 $ 2,280
Gross realized investment losses........................... (1,040) (1) (1,049) (156)
------- ------- ------- --------
Net realized investment gains (losses)..................... $ (999) $ 108 $ (894) $ 2,124
======= ======= ======= ========
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 3.1 percent for the three months ended
September 30, 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 $44.1 million for the three
months ended September 30, 2006 as compared with $60.9 million for the same
period in 2005. The weighted average interest rate for the three months ended
September 30, 2006 was 8.0% as compared with 5.9% for the same period in 2005.
Interest expense increased by 14.9 percent for the nine months ended
September 30, 2006 as compared with the same period in 2005. Weighted average
debt outstanding was $48.6 million for the nine months ended September 30, 2006
compared to $62.6 million in the same period in 2005. The weighted average
interest rate for the nine months ended September 30, 2006 was 7.5% as compared
with 5.3% for the same period in 2005.
27
INCOME TAXES
For the three and nine months ended September 30, 2006, the Company's
effective tax rate differs from the statutory tax rate due primarily to
tax-exempt investment income. Tax-exempt investment income was $4.5 million and
$13.3 million for the three and nine months ended September 30, 2006. Tax-exempt
investment income was $4.1 million and $12.1 million for the three and nine
months ended September 30, 2005.
LIQUIDITY AND CAPITAL RESOURCES
It is anticipated that the liquidity requirements of CNA Surety will be
met primarily with funds generated from its insurance operations. The principal
sources of consolidated cash flows are premiums, investment income, sales and
maturities of investments, and reinsurance recoveries. CNA Surety also may
generate funds from additional borrowings under the credit facility described
below. The primary cash flow uses are payments for claims, operating expenses,
reinsurance premiums, federal income taxes, and debt service. In general, surety
operations generate premium collections from customers in advance of cash
outlays for claims. Premiums are invested until such time as funds are required
to pay claims and claims adjusting expenses.
The Company believes that total invested assets, including cash and
short-term investments, are sufficient in the aggregate and have suitably
scheduled maturities to satisfy all policy claims and other operating
liabilities, including dividend and income tax sharing payments of its insurance
subsidiaries. At September 30, 2006, the carrying value of the Company's
insurance subsidiaries' invested assets was comprised of $787.0 million of fixed
income securities, $52.7 million of short-term investments, $0.2 million of
other investments and $2.1 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 nine months of 2006, the Company paid an additional $31.9
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. Through September 30, 2006, the total paid by the Company for surety
losses of the large national contractor is $57.9 million. 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 September 30, 2006, the parent company's
invested assets consisted of $0.8 million of fixed income securities, $1.6
million of equity securities, and $8.6 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 September 30, 2006 and
December 31, 2005 respectively, parent company short-term investments and cash
included $6.9 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 $42.9 million for the three months ended September 30, 2006 compared to net
cash flow provided by operating activities of $12.6 million for the comparable
period in 2005. The increase in net cash flow provided by operating activities
primarily relates to the decrease in operating cash flow in the third quarter of
2005 which resulted from the deposit of $32.7 million with an affiliate to
enable the affiliate to establish a trust to fund future payments under a bond.
The Company's consolidated net cash flow provided by operating activities
was $80.5 million for the nine months ended September 30, 2006 compared to net
cash flow provided by operating activities of $68.4 million for the comparable
period in 2005. The increase in net cash flow provided by operating activities
primarily relates to increased premiums received and the absence of the payment
of $32.7 million in 2005 to establish the trust discussed above, offset by two
commutation receipts which totaled $24.0 million in the second quarter of 2005,
higher loss payments and increased estimated federal income tax 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 provided an aggregate of up to
$50.0 million in borrowings under a revolving credit facility. In the current
quarter, the outstanding 2005 Credit Facility balance of $20.0 million was paid.
Also, in September 2006, the Company reduced the available aggregate revolving
credit facility to $25.0 million in borrowings. The 2005 Credit Facility matures
on June 30, 2008. No other debt matures in the next five years.
28
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%. There was no outstanding balance under the
2005 Credit Facility at September 30, 2006. As such, there was no applicable
margin and the weighted average interest rate was 0.325% at September 30, 2006.
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 as of and for the period ended September 30,
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 September 30, 2006 the interest
rate on the junior subordinated debenture was 8.78%.
A summary of the Company's commitments as of September 30, 2006 is
presented in the following table (in millions):
SEPTEMBER 30, 2006 2006 2007 2008 2009 2010 THEREAFTER TOTAL
--------------------------------------------- ------ ------ ------ ------ ------ ---------- -------
Debt (a)..................................... $ 0.7 $ 2.8 $ 2.8 $ 2.7 $ 2.7 $ 94.5 $106.2
Operating leases............................. 0.5 1.9 1.8 1.7 1.7 2.4 10.0
Loss and loss adjustment expense reserves.... 33.1 218.6 71.2 28.7 19.5 49.1 420.2
Other long-term liabilities (b).............. 0.1 1.1 1.0 0.8 0.5 6.5 10.0
------ ------ ------ ------ ------ ------ ------
Total........................................ $ 34.4 $224.4 $ 76.8 $ 33.9 $ 24.4 $152.5 $546.4
====== ====== ====== ====== ====== ====== ======
(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 Company of
America ("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 Universal Surety of America 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 dividends of $10.5 million and $10.0 million from its insurance
subsidiaries during the first nine months of 2006 and 2005, respectively. CNA
Surety
29
received $0.1 million in cash from its non-insurance subsidiaries during the
first nine 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 nine months of 2005.
Combined statutory surplus totaled $323.4 million at September 30, 2006,
resulting in a net written premium to statutory surplus ratio of to 1.2 to 1.0.
Insurance regulations restrict Western Surety's maximum net retention on a
single surety bond to 10 percent of statutory surplus. Under the 2006 Excess of
Loss Treaty, the Company's net retention on new bonds would generally be $10
million plus a 5% co-participation in the $90 million layer of excess
reinsurance above the Company's retention. Based on statutory surplus as of
September 30, 2006, this regulation would limit Western Surety's largest net
risk to $32.3 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 intercompany tax sharing agreements
between CNA Surety and its subsidiaries, the tax of each subsidiary shall be
determined based upon each subsidiary's separate return liability. Intercompany
tax payments are made at such times when estimated tax payments would be
required by (or refunds received from) the Internal Revenue Service. CNA Surety
received $31.4 million and $11.8 million from its subsidiaries for the nine
months ended September 30, 2006 and September 30, 2005, respectively.
Western Surety and Surety Bonding each qualify as an acceptable surety for
federal and other public works project bonds pursuant to U.S. Department of
Treasury regulations. U.S. Treasury underwriting limitations are based on an
insurer's statutory surplus. Effective July 1, 2005 through June 30, 2006, the
underwriting limitations of Western Surety and Surety Bonding were $24.6 million
and $0.7 million, respectively. Effective July 1, 2006 through June 30, 2007,
the underwriting limitations of Western Surety and Surety Bonding are $26.8
million and $0.7 million, respectively. Through the Quota Share Treaty between
CCC and Western Surety, CNA Surety has access to CCC and its affiliates' U.S.
Department of Treasury underwriting limitations. Effective July 1, 2005 through
June 30, 2006, the underwriting limitations of CCC and its affiliates totaled
$645.7 million. Effective July 1, 2006 through June 30, 2007, the underwriting
limitations of CCC and its affiliates total $635.6 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.
FINANCIAL CONDITION
INVESTMENT PORTFOLIO
The estimated fair value and amortized cost or cost of fixed income and
equity securities held by CNA Surety at September 30, 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 MORE THAN FAIR
SEPTEMBER 30, 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.................................. $ 14,846 $ -- $ (137) $ (151) $ 14,558
U.S. Agencies.................................. 40,030 60 -- (273) 39,817
Collateralized mortgage obligations............ 17,246 345 -- (339) 17,252
Mortgage pass-through securities............... 40,446 76 -- (1,236) 39,286
Obligations of states and political
subdivisions................................... 515,553 13,982 (8) (4) 529,523
Corporate bonds.................................. 66,936 1,465 (154) (1,061) 67,186
Non-agency collateralized mortgage obligations... 37,068 242 -- (853) 36,457
Other asset-backed securities:
Second mortgages/home equity loans............. 20,925 -- (38) (137) 20,750
Credit card receivables........................ 17,228 252 -- -- 17,480
Other.......................................... 5,613 70 -- (143) 5,540
-------- -------- -------- --------- --------
Total fixed income securities.................. 775,891 16,492 (337) (4,197) 787,849
Equity securities................................ 1,447 125 -- -- 1,572
-------- -------- -------- -------- --------
Total.......................................... $777,338 $ 16,617 $ (337) $ (4,197) $789,421
======== ======== ======== ======== ========
30
GROSS UNREALIZED LOSSES
AMORTIZED GROSS ----------------------- ESTIMATED
COST OR UNREALIZED LESS THAN MORE 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) $ 15,452
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 following table summarizes for fixed income securities in an
unrealized loss position at September 30, 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):
SEPTEMBER 30, 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....................................... $ 3,583 $ 4 $ 224,117 $ 3,468
7-12 months...................................... 32,262 333 32,630 1,049
13-24 months..................................... 125,645 3,616 32,429 1,105
Greater than 24 months........................... 12,081 581 1,089 75
---------- ---------- ---------- ----------
Total............................................ $ 173,571 $ 4,534 $ 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 Income.
During the third quarter of 2006, the Company recognized impairment losses
on 21 municipal fixed income securities that were in an unrealized loss
position. In response to the significant change in interest rates in the third
quarter, as well as a revised outlook on future interest rates, the Company does
not have the intention of holding these securities to their anticipated
recovery. The other-than-temporary impairment losses on these securities were
$0.9 million.
31
As of September 30, 2006, 65 securities held by the Company were in an
unrealized loss position. The Company believes that 64 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 65 securities, 44 were rated "AAA" by Standard & Poor's ("S&P") and
"Aaa" by Moody's Investor Services ("Moody's") and all were investment grade.
Two of these 65 securities were in a loss position that exceeded 5% of its book
value, with the largest percentage unrealized loss being approximately 6.8% of
that security's book value resulting in an unrealized loss of $0.1 million. The
largest unrealized loss was $0.4 million, which was approximately 4.7% of that
security's book value.
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 4.9% ($0.2 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.
IMPACT OF PENDING ACCOUNTING STANDARDS
In September 2006, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standard ("SFAS") No. 158, "Employers'
Accounting for Defined Benefit Pension and Other Postretirement Plans" (an
amendment of FASB Statements No. 87, 88, 106 and 132(R) ("SFAS 158"). SFAS 158
requires a company who sponsors one or more single-employer defined benefit
plans to recognize the overfunded or underfunded status of a defined benefit
postretirement plan as an asset or liability in its statement of financial
position and to recognize changes in that funded status in the year in which the
changes occur through comprehensive income. SFAS 158 requires a company to
measure benefit plan assets and obligations as of the date of the company's
fiscal year-end statement of financial position. SFAS 158 also requires a
company to disclose in the notes to financial statements additional information
about certain effects on net periodic benefit cost for the next fiscal year that
arise from delayed recognition of the gains or losses, prior service costs or
credits, and transition asset or obligation. The requirement to recognize the
funded status of a benefit plan and the disclosure requirements are effective as
of the end of the fiscal year ending after December 15, 2006. The requirement to
measure plan assets and benefit obligations as of the date of the fiscal
year-end statement of financial position is effective for fiscal years ending
after December 15, 2008. The Company is currently evaluating the impact that
adopting SFAS 158 will have on our financial condition.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurement"
("SFAS 157"). SFAS 157 defines fair value, establishes a framework for measuring
fair value in accordance with GAAP and expands disclosures about fair value
measurements. SFAS 157 retains the exchange price notion in the definition of
fair value and clarifies that the exchange price is the price in an orderly
transaction between market participants to sell the asset or transfer the
liability in the market in which the reporting entity would transact for the
asset or liability. SFAS 157 emphasizes that fair value is a market-based
measurement, not an entity-specific measurement and the fair value measurement
should be determined based on the assumptions that market participants would use
in pricing the asset or liability. SFAS 157 expands disclosures surrounding the
use of fair value to measure assets and liabilities and specifically focuses on
the sources used to measure fair value. In instances of recurring use of fair
value measures using unobservable inputs, SFAS 157 requires separate disclosure
of the effect on earnings for the period. SFAS 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and
interim periods within the year of adoption. The Company is currently evaluating
the impact that adopting SFAS 157 will have on our operations and financial
condition.
In September 2006, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin ("SAB") No. 108, "Considering the Effects of Prior
Year Misstatements when Quantifying Misstatements in Current Year Financial
Statements" ("SAB 108"). SAB 108 requires registrants to use a dual approach to
include both a balance sheet approach and an income statement approach when
quantifying and evaluating the materiality of a misstatement in a company's
financial statements and the related financial statement disclosures. If either
approach results in quantifying a misstatement that is material, then a
registrant shall adjust the financial statements. SAB 108 provides transition
guidance for correcting errors existing in prior years. If prior year errors
that had been previously considered immaterial (based on the appropriate use of
the registrant's prior approach) now are considered material based on the
approach in SAB 108, then the registrant need not restate prior period financial
statements. SAB 108 does not change the requirements for the correction of an
error discovered in prior year financial statements. Errors discovered in prior
year financial statements shall continue to be restated in accordance with SFAS
No. 154, "Accounting Changes and Error Correction". SAB 108 is effective for
financial statements issued for fiscal years ending after December 15, 2006.
Adoption of SAB 108 is not expected to have an impact on the Company's results
of operations or financial condition.
32
In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109" ("FIN
48"). FIN 48 prescribes a comprehensive model for how a company should
recognize, measure, present, and disclose in its financial statements uncertain
tax positions that the company has taken or expects to take on a tax return. FIN
48 states that a tax benefit from an uncertain position may be recognized only
if it is "more likely than not" that the position is sustainable, based on its
technical merits. The tax benefit of a qualifying position is the largest amount
of tax benefit that is greater than 50 percent likely of being realized upon
ultimate settlement with a taxing authority having full knowledge of all
relevant information. FIN 48 is effective for fiscal years beginning after
December 15, 2006. The Company is currently evaluating the impact that adopting
FIN 48 will have on the Company's results of operations and financial condition.
In January 2006, the FASB issued SFAS 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 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 financial
condition.
In September 2005, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants issued Statement of Position,
"Accounting by Insurance Enterprises for Deferred Acquisition Costs in
Connection with Modifications or Exchanges of Insurance Contracts" ("SOP
05-01"). SOP 05-01 provides guidance on accounting by insurance enterprises for
deferred acquisition costs on internal replacements of insurance and investment
contracts other than those specifically described in SFAS No. 97, "Accounting
and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and
for Realized Gains and Losses from the Sale of Investments". SOP 05-01 defines
an internal replacement as a modification in product benefits, features, rights,
or coverages that occurs by the exchange of a contract for a new contract, or by
amendment, endorsement, or rider to a contract, or by the election of a feature
or coverage within a contract. SOP 05-01 is effective for internal replacements
occurring in fiscal years beginning after December 15, 2006. The Company is
currently evaluating the impact that adopting SOP 05-01 will have on the
Company's results of operations and financial condition.
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;
33
- the effects of corporate bankruptcies on surety bond claims, as well as on
capital markets;
- changes in foreign or domestic political, social and economic conditions;
- regulatory initiatives and compliance with governmental regulations,
judicial decisions, including interpretation of policy provisions,
decisions regarding coverage, trends in litigation and the outcome of any
litigation involving the Company, and rulings and changes in tax laws and
regulations;
- regulatory limitations, impositions and restrictions upon the Company,
including the effects of assessments and other surcharges for guaranty
funds and other mandatory pooling arrangements;
- the impact of competitive products, policies and pricing and the
competitive environment in which the Company operates, including changes
in the Company's books of business;
- product and policy availability and demand and market responses, including
the level of ability to obtain rate increases and decline or non-renew
underpriced accounts, to achieve premium targets and profitability and to
realize growth and retention estimates;
- development of claims and the impact on loss reserves, including changes
in claim settlement practices;
- the performance of reinsurance companies under reinsurance contracts with
the Company;
- results of financing efforts, including the availability of bank credit
facilities;
- changes in the Company's composition of operating segments;
- the sufficiency of the Company's loss reserves and the possibility of
future increases in reserves;
- the risks and uncertainties associated with the Company's loss reserves;
and,
- the possibility of further changes in the Company's ratings by ratings
agencies, including the inability to access certain markets or
distribution channels and the required collateralization of future payment
obligations as a result of such changes, and changes in rating agency
policies and practices.
Any forward-looking statements made in this report are made by the Company
as of the date of this report. The Company does not have any obligation to
update or revise any forward-looking statement contained in this report, even if
the Company's expectations or any related events, conditions or circumstances
change.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
CNA Surety's investment portfolio is subject to economic losses due to
adverse changes in the fair value of its financial instruments, or market risk.
Interest rate risk represents the largest market risk factor affecting the
Company's consolidated financial condition due to its significant level of
investments in fixed income securities. Increases and decreases in prevailing
interest rates generally translate into decreases and increases in the fair
value of the Company's fixed income portfolio. The fair value of these interest
rate sensitive instruments may also be affected by the credit-worthiness of the
issuer, prepayment options, relative value of alternative investments, the
liquidity of the instrument, income tax considerations and general market
conditions. The Company manages its exposure to interest rate risk primarily
through an asset/liability matching strategy. The Company's exposure to interest
rate risk is mitigated by the relative short-term nature of its insurance and
other liabilities. The targeted effective duration of the Company's investment
portfolio is approximately 5 years, consistent with the expected duration of its
insurance and other liabilities.
The tables below summarize the estimated effects of certain hypothetical
increases and decreases in interest rates. It is assumed that the changes occur
immediately and uniformly across each investment category. The hypothetical
changes in market interest rates selected reflect the Company's expectations of
the reasonably possible best or worst case scenarios over a one-year period. The
hypothetical fair values are based upon the same prepayment assumptions that
were utilized in computing fair values as of September 30, 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.
34
HYPOTHETICAL
ESTIMATED FAIR PERCENTAGE
HYPOTHETICAL VALUE AFTER INCREASE
FAIR VALUE AT CHANGE IN HYPOTHETICAL (DECREASE) IN
SEPTEMBER 30, INTEREST RATE CHANGE IN STOCKHOLDERS'
2006 (BP=BASIS POINTS) INTEREST RATE EQUITY
-------------- ----------------- -------------- -------------
(DOLLARS IN THOUSANDS)
U.S. Government and government agencies and authorities.. $ 110,913 200 bp increase $ 101,041 (1.2)%
100 bp increase 106,393 (0.5)
100 bp decrease 113,750 0.3
200 bp decrease 115,183 0.5
States, municipalities and political subdivisions........ 529,523 200 bp increase 472,749 (6.8)
100 bp increase 500,941 (3.4)
100 bp decrease 559,782 3.6
200 bp decrease 592,515 7.5
Corporate bonds and all other............................ 147,413 200 bp increase 135,901 (1.4)
--------------
100 bp increase 141,504 (0.7)
100 bp decrease 153,667 0.7
200 bp decrease 160,181 1.5
Total fixed income securities available-for-sale......... $ 787,849 200 bp increase 709,691 (9.4)
==============
100 bp increase 748,838 (4.6)
100 bp decrease 827,199 4.6
200 bp decrease 867,879 9.5
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
35
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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - None.
ITEM 5. OTHER INFORMATION - Reports on Form 8-K:
July 31, 2006; CNA Surety Corporation Earnings Press Release issued on
July 31, 2006.
36
ITEM 6. EXHIBITS
EXHIBIT NUMBER
Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002................................................................................... 31.1
Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002................................................................................... 31.2
Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002................................................................................... 32.1
Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002................................................................................... 32.2
----------
* Exhibits 32.1 and 32.2 are being furnished and shall not be deemed "filed"
for the purpose of Section 18 of the Securities Exchange Act of 1934, as
amended, or otherwise subject to the liabilities of that Section. These
Exhibits shall not be incorporated by reference into any registration
statement or other document pursuant to the Securities Act of 1933, as
amended.
37
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the Registrant has duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized.
CNA SURETY CORPORATION (Registrant)
/s/ John F. Welch
--------------------------------------------
John F. Welch
President and Chief Executive Officer
/s/ John F. Corcoran
--------------------------------------------
John F. Corcoran
Senior Vice President and Chief Financial Officer
Date: October 31, 2006
38
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.
39