UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2008

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

For the transition period from                      to                     

CNA SURETY CORPORATION

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 þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o		Smaller Reporting Company o
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ 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. o Yes o 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:

44,136,691 shares of Common Stock, $.01 par value as of April 18, 2008.

 

 

CNA SURETY CORPORATION AND SUBSIDIARIES

INDEX

		Page
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (Unaudited):			3
Condensed Consolidated Balance Sheets at March 31, 2008 and at December 31, 2007			3
Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2008 and 2007			4
Condensed Consolidated Statements of Stockholders’ Equity for the Three Months Ended March 31, 2008 and 2007			5
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2008 and 2007			6
Notes to Condensed Consolidated Financial Statements			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			17
Item 3. Quantitative and Qualitative Disclosures About Market Risk			31
Item 4. Controls and Procedures			33
PART II. OTHER INFORMATION			33
Item 1. Legal Proceedings			33
Item 1A. Risk Factors			33
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			33
Item 3. Defaults Upon Senior Securities			33
Item 4. Submission of Matters to a Vote of Security Holders			33
Item 5. Other Information			34
Item 6. Exhibits			34
302 Certification of Chief Executive Officer
302 Certification of Chief Financial Officer
906 Certification of Chief Executive Officer
906 Certification of Chief Financial Officer

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

		March 31,				December 31,
		2008				2007
ASSETS
Invested assets:
Fixed income securities, at fair value (amortized cost: $976,729 and $949,708)		$	986,179			$	963,354
Equity securities, at fair value (cost: $1,860 and $1,683)			1,858				1,789
Short-term investments, at cost (approximates fair value)			20,695				49,453
Total invested assets			1,008,732				1,014,596
Cash			13,350				10,230
Deferred policy acquisition costs			105,834				104,280
Insurance receivables:
Premiums, including $12,123 and $12,317 from affiliates, (net of allowance for doubtful accounts: $1,057 and $1,145)			42,525				36,317
Reinsurance, including $57,095 and $50,547 from affiliates			139,427				127,119
Deposit with affiliated ceding company			34,919				34,644
Intangible assets (net of accumulated amortization: $25,523 and $25,523)			138,785				138,785
Current income taxes receivable			––				1,960
Property and equipment, at cost (less accumulated depreciation and amortization: $29,964 and $29,467)			25,121				24,288
Prepaid reinsurance premiums (including $207 and $322 from affiliates)			404				510
Accrued investment income			11,926				12,242
Other assets			17,402				2,683
Total assets		$	1,538,425			$	1,507,654
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses		$	482,188			$	472,842
Unearned premiums			264,627				258,930
Total reserves			746,815				731,772
Debt			30,816				30,791
Deferred income taxes, net			16,757				17,756
Reinsurance and other payables to affiliates			183				643
Accrued expenses			11,778				18,273
Liability for postretirement benefits			10,159				10,001
Federal income tax payable			7,321				––
Other liabilities			26,319				30,713
Total liabilities			850,148				839,949
Commitments and contingencies (See Notes 3, 5, & 8)
STOCKHOLDERS’ EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 45,517 shares issued and 44,137 shares outstanding at March 31, 2008 and 45,505 shares issued and 44,121 shares outstanding at December 31, 2007			455				455
Additional paid-in capital			274,722				274,069
Retained earnings			422,143				399,241
Accumulated other comprehensive income			5,776				8,800
Treasury stock, 1,380 and 1,384 shares, at cost			(14,819	)			(14,860	)
Total stockholders’ equity			688,277				667,705
Total liabilities and stockholders’ equity		$	1,538,425			$	1,507,654

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

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

		Three Months Ended
		March 31,
		2008				2007
Revenues:
Net earned premium		$	102,641			$	98,303
Net investment income			11,765				10,701
Net realized investment (losses) gains			(9	)			279
Total revenues			114,397				109,283
Expenses:
Net losses and loss adjustment expenses			25,968				24,943
Net commissions, brokerage and other underwriting expenses			55,287				53,898
Interest expense			619				721
Total expenses			81,874				79,562
Income before income taxes			32,523				29,721
Income tax expense			9,621				8,972
Net income		$	22,902			$	20,749
Earnings per common share		$	0.52			$	0.47
Earnings per common share, assuming dilution		$	0.52			$	0.47
Weighted average shares outstanding			44,130				43,931
Weighted average shares outstanding, assuming dilution			44,273				44,217

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

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)

		Common																				Accumulated
		Stock								Additional												Other				Treasury				Total
		Shares				Common				Paid-In				Comprehensive				Retained				Comprehensive				Stock				Stockholders’
		Outstanding				Stock				Capital				Income (Loss)				Earnings				Income (Loss)				At Cost				Equity
Balance, December 31, 2006			43,872			$	453			$	268,651							$	306,745			$	4,993			$	(14,940	)		$	565,902
Comprehensive income:
Net income			—				—				—			$	20,749				20,749				—				—				20,749
Other comprehensive income:
Change in unrealized gains on securities, after income tax benefit of $644 (net of reclassification adjustment of ($161), after income tax benefit of $87)			—				—				—				(1,196	)			—				(1,196	)			—				(1,196	)
Net change related to postretirement benefits, after income tax expense of $15			—				—				—				26				—				26				—				26
Total comprehensive income			—				—				—			$	19,579				—				—				—				––
Stock-based compensation			—				—				490								—				—				—				490
Stock options exercised and other			109				1				1,571								—				—				37				1,609
Balance, March 31, 2007			43,981			$	454			$	270,712							$	327,494			$	3,823			$	(14,903	)		$	587,580
Balance, December 31, 2007			44,121			$	455			$	274,069							$	399,241			$	8,800			$	(14,860	)		$	667,705
Comprehensive income:
Net income			—				—				—			$	22,902				22,902				—				—				22,902
Other comprehensive income:
Change in unrealized gains on securities, after income tax benefit of $1,506 (net of reclassification adjustment of $1, after income tax expense of $0)			—				—				—				(2,797	)			—				(2,797	)			—				(2,797	)
Net change related to postretirement benefits, after income tax expense of $206			—				—				—				(227	)			—				(227	)			—				(227	)
Total comprehensive income			—				—				—			$	19,878				—				—				—				—
Stock-based compensation			—				—				500								—				—				—				500
Stock options exercised and other			16				—				153								—				—				41				194
Balance, March 31, 2008			44,137			$	455			$	274,722							$	422,143			$	5,776			$	(14,819	)		$	688,277

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

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)

		Three Months Ended
		March 31,
		2008				2007
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	22,902			$	20,749
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for doubtful accounts			(91	)			(148	)
Depreciation and amortization			1,315				1,426
Amortization (accretion) of bond premium (discount), net			617				(155	)
Loss (gain) on disposal of property and equipment			37				(31	)
Net realized investment losses (gains)			9				(279	)
Stock-based compensation			500				490
Changes in:
Insurance receivables			(18,425	)			(5,295	)
Reserve for unearned premiums			5,697				9,858
Reserve for unpaid losses and loss adjustment expenses			9,346				(2,250	)
Deposits with affiliated ceding company			(275	)			(305	)
Deferred policy acquisition costs			(1,554	)			(2,841	)
Deferred income taxes, net			283				289
Reinsurance and other payables to affiliates			(460	)			129
Prepaid reinsurance premiums			106				614
Accrued expenses			(6,495	)			(8,494	)
Other assets and liabilities			5,681				149
Net cash provided by operating activities			19,193				13,906
CASH FLOWS FROM INVESTING ACTIVITIES:
Fixed income securities:
Purchases			(52,316	)			(66,628	)
Maturities			5,476				8,008
Sales			19,000				3,214
Purchases of equity securities			(300	)			(298	)
Proceeds from the sale of equity securities			114				202
Changes in short-term investments			28,960				43,554
Purchases of property and equipment, net			(2,161	)			(1,549	)
Change in receivables for securities sold			(15,141	)			––
Other, net			100				(9	)
Net cash used in investing activities			(16,268	)			(13,506	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Employee stock option exercises and other			195				1,609
Net cash provided by financing activities			195				1,609
Increase in cash			3,120				2,009
Cash at beginning of period			10,230				7,164
Cash at end of period		$	13,350			$	9,173
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for
Interest		$	670			$	711
Income taxes		$	38			$	584

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

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2008
(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 (“Universal Surety”), 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 62% of the outstanding common stock of CNA Surety. Loews Corporation (“Loews”) owns approximately 90% 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”).

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 2007 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.

Earnings Per Share

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

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

		Three Months Ended
		March 31,
		2008				2007
Net income		$	22,902			$	20,749
Shares:
Weighted average shares outstanding			44,121				43,872
Weighted average shares of options exercised and additional stock issuance			9				59
Total weighted average shares outstanding			44,130				43,931
Effect of dilutive options			143				286
Total weighted average shares outstanding, assuming dilution			44,273				44,217
Earnings per share		$	0.52			$	0.47
Earnings per share, assuming dilution		$	0.52			$	0.47

     No adjustments were made to reported net income in the computation of earnings per share. Options to purchase shares of common stock of 0.6 million were excluded from the calculation of diluted earnings per share for the three months ended March 31, 2008 because the exercise price of these options was greater than the average market price of CNA Surety’s common stock. There were no options excluded from the calculation of diluted earnings per share for the three months ended March 31, 2007.

Accounting Pronouncements

     In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”), which provides companies with an option to report selected financial assets and liabilities at fair value, with changes in fair value recorded in earnings. SFAS 159 helps to mitigate this type of accounting-induced earnings volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company’s choice to use fair value on its earnings. It also requires entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. SFAS 159 does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), discussed below, or SFAS No. 107, “Disclosures about Fair Value of Financial Instruments”. SFAS 159 is effective for fiscal years ending after November 15, 2007. The Company adopted SFAS 159 on January 1, 2008 and did not elect the fair value option for any assets or liabilities under SFAS 159. The adoption and subsequent application of SFAS 159 is not expected to have a material impact on the Company’s financial condition or results of operations.

     In September 2006, the FASB issued 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. For fiscal years beginning after November 15, 2007, companies are required to implement the standard for financial assets and liabilities, as well as for any other assets and liabilities that are carried at fair value on a recurring basis in financial statements. In February 2008, the FASB issued Staff Position SFAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP SFAS 157-2”), which delays the effective date of SFAS 157 for all nonrecurring fair value measurements of nonfinancial assets and nonfinancial liabilities until fiscal years beginning after November 15, 2008.

     SFAS No. 157 also requires the Company to consider its own credit spreads when measuring the fair value of liabilities. The impact of considering the Company’s own credit spreads when measuring the fair value of liabilities, including derivatives, did not have a material impact on fair value measurements. Overall, the impact of partially adopting SFAS No. 157 did not have a significant impact on the financial condition at the date of adoption or the results of operations for the three months ended March 31, 2008.

2. Investments

     The estimated fair value and amortized cost or cost of fixed income and equity securities held at March 31, 2008 and December 31, 2007, by investment category, were as follows (dollars in thousands):

						Gross				Gross Unrealized Losses
		Amortized Cost				Unrealized				Less Than				More Than				Estimated
March 31, 2008		or Cost				Gains				12 Months				12 Months				Fair Value
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury		$	17,775			$	1,167			$	—			$	—			$	18,942
U.S. Agencies			52,611				1,422				—				—				54,033
Collateralized mortgage obligations			29,220				543				(64	)			—				29,699
Mortgage pass-through securities			61,759				658				(39	)			(166	)			62,212
Obligations of states and political subdivisions			645,533				15,609				(5,337	)			(3,887	)			651,918
Corporate bonds			97,266				2,248				(105	)			(1,592	)			97,817
Non-agency collateralized mortgage obligations			35,022				16				(118	)			(580	)			34,340
Other asset-backed securities:
Second mortgages/home equity loans			9,528				—				(58	)			(717	)			8,753
Credit card receivables			17,235				444				(331	)			—				17,348
Other			10,780				337				—				––				11,117
Total fixed income securities			976,729				22,444				(6,052	)			(6,942	)			986,179
Equity securities			1,860				50				(52	)			—				1,858
Total		$	978,589			$	22,494			$	(6,104	)		$	(6,942	)		$	988,037

						Gross				Gross Unrealized Losses
		Amortized Cost				Unrealized				Less Than				More Than				Estimated
December 31, 2007		or Cost				Gains				12 Months				12 Months				Fair Value
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury		$	17,790			$	485			$	—			$	—			$	18,275
U.S. Agencies			52,617				706				—				(15	)			53,308
Collateralized mortgage obligations			30,086				502				(11	)			(107	)			30,470
Mortgage pass-through securities			54,659				401				—				(586	)			54,474
Obligations of states and political subdivisions			625,858				15,408				(2,500	)			(641	)			638,125
Corporate bonds			95,714				1,493				(97	)			(1,408	)			95,702
Non-agency collateralized mortgage obligations			35,011				232				—				(699	)			34,544
Other asset-backed securities:
Second mortgages/home equity loans			9,951				—				—				(50	)			9,901
Credit card receivables			17,234				451				—				—				17,685
Other			10,788				157				—				(75	)			10,870
Total fixed income securities			949,708				19,835				(2,608	)			(3,581	)			963,354
Equity securities			1,683				106				—				—				1,789
Total		$	951,391			$	19,941			$	(2,608	)		$	(3,581	)		$	965,143

     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 which are 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.

     No other than temporary impairments were recorded for the three months ended March 31, 2008 and 2007.

     As of March 31, 2008, 68 fixed income securities held by the Company were in an unrealized loss position. The Company believes that 62 of these securities are in an unrealized loss position due to general market disruptions, the relative performance and changing market views of asset classes and changes in interest rates. However, the Company believes there are no credit issues specific to these individual securities. Therefore, the Company expects these securities will recover in value at or before maturity. Of these 62 securities, 30 were rated AAA by Standard & Poor’s (“S&P”) and Aaa by Moody’s Investor Services (“Moody’s”) and all were

investment grade. Only four of these 62 securities were in a loss position that exceeded 5% of its book value, with the largest unrealized loss percentage being 10.3% of that security’s book value resulting in an unrealized loss of $0.6 million, which was also the largest unrealized loss.

     Of the six remaining securities that were in an unrealized loss position, one was issued by the financing subsidiary of a large domestic automaker. The security was in an unrealized loss position of 17.2% ($0.7 million) of its book value and was rated below investment grade by S&P and Moody’s. One of the other securities, rated investment grade by S&P and Moody’s, was issued by a large student loan provider and was in an unrealized loss position of 25.3% ($0.8 million) of its book value. Another of these securities was an asset-backed security collateralized by sub-prime home loans that was downgraded during the quarter from AAA to Baa3/BBB as a result of a downgrade of the bond insurer supporting the security. This security was in an unrealized loss position of 14.4% ($0.7 million) of its book value. The three remaining securities, rated investment grade by S&P and Moody’s, were issued by governmental utility authorities and were in an unrealized loss position of 9.4% ($0.5 million), 14.1% ($1.5 million) and 19.6% ($1.1 million), respectively. The Company believes that the financial condition of these issuers is strong and expects that these unrealized losses will reverse at or before maturity.

     The Company intends and believes it has the ability to hold these investments 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.

3. Reinsurance

     The effect of reinsurance on the Company’s written and earned premium was as follows (dollars in thousands):

		Three Months Ended March 31,
		2008								2007
		Written				Earned				Written				Earned
Direct		$	91,060			$	84,346			$	92,555			$	80,674
Assumed			25,565				26,583				25,859				27,882
Ceded			(8,181	)			(8,288	)			(9,639	)			(10,253	)
Net premiums		$	108,444			$	102,641			$	108,775			$	98,303

     Assumed premiums primarily includes all surety business written or renewed, net of reinsurance, by CCC and CIC, and their affiliates, after September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of the business assumed from these affiliates.

     Assumed premium also includes surety business written by another affiliate, First Insurance Company of Hawaii, Ltd. and its subsidiaries First Indemnity Insurance of Hawaii, Inc., First Fire and Casualty Insurance of Hawaii, Inc. and First Security Insurance of Hawaii, Inc. (collectively, “FICOH”). CNAF owns approximately 50% of the outstanding common stock of First Insurance Company of Hawaii, Ltd. Under the terms of this excess of loss agreement that covers certain contract business, FICOH retains losses of $2 million per principal and Western Surety assumes 80% of $5 million per principal subject to an aggregate annual limit of $8 million. Premiums assumed by Western Surety under this agreement were less than $0.1 million for the three months ended March 31, 2008 and 2007.

     The effect of reinsurance on the Company’s provision for loss and loss adjustment expenses and the corresponding ratio to earned premium was as follows (dollars in thousands):

		Three Months Ended March 31,
		2008								2007
		$				Ratio				$				Ratio
Gross losses and loss adjustment expenses		$	39,105				35.3	%		$	28,293				26.1	%
Ceded amounts			(13,137	)			158.5	%			(3,350	)			32.7	%
Net losses and loss adjustment expenses		$	25,968				25.3	%		$	24,943				25.4	%

     2008 Third Party Reinsurance Compared to 2007 Third Party Reinsurance

     Effective January 1, 2008, CNA Surety entered into a new excess of loss treaty (“2008 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2007 Excess of Loss Treaty. Under the 2008 Excess of Loss Treaty, the Company’s net retention per principal remained at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provides aggregate coverage of $185 million and 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 2008 on bonds that were in force during 2008. The contract also includes a provision for additional premiums based on losses ceded under the contract. The primary difference between the 2008 Excess of Loss Treaty and the Company’s 2007 Excess of Loss Treaty is as follows. The base annual premium for the 2008 Excess of Loss Treaty is $33.3 million compared to the base annual cost of the 2007 Excess of Loss Treaty of $38.3 million before additional premium resulting from loss activity. The Company’s estimate of these additional premiums under the 2007 Excess of Loss Treaty is $4.3 million. Only the large national contractor that was excluded from the 2007 treaty remained excluded from the 2008 Excess of Loss Treaty.

Related Party Reinsurance

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

     The Services and Indemnity Agreement provides the Company’s insurance subsidiaries with the authority to perform various administrative, management, underwriting and claim functions in order to conduct the business of CCC and CIC and to be reimbursed by CCC for services rendered. In consideration for providing the foregoing services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. This agreement was renewed on January 1, 2008 and expires on December 31, 2008 and is annually renewable thereafter.

     Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all surety business written or renewed by CCC and CIC after the Merger Date. The Quota Share Treaty was renewed on January 1, 2008 and expires on December 31, 2008 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 March 31, 2008.

     Through the Stop Loss Contract, the Company’s insurance subsidiaries were protected from adverse loss experience on certain business underwritten after the Merger Date. The Stop Loss Contract between the insurance subsidiaries and CCC limited the insurance subsidiaries’ prospective net loss ratios with respect to certain accounts and lines of insured business for three full accident years following the Merger Date. In the event the insurance subsidiaries’ accident year net loss ratio exceeds 24% in any of the accident years 1997 through 2000 on certain insured accounts (the “Loss Ratio Cap”), the Stop Loss Contract requires CCC at the end of each calendar quarter following the Merger Date, to pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which the Company’s actual accident year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. In consideration for the coverage provided by the Stop Loss Contract, the insurance subsidiaries paid to CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. As of March 31, 2008, the net amount billed and received by the Company was $42.3 million under the Stop Loss Contract. The amount received under the Stop Loss Contract included $24.0 million held by the Company for losses covered by this contract that were incurred but not paid as of March 31, 2008. As a result of adverse development of losses subject to the Stop Loss Contract during the three months ended March 31, 2008, the Company has a receivable from CCC of $6.5 million, which will be billed during the second quarter of 2008. As of December 31, 2007, the net amount billed and received by the Company under the Stop Loss Contract was $42.3 million. The amount received under the Stop Loss Contract included $24.0 million held by the Company for losses covered by this contract that were incurred but not paid as of December 31, 2007.

     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 was 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, which expired on 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. In January 2007, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which expired on December 31, 2007, was for an additional premium of $0.5 million, which was based on the level of actual premiums written on bonds for the large national contractor. In December 2007, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which will expire on December 31, 2008, was for an additional premium subject to the level of actual premiums written on bonds for the large national contractor. As of both March 31, 2008 and December 31, 2007, the Company had ceded losses of $50.0 million under the terms of this contract, with unpaid ceded losses of $46.8 million.

     As of March 31, 2008 and December 31, 2007, CNA Surety had an insurance receivable balance from CCC and CIC of $69.2 million and $62.9 million respectively. At March 31, 2008, this receivable included $57.1 million of reinsurance recoverables, including the amount due under the Stop Loss Contract discussed above, and $12.1 million of premiums receivable. At December 31, 2007, this receivable included $50.5 million of reinsurance recoverables and $12.4 million of premiums receivable. CNA Surety had reinsurance payables to CCC and CIC of $0.2 million as of March 31, 2008 and $0.1 million as of December 31, 2007.

4. Fair Value of Financial Instruments

     As previously discussed, the Company adopted provisions of SFAS 157 on January 1, 2008. SFAS 157 defines fair value and establishes a framework for measuring fair value in accordance with GAAP. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company uses the following fair value hierarchy in selecting inputs, with the highest priority given to Level 1, as these are the most transparent or reliable:

	•		Level 1 – Quoted prices for identical instruments in active markets.
	•		Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable in active markets.
	•		Level 3 – Valuations derived from valuation techniques in which one or more significant inputs are unobservable.

     The Company is responsible for the valuation process and as part of this process may use data from outside sources in establishing fair value. The Company performs due diligence to understand the inputs used or how the valuation was calculated or derived. The Company corroborates the reasonableness of external inputs in the valuation process.

     The following section describes the valuation methodologies used to measure different financial instruments at fair value, including an indication of the level in the fair value hierarchy in which the instrument is generally classified.

Fixed Income Securities

     Securities valued using Level 1 inputs include highly liquid government bonds for which quoted market prices are available. Securities using Level 2 inputs are valued using pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models utilizing observable inputs. Most fixed income securities are valued using Level 2 inputs. Level 2 includes corporate bonds, municipal bonds, asset-backed securities and mortgage pass-through securities.

Equity Securities

     Level 1 includes publicly traded securities valued using quoted market prices.

Short-Term Investments

     The valuation of securities that are actively traded or have quoted prices are classified as Level 1. These securities include money market funds and U.S. Treasury bills. Level 2 includes commercial paper, for which all significant inputs are observable.

     Assets measured at fair value on a recurring basis are summarized below (amounts in thousands):

		March 31, 2008
		Fair Value Measurements Using
		Level 1				Level 2				Level 3				Assets at Fair Value
Assets:
Fixed income securities at fair value		$	33,552			$	952,627				––			$	986,179
Equity securities at fair value			1,858				––				––				1,858
Short term investments at fair value (a)			13,802				6,893				––				20,695
Total assets		$	49,212			$	959,520				––			$	1,008,732

     The Company had no assets or liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at either the adoption of SFAS 157 on January 1, 2008 or at March 31, 2008.

5. Reserves for Losses and Loss Adjustment Expenses

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

		Three Months Ended
		March 31,
		2008				2007
Reserves at beginning of period:
Gross		$	472,842			$	434,224
Ceded reinsurance			150,496				144,858
Net reserves at beginning of period			322,346				289,366
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period			25,966				24,969
Increase (decrease) in provision for insured events of prior periods			2				(26	)
Total net incurred			25,968				24,943
Net payments attributable to:
Current period events			815				2,275
Prior period events			22,858				23,736
Total net payments			23,673				26,011
Net reserves at end of period			324,641				288,298
Ceded reinsurance at end of period			157,547				143,676
Gross reserves at end of period		$	482,188			$	431,974

6. 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 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 utilization fee, can vary based on the Company’s leverage ratio (debt to total capitalization) from 0.80% to 1.00%. There was no outstanding balance under the 2005 Credit Facility at March 31, 2008 or March 31, 2007. As such, the Company incurred only the facility fee of 0.300% for the three months ended March 31, 2008 and 0.325% for the three months ended March 31, 2007.

     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 three months ended March 31, 2008 and 2007.

     In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities bear interest at a rate of LIBOR plus 337.5 basis points with a 30-year term and are redeemable at par value 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 2034. As of March 31, 2008 and 2007, the interest rate on the junior subordinated debenture was 6.44% and 8.74% respectively.

7. Employee Benefits

     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 medical benefit plan provides coverage for employees, and their eligible dependents, hired by Western Surety before November 1, 1991 and who retire at age 55 or later with at least 15 years of service. Only employees hired by Western Surety prior to 1988 are eligible for the sick leave plan. Further, benefits for the sick leave plan are based on unused accrued sick leave as of December 31, 2003, the date the accruals were frozen. The postretirement medical benefit 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
		March 31,
		2008				2007
Net periodic benefit cost:
Service cost		$	59			$	76
Interest cost			145				173
Amortization of prior service cost			(27	)			(41	)
Net amortization of actuarial loss			6				82
Net periodic benefit cost		$	183			$	290

     As a result of adopting 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”) as of December 31, 2006, amortization of prior service costs and net actuarial (gains)/losses recognized through the statement of income are also adjusted through other comprehensive income.

     The Company expects to contribute $0.3 million to the postretirement benefit plans to pay benefits in 2008. As of March 31, 2008, less than $0.1 million of contributions have been made to the postretirement benefit plans.

8. 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.

9. Stockholders Equity

     The compensation expense recorded for the Company’s stock-based compensation plans was $0.5 million for the three months ended March 31, 2008 and 2007, respectively. The total income tax benefit recognized in the income statement for stock-based compensation arrangements was $0.2 million for the three months ended March 31, 2008 and 2007, respectively. The amount of cash received from the exercise of stock options was $0.2 million and $1.6 million for the three months ended March 31, 2008 and 2007, respectively.

Equity Compensation Plans

     The Company 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, restricted stock, bonus shares or stock appreciation rights (“SARs”) to be granted under the 2006 Long-Term Equity Compensation Plan (the “2006 Plan”), approved by shareholders on April 25, 2006. The aggregate number of shares initially available for which options may be granted under the 2006 Plan was 3,000,000. Option exercises under the 2006 Plan are settled in newly issued common shares.

     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.

     On February 8, 2008, 259,380 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $6.32 for these options. The fair value of these options was estimated at grant date using a Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 2.7%; dividend yield of 0.0%; expected option life of 5.3 years; and volatility of 38.3%. The Company estimated the expected option life of the 2008 grant based on its analysis of past exercise patterns for similar options and did not use the simplified method used for estimating the expected option life of the 2007 grant described below. As of March 31, 2008, the number of shares available for granting of options under the 2006 Plan was 2,423,885.

     On February 13, 2007, 334,100 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $9.04 for these options. The fair value of these options was estimated at grant date using a Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 4.8%; dividend yield of 0.0%; expected option life of 6.3 years; and volatility of 34.7%. The Company estimated the expected option life using the simplified method allowed under the Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No. 107 (“SAB 107”). The Company’s stock options qualify for this method based on the criteria defined in SAB 107.

     A summary of option activity for the three months ended March 31, 2008 and 2007 is presented below:

						Weighted
						Average
		Shares				Exercise
		Subject				Price Per
		To Option				Share
Outstanding options at January 1, 2007			1,008,525			$	12.02
Options granted			334,100			$	20.70
Options forfeited			(15,650	)		$	12.75
Options expired			(200	)		$	15.88
Options exercised			(103,485	)		$	12.06
Outstanding options at March 31, 2007			1,223,290			$	14.37
Outstanding options at January 1, 2008			1,054,588			$	14.53
Options granted			259,380			$	16.35
Options forfeited			(8,390	)		$	16.56
Options expired			(3,000	)		$	9.35
Options exercised			(11,625	)		$	11.18
Outstanding options at March 31, 2008			1,290,953			$	14.93

     A summary of the status of the Company’s non-vested options as of March 31, 2008 and 2007 and changes during the three months then ended is presented below:

						Weighted
		Shares				Average
		Subject				Grant Date
		To Option				Fair Value
Non-vested options at January 1, 2007			481,613			$	4.51
Options granted			334,100			$	9.04
Options vested			––				––
Options forfeited			(15,650	)		$	4.82
Non-vested options at March 31, 2007			800,063			$	6.40
Non-vested options at January 1, 2008			554,557			$	7.23
Options granted			259,380			$	6.32
Options vested			(78,820	)		$	9.04
Options forfeited			(8,390	)		$	6.72
Non-vested options at March 31, 2008			726,727			$	6.80

     A summary of the options vested or expected to vest and options exercisable as of March 31, 2008 is presented below:

Options Vested or Expected to Vest

Weighted

Weighted Average

Average

Aggregate

Remaining

Number

Exercise Price

Intrinsic Value

Contractual Life

March 31, 2008

1,189,528

$

14.65

$

2,513,081

7.4 years

Options Exercisable

Weighted

Weighted Average

Average

Aggregate

Remaining

Number

Exercise Price

Intrinsic Value

Contractual Life

March 31, 2008

564,226

$

12.74

$

1,915,500

6.1 years

     The total intrinsic value of options exercised was less than $0.1 million and $1.0 million for the three months ended March 31, 2008 and 2007, respectively. The tax benefits recognized by the Company for these exercises was negligible for the three months ended March 31, 2008 and $0.3 million for the three months ended March 31, 2007.

     As of March 31, 2008, there was $2.5 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: 2008 — $1.2 million; 2009 — $0.8 million; 2010 — $0.4 million; and 2011 — $0.1 million.

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, 2007.

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 claim file, some estimates need to be adjusted during the life cycle of the claim 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 also 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 indemnity recoveries.

     The following table shows the estimated liability as of March 31, 2008 for unpaid claims applicable to reported claims and to IBNR for each sub-line of business (dollars in thousands):

		Gross Case Loss				Gross IBNR Loss				Total Gross
		and LAE Reserves				and LAE Reserves				Reserves
Contract		$	106,070			$	193,117			$	299,187
Commercial			114,140				56,856				170,996
Fidelity and other			4,481				7,524				12,005
Total		$	224,691			$	257,497			$	482,188

     Periodic actuarial analyses of the Company’s loss reserves are performed. 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 of expected claim activity prepared in connection with the comprehensive review.

     The actuarial analyses are based upon multiple projection methodologies that involve detailed statistical analysis of past claim reporting, settlement activity and indemnification 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.

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

			–  Current claim activity, including the frequency and severity of current claims;
			–  Changes in underwriting standards and business mix such as the Company’s efforts to reduce exposures to large commercial bonds;
			–  Changes in the claims handling process; 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.

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

     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 Mack methodology and the point estimate analysis were utilized 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, the 50th and 75th percentile were selected as representing a reasonable range of reserve estimates.

     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 indemnification 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 indemnification recoveries. Conversely, if the Company were to experience an unusually low number of large claims and/or an unusually high number of large indemnification 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.

     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 in stockholders’ equity as a separate component of accumulated other comprehensive income. Cash flows from purchases, sales and maturities are reported gross in the investing activities section of the Condensed Consolidated Statements of Cash Flows.

     The amortized cost of fixed income securities is determined based on cost and the cumulative effect of amortization of premiums and accretion of discounts. 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 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.

     For discussion of the Company’s valuation of investments, see Note 4. Fair Value of Financial Instruments of the Condensed Consolidated Financial Statements.

Intangible Assets

     CNA Surety’s Condensed Consolidated Balance Sheet as of March 31, 2008 and December 31, 2007 includes intangible assets of approximately $138.8 million. This amount represents goodwill and identified intangibles with indefinite useful lives arising from the acquisition of Capsure Holdings Corp. (“Capsure”).

     A significant amount of judgment is required in performing intangible assets impairment tests. Such tests include periodically determining or reviewing the estimated fair value of CNA Surety’s reporting units. Under the relevant standard, fair value refers to the amount for which the entire reporting unit may be bought or sold. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. The Company uses a valuation technique based on discounted cash flows. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of 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. Contract bonds provide coverage for the length of the bonded project and not a fixed time period. As such, the Company uses estimates of the contract length as the basis for recognizing premium revenue on these bonds. 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 Acquisitions Costs

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

Results of Operations

Financial Measures

     The Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) discusses certain accounting principles generally accepted in the United States of America (“GAAP”) and non-GAAP financial measures in order to provide information used by management to monitor the Company’s operating performance. Management utilizes various financial measures to monitor the Company’s insurance operations and investment portfolio. Underwriting results, which are derived from certain income statement amounts, are considered a non-GAAP financial measure and are used by management to monitor performance of the Company’s insurance operations.

     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.

     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 Actual Results for the Three Months Ended March 31, 2008 and 2007

Analysis of Net Income

     Net income for the three months ended March 31, 2008 was $22.9 million, or $0.52 per diluted share, compared to $20.7 million, or $0.47 per diluted share, for the same period in 2007. The increase in net income reflects higher earned premium and higher net investment income, partially offset by higher underwriting costs.

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

Results of Insurance Operations

     Underwriting components for the Company for the three months ended March 31, 2008 and 2007 are summarized in the following table (dollars in thousands):

		Three Months
		Ended
		March 31,
		2008				2007
Gross written premiums		$	116,625			$	118,414
Net written premiums		$	108,444			$	108,775
Net earned premiums		$	102,641			$	98,303
Net losses and loss adjustment expenses		$	25,968			$	24,943
Net commissions, brokerage and other expenses		$	55,287			$	53,898
Loss ratio			25.3	%			25.4	%
Expense ratio			53.9				54.8
Combined ratio			79.2	%			80.2	%

Premiums Written/Earned

     CNA Surety primarily markets contract and commercial surety bonds. Contract surety bonds generally secure a contractor’s performance and/or payment obligation with respect to a construction project. Contract surety bonds are generally required by federal, state and local governments for public works projects. The most common types include bid, performance and payment bonds. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. The commercial surety market includes numerous types of bonds categorized as court judicial, court fiduciary, public official, license and permit and many miscellaneous bonds that include guarantees of financial performance. The Company also writes fidelity bonds

that cover losses arising from employee dishonesty and other insurance products that are generally companion products to certain surety bonds. For example, the Company writes surety bonds for notaries and also offers related errors and omissions (“E&O”) insurance coverage.

     Through one of its insurance subsidiaries, Western Surety Company (“Western Surety”), 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 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of this assumed business.

     Gross written premiums are summarized in the following table (dollars in thousands):

		Three Months
		Ended
		March 31,
		2008				2007
Contract		$	71,952			$	73,143
Commercial			35,595				36,230
Fidelity and other			9,078				9,041
Total		$	116,625			$	118,414

     For the quarter ended March 31, 2008, gross written premiums decreased 1.5% to $116.6 million compared to $118.4 million for the quarter ended March 31, 2007. Contract surety gross written premiums decreased 1.6% to $72.0 million in the first quarter due to moderation of spending in the non-residential and public construction sectors. Commercial surety gross written premiums decreased 1.8% to $35.6 million in the quarter as continued selective underwriting in the large commercial market resulted in lower premium production. Small commercial and related fidelity and other premiums were flat compared to the quarter ended March 31, 2007. The Company expects that current economic and market conditions will constrain growth in gross written premium in 2008.

     Net written premiums are summarized in the following table (dollars in thousands):

		Three Months
		Ended
		March 31,
		2008				2007
Contract		$	64,592			$	64,447
Commercial			34,774				35,287
Fidelity and other			9,078				9,041
Total		$	108,444			$	108,775

     Net written premiums decreased slightly to $108.4 million from the first quarter of 2007 as the decrease in written premium discussed above was largely offset by lower reinsurance costs.

     Net earned premiums are summarized in the following table (dollars in thousands):

		Three Months
		Ended
		March 31,
		2008				2007
Contract		$	62,790			$	58,496
Commercial			32,077				32,003
Fidelity and other			7,774				7,804
Total		$	102,641			$	98,303

     For the quarter ended March 31, 2008, net earned premiums increased 4.4% to $102.6 million compared to the first quarter of 2007 due to lower reinsurance costs and the increase in gross premiums written over the past year.

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.

     2008 Third Party Reinsurance Compared to 2007 Third Party Reinsurance

     Effective January 1, 2008, CNA Surety entered into a new excess of loss treaty (“2008 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2007 Excess of Loss Treaty. Under the 2008 Excess of Loss Treaty, the Company’s net retention per principal remained at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provides aggregate coverage of $185 million and 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 2008 on bonds that were in force during 2008. The contract also includes a provision for additional premiums based on losses ceded under the contract. The primary difference between the 2008 Excess of Loss Treaty and the Company’s 2007 Excess of Loss Treaty is as follows. The base annual premium for the 2008 Excess of Loss Treaty is $33.3 million compared to the base annual cost of the 2007 Excess of Loss Treaty of $38.3 million before additional premium resulting from loss activity. The Company’s estimate of these additional premiums under the 2007 Excess of Loss Treaty is $4.3 million. Only the large national contractor that was excluded from the 2007 treaty remained excluded from the 2008 Excess of Loss Treaty.

Related Party Reinsurance

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

     The Services and Indemnity Agreement provides the Company’s insurance subsidiaries with the authority to perform various administrative, management, underwriting and claim functions in order to conduct the business of CCC and CIC and to be reimbursed by CCC for services rendered. In consideration for providing the foregoing services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. This agreement was renewed on January 1, 2008 and expires on December 31, 2008 and is annually renewable thereafter.

     Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all surety business written or renewed by CCC and CIC after the Merger Date. The Quota Share Treaty was renewed on January 1, 2008 and expires on December 31, 2008 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 March 31, 2008.

     Through the Stop Loss Contract, the Company’s insurance subsidiaries were protected from adverse loss experience on certain business underwritten after the Merger Date. The Stop Loss Contract between the insurance subsidiaries and CCC limited the insurance subsidiaries’ prospective net loss ratios with respect to certain accounts and lines of insured business for three full accident years following the Merger Date. In the event the insurance subsidiaries’ accident year net loss ratio exceeds 24% in any of the accident years 1997 through 2000 on certain insured accounts (the “Loss Ratio Cap”), the Stop Loss Contract requires CCC at the end of each calendar quarter following the Merger Date, to pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which the Company’s actual accident year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. In consideration for the coverage provided by the Stop Loss Contract, the insurance subsidiaries paid to CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. As of March 31, 2008, the net amount billed and received by the Company was $42.3 million under the Stop Loss Contract. The amount

received under the Stop Loss Contract included $24.0 million held by the Company for losses covered by this contract that were incurred but not paid as of March 31, 2008. As a result of adverse development of losses subject to the Stop Loss Contract during the three months ended March 31, 2008, the Company has a receivable from CCC of $6.5 million, which will be billed during the second quarter of 2008. As of December 31, 2007, the net amount billed and received by the Company under the Stop Loss Contract was $42.3 million. The amount received under the Stop Loss Contract included $24.0 million held by the Company for losses covered by this contract that were incurred but not paid as of December 31, 2007.

     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 was 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, which expired on 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. In January 2007, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which expired on December 31, 2007, was for an additional premium of $0.5 million, which was based on the level of actual premiums written on bonds for the large national contractor. In December 2007, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which will expire on December 31, 2008, was for an additional premium subject to the level of actual premiums written on bonds for the large national contractor. As of March 31, 2008 and December 31, 2007, the Company had ceded losses of $50.0 million under the terms of this contract, with unpaid ceded losses of $46.8 million.

     As of March 31, 2008 and December 31, 2007, CNA Surety had an insurance receivable balance from CCC and CIC of $69.2 million and $62.9 million, respectively. At March 31, 2008, this receivable includes $57.1 million of reinsurance recoverables, including the amount due under the Stop Loss Contract discussed above, and $12.1 million of premiums receivable. At December 31, 2007, this receivable included $50.5 million of reinsurance recoverables and $12.4 million of premiums receivable. CNA Surety had reinsurance payables to CCC and CIC of $0.2 million as of March 31, 2008 and $0.1 million as of December 31, 2007.

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 has enacted various exposure management initiatives. With respect to risks on large commercial accounts, the Company generally limits its exposure to $25.0 million per account, but will selectively accept higher exposures.

     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 an estimate of the Company’s exposure in the event of default before indemnification. The Company does have accounts with bonded backlogs greater than $30.0 million.

     The Company manages its exposure to any one contract credit and aggressively looks for co-surety, shared accounts and other means to support or reduce larger exposures. Reinsurance and indemnification rights, including rights to contract proceeds on construction projects in the event of default, exist that substantially reduce CNA Surety’s exposure to loss.

Net Loss Ratio

     The net loss ratio was 25.3% for the three months ended March 31, 2008 compared with 25.4% for the same period in 2007. These loss ratios include nominal revisions of prior accident year reserves, known as reserve development, for both the current quarter and the same period last year.

Expense Ratio

     The expense ratio was 53.9% for the three months ended March 31, 2008 compared to 54.8% for the same period in 2007. The improvement in the ratio reflects earned premium growth as discussed previously and continued focus on expense management.

Investment Income and Realized Investment Gains/Losses

     Net investment income was $11.8 million for the three months ended March 31, 2008 compared to $10.7 million for the same period in 2007. This increase is due to an increase in invested assets. The annualized pre-tax yield was 4.6% and 4.7% for the three months ended March 31, 2008 and 2007, respectively. The annualized after-tax yield was 3.8% for the three months ended March 31, 2008 and 2007, respectively.

     The following summarizes net realized investment gains (losses) activity (dollars in thousands):

		Three Months Ended
		March 31,
		2008				2007
Gross realized investment gains		$	3			$	279
Gross realized investment losses			(12	)			—
Net realized investment gains		$	(9	)		$	279

     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 decreased by 14.2% for the three months ended March 31, 2008 compared with the same period in 2007, due to lower interest rates. Weighted average debt outstanding was $30.9 million for both the three months ended March 31, 2008 and 2007. The weighted average interest rate for the three months ended March 31, 2008 was 7.4% as compared with 8.7% for the same period in 2007.

Income Taxes

     The Company’s income tax expense for the three months ended March 31, 2008 was $9.6 million compared to $9.0 million for the three months ended March 31, 2007. The effective income tax rates for these periods were 29.6% and 30.2%, respectively. The Company’s effective tax rate differs from the statutory tax rate due primarily to tax-exempt investment income. Tax-exempt investment income was $5.8 million and $4.8 million for the three months ended March 31, 2008 and 2007, respectively.

Liquidity and Capital Resources

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

     The Company believes that total invested assets, including cash and short-term investments, are sufficient in the aggregate and have suitably scheduled maturities to satisfy all policy claims and other operating liabilities, including dividend and income tax sharing payments of its insurance subsidiaries. At March 31, 2008, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $986.2 million of fixed income securities, $18.4 million of short-term investments and $5.6 million

of cash. At December 31, 2007, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $963.4 million of fixed income securities, $42.2 million of short-term investments and $4.7 million of cash.

     Cash flow at the parent company level is derived principally from dividend and tax sharing payments from its insurance subsidiaries, and to a lesser extent, investment income. The principal obligations at the parent company level are to service debt and pay operating expenses, including income taxes. At March 31, 2008, the parent company’s invested assets consisted of $1.9 million of equity securities, $2.3 million of short-term investments and $7.0 million of cash. At December 31, 2007, the parent company’s invested assets consisted of $1.8 million of equity securities, $7.3 million of short-term investments and $4.8 million of cash. At March 31, 2008 and December 31, 2007, parent company short-term investments and cash included $8.2 million and $9.8 million, respectively, of restricted cash primarily related to premium receipt collections ultimately due to the Company’s insurance subsidiaries.

     The Company’s consolidated net cash flow provided by operating activities was $19.2 million for the three months ended March 31, 2008 compared to net cash flow provided by operating activities of $13.9 million for the comparable period in 2007. The increase in net cash flow provided by operating activities primarily relates to lower loss payments in the current quarter. Also, the three-month period ended March 31, 2007 was impacted by the return of cash collateral which reduced cash flows by $2.8 million for that period.

     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 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 utilization fee, can vary based on the Company’s leverage ratio (debt to total capitalization) from 0.80% to 1.00%. There was no outstanding balance under the 2005 Credit Facility at March 31, 2008 or March 31, 2007. As such, the Company incurred only the facility fee of 0.300% for the three months ended March 31, 2008 and 0.325% for the three months ended March 31, 2007.

     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 three months ended March 31, 2008 and 2007.

     In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities bear interest at a rate of LIBOR plus 337.5 basis points with a 30-year term and are redeemable at par value 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 2034. As of March 31, 2008 and 2007, the interest rate on the junior subordinated debenture was 6.44% and 8.74%, respectively.

     A summary of the Company’s commitments as of March 31, 2008 is presented in the following table (in millions):

Contractual Obligations as of March 31, 2008		2008				2009				2010				2011				2012				Thereafter				Total
Debt (a)		$	1.5			$	2.0			$	2.0			$	2.0			$	2.0			$	73.6			$	83.1
Operating leases			1.5				2.0				2.0				1.8				1.0				––				8.3
Loss and loss adjustment expense reserves			175.1				127.5				88.4				29.3				17.2				44.7				482.2
Other long-term liabilities (b)			0.3				1.1				0.7				0.5				0.5				9.5				12.6
Total		$	178.4			$	132.6			$	93.1			$	33.6			$	20.7			$	127.8			$	586.2

     As an insurance holding company, CNA Surety is dependent upon dividends and other permitted payments from its insurance subsidiaries to pay operating expenses and meet debt service requirements, as well as to pay cash dividends. The payment of dividends by the insurance subsidiaries is subject to varying degrees of supervision by the insurance regulatory authorities in the insurance subsidiaries’ states of domicile. Western Surety, Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“Universal Surety”) are domiciled in South Dakota. In South Dakota, insurance companies may only pay dividends from earned surplus excluding surplus arising from unrealized capital gains or revaluation of assets. 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 South Dakota Division of Insurance 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 2008 is based on statutory surplus and income at and for the year ended December 31, 2007. Without prior regulatory approval in 2008, Western Surety may pay dividends of $96.7 million to CNA Surety. CNA Surety received no dividends from its insurance subsidiaries or its non-insurance subsidiaries during the first three months of 2008 or 2007.

     Combined statutory surplus totaled $464.0 million at March 31, 2008, resulting in an annualized net written premium to statutory surplus ratio of to 0.9 to 1. Insurance regulations restrict Western Surety’s maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2008 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 March 31, 2008, this regulation would limit Western Surety’s largest gross risk to $131.9 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 the Internal Revenue Service. CNA Surety did not receive any intercompany tax payments from its subsidiaries for the three months ended March 31, 2008 or 2007.

     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, 2007 through June 30, 2008, the underwriting limitations of Western Surety and Surety Bonding are $34.2 million and $0.7 million, respectively. Through the Quota Share Treaty previously discussed, CNA Surety has access to CCC and its affiliates’ U.S. Department of Treasury underwriting limitations. Effective July 1, 2007 through June 30, 2008, the underwriting limitations of CCC and its affiliates total $739.9 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business.

     Subject to the aforementioned uncertainties concerning the Company’s per principal net retentions, CNA Surety management believes that the Company has sufficient available resources, including capital protection against large losses provided by the Company’s excess of loss reinsurance arrangements, to meet its present capital needs.

Financial Condition

Investment Portfolio

     The estimated fair value and amortized cost or cost of fixed income and equity securities held by CNA Surety at March 31, 2008 and December 31, 2007, by investment category, were as follows (dollars in thousands):

						Gross				Gross Unrealized Losses
		Amortized Cost				Unrealized				Less Than				More Than				Estimated
March 31, 2008		or Cost				Gains				12 Months				12 Months				Fair Value
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury		$	17,775			$	1,167			$	—			$	—			$	18,942
U.S. Agencies			52,611				1,422				—				—				54,033
Collateralized mortgage obligations			29,220				543				(64	)			—				29,699
Mortgage pass-through securities			61,759				658				(39	)			(166	)			62,212
Obligations of states and political subdivisions			645,533				15,609				(5,337	)			(3,887	)			651,918
Corporate bonds			97,266				2,248				(105	)			(1,592	)			97,817
Non-agency collateralized mortgage obligations			35,022				16				(118	)			(580	)			34,340
Other asset-backed securities:
Second mortgages/home equity loans			9,528				—				(58	)			(717	)			8,753
Credit card receivables			17,235				444				(331	)			—				17,348
Other			10,780				337				—				––				11,117
Total fixed income securities			976,729				22,444				(6,052	)			(6,942	)			986,179
Equity securities			1,860				50				(52	)			—				1,858
Total		$	978,589			$	22,494			$	(6,104	)		$	(6,942	)		$	988,037

						Gross				Gross Unrealized Losses
		Amortized Cost				Unrealized				Less Than				More Than				Estimated
December 31, 2007		or Cost				Gains				12 Months				12 Months				Fair Value
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury		$	17,790			$	485			$	—			$	—			$	18,275
U.S. Agencies			52,617				706				—				(15	)			53,308
Collateralized mortgage obligations			30,086				502				(11	)			(107	)			30,470
Mortgage pass-through securities			54,659				401				—				(586	)			54,474
Obligations of states and political subdivisions			625,858				15,408				(2,500	)			(641	)			638,125
Corporate bonds			95,714				1,493				(97	)			(1,408	)			95,702
Non-agency collateralized mortgage obligations			35,011				232				—				(699	)			34,544
Other asset-backed securities:
Second mortgages/home equity loans			9,951				—				—				(50	)			9,901
Credit card receivables			17,234				451				—				—				17,685
Other			10,788				157				—				(75	)			10,870
Total fixed income securities			949,708				19,835				(2,608	)			(3,581	)			963,354
Equity securities			1,683				106				—				—				1,789
Total		$	951,391			$	19,941			$	(2,608	)		$	(3,581	)		$	965,143