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 June 30, 2008

OR

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 (State or other jurisdiction of incorporation or organization)		36-4144905 (I.R.S. Employer Identification No.)

333 S. WABASH AVE., CHICAGO, ILLINOIS (Address of principal executive offices)		60604 (Zip 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. (Check one):

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:

44,145,647 shares of Common Stock, $.01 par value as of July 18, 2008.

 

 

CNA SURETY CORPORATION AND SUBSIDIARIES

INDEX

		Page
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (Unaudited):
Condensed Consolidated Balance Sheets at June 30, 2008 and at December 31, 2007			3
Condensed Consolidated Statements of Income for the Three and Six Months Ended June 30, 2008 and 2007			4
Condensed Consolidated Statements of Stockholders’ Equity for the Six Months Ended June 30, 2008 and 2007			5
Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 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			32
Item 4. Controls and Procedures			33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			34
Item 1A. Risk Factors			34
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			34
Item 3. Defaults Upon Senior Securities			34
Item 4. Submission of Matters to a Vote of Security Holders			34
Item 5. Other Information			34
Item 6. Exhibits			34

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)

(UNAUDITED)

		June 30,				December 31,
		2008				2007
ASSETS
Invested assets:
Fixed income securities, at fair value (amortized cost: $965,836 and $949,708)		$	962,179			$	963,354
Equity securities, at fair value (cost: $1,546 and $1,683)			1,527				1,789
Short-term investments, at cost (approximates fair value)			86,849				49,453
Total invested assets			1,050,555				1,014,596
Cash			6,322				10,230
Deferred policy acquisition costs			107,248				104,280
Insurance receivables:
Premiums, including $12,031 and $12,317 from affiliates, (net of allowance for doubtful accounts: $1,124 and $1,145)			48,046				36,317
Reinsurance, including $57,831 and $50,547 from affiliates			138,535				127,119
Deposit with affiliated ceding company			35,181				34,644
Intangible assets (net of accumulated amortization: $25,523 and $25,523)			138,785				138,785
Current income taxes receivable			1,147				1,960
Property and equipment, at cost (less accumulated depreciation and amortization: $31,165 and $29,467)			25,426				24,288
Prepaid reinsurance premiums (including $153 and $322 from affiliates)			496				510
Accrued investment income			12,436				12,242
Other assets (including $470 and $0 receivable from affiliates)			2,466				2,683
Total assets		$	1,566,643			$	1,507,654
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses		$	495,041			$	472,842
Unearned premiums			272,619				258,930
Total reserves			767,660				731,772
Debt			30,842				30,791
Deferred income taxes, net			11,987				17,756
Reinsurance and other payables to affiliates			24				643
Accrued expenses			13,220				18,273
Liability for postretirement benefits			10,296				10,001
Other liabilities			28,365				30,713
Total liabilities			862,394				839,949
Commitments and contingencies (See Notes 3, 5, & 8)
STOCKHOLDERS’ EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 45,522 shares issued and 44,141 shares outstanding at June 30, 2008 and 45,505 shares issued and 44,121 shares outstanding at December 31, 2007			455				455
Additional paid-in capital			275,193				274,069
Retained earnings			446,193				399,241
Accumulated other comprehensive income (loss)			(2,773	)			8,800
Treasury stock, 1,381 and 1,384 shares, at cost			(14,819	)			(14,860	)
Total stockholders’ equity			704,249				667,705
Total liabilities and stockholders’ equity		$	1,566,643			$	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								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
Revenues:
Net earned premium		$	108,477			$	105,687			$	211,118			$	203,990
Net investment income			11,746				10,763				23,511				21,464
Net realized investment losses			(21	)			(830	)			(30	)			(551	)
Total revenues			120,202				115,620				234,599				224,903
Expenses:
Net losses and loss adjustment expenses			27,390				26,854				53,358				51,797
Net commissions, brokerage and other underwriting expenses			57,825				57,020				113,112				110,918
Interest expense			532				728				1,151				1,449
Total expenses			85,747				84,602				167,621				164,164
Income before income taxes			34,455				31,018				66,978				60,739
Income tax expense			10,405				9,124				20,026				18,096
Net income		$	24,050			$	21,894			$	46,952			$	42,643
Earnings per common share		$	0.54			$	0.50			$	1.06			$	0.97
Earnings per common share, assuming dilution		$	0.54			$	0.50			$	1.06			$	0.96
Weighted average shares outstanding			44,132				43,938				44,134				43,959
Weighted average shares outstanding, assuming dilution			44,231				44,217				44,255				44,248

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			—				—				—			$	42,643				42,643				—				—				42,643
Other comprehensive income:
Change in unrealized gains on securities, after income tax benefit of $5,452 (net of reclassification adjustment of ($142), after income tax benefit of $76)			—				—				—				(10,126	)			—				(10,126	)			—				(10,126	)
Net change related to postretirement benefits, after income tax expense of $29			—				—				—				53				—				53				—				53
Total comprehensive income			—				—				—			$	32,570				—				—				—				—
Stock-based compensation			—				—				980								—				—				—				980
Stock options exercised and other			119				1				1,737								—				—				37				1,775
Balance, June 30, 2007			43,991			$	454			$	271,368							$	349,388			$	(5,080	)		$	(14,903	)		$	601,227
Balance, December 31, 2007			44,121			$	455			$	274,069							$	399,241			$	8,800			$	(14,860	)		$	667,705
Comprehensive income:
Net income			—				—				—			$	46,952				46,952				—				—				46,952
Other comprehensive income:
Change in unrealized gains on securities, after income tax benefit of $6,100 (net of reclassification adjustment of ($49), after income tax benefit of $26)			—				—				—				(11,328	)			—				(11,328	)			—				(11,328	)
Net change related to postretirement benefits, after income tax benefit of $204			—				—				—				(245	)			—				(245	)			—				(245	)
Total comprehensive income			—				—				—			$	35,379				—				—				—				—
Stock-based compensation			—				—				919								—				—				—				919
Stock options exercised and other			20				—				205								—				—				41				246
Balance, June 30, 2008			44,141			$	455			$	275,193							$	446,193			$	(2,773	)		$	(14,819	)		$	704,249

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)

		Six Months Ended
		June 30,
		2008				2007
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	46,952			$	42,643
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for doubtful accounts			80				151
Depreciation and amortization			2,691				3,207
Amortization of bond premium, net			1,391				98
Loss on disposal of property and equipment			46				8
Net realized investment losses			30				551
Stock-based compensation			919				980
Changes in:
Insurance receivables			(23,225	)			(12,396	)
Reserve for unearned premiums			13,689				19,861
Reserve for unpaid losses and loss adjustment expenses			22,199				1,345
Deposits with affiliated ceding company			(537	)			(721	)
Deferred policy acquisition costs			(2,968	)			(6,075	)
Deferred income taxes, net			101				(486	)
Reinsurance and other payables to affiliates			(619	)			119
Prepaid reinsurance premiums			14				1,138
Accrued expenses			(5,053	)			(6,650	)
Other assets and liabilities			(1,431	)			(10,715	)
Net cash provided by operating activities			54,279				33,058
CASH FLOWS FROM INVESTING ACTIVITIES:
Fixed income securities:
Purchases			(62,290	)			(101,829	)
Maturities			20,206				12,428
Sales			24,177				5,359
Purchases of equity securities			(333	)			(320	)
Proceeds from the sale of equity securities			460				202
Changes in short-term investments			(37,028	)			50,790
Purchases of property and equipment, net			(3,825	)			(3,275	)
Other, net			200				(21	)
Net cash used in investing activities			(58,433	)			(36,666	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Employee stock option exercises and other			246				1,775
Net cash provided by financing activities			246				1,775
Decrease in cash			(3,908	)			(1,833	)
Cash at beginning of period			10,230				7,164
Cash at end of period		$	6,322			$	5,331
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest		$	1,187			$	1,399
Income taxes		$	19,089			$	18,128

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

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Significant Accounting Policies

Formation of CNA Surety Corporation and Merger

     In December 1996, CNA Financial Corporation (“CNAF”) and Capsure Holdings Corp. (“Capsure”) agreed to merge (the “Merger”) the surety business of CNAF with Capsure’s insurance subsidiaries, Western Surety Company (“Western Surety”), Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“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 June 30,								Six Months Ended June 30,
		2008				2007				2008				2007
Net income		$	24,050			$	21,894			$	46,952			$	42,643
Shares:
Weighted average shares outstanding			44,130				43,931				44,121				43,872
Weighted average shares of options exercised and additional stock issuance			2				7				13				87
Total weighted average shares outstanding			44,132				43,938				44,134				43,959
Effect of dilutive options			99				279				121				289
Total weighted average shares outstanding, assuming dilution			44,231				44,217				44,255				44,248
Earnings per share		$	0.54			$	0.50			$	1.06			$	0.97
Earnings per share, assuming dilution		$	0.54			$	0.50			$	1.06			$	0.96

     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 both the three months and six months ended June 30, 2008 because the exercise price of these options was greater than the average market price of CNA Surety’s common stock during the respective periods. Options to purchase shares of common stock of 0.3 million were excluded from the calculation of diluted earnings per share for the three months ended June 30, 2007 because the exercise price of the options was greater than the average market price. No shares were excluded from the calculation of diluted earnings per share for the six months ended June 30, 2007.

Accounting Pronouncements

     In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“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. 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.

     The Company adopted SFAS 157 on January 1, 2008 for its financial assets and liabilities. 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 period ended June 30, 2008.

2. Investments

     The estimated fair value and amortized cost or cost of fixed income and equity securities held by CNA Surety at June 30, 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
June 30, 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		$	17,759			$	583			$	—			$	—			$	18,342
U.S. Agencies			54,605				653				(16	)			—				55,242
Collateralized mortgage obligations			31,112				456				(175	)			—				31,393
Mortgage pass-through securities			59,860				301				(340	)			(564	)			59,257
Obligations of states and political subdivisions			633,233				9,913				(3,392	)			(6,565	)			633,189
Corporate bonds			97,040				677				(835	)			(1,806	)			95,076
Non-agency collateralized mortgage obligations			35,036				32				(67	)			(1,232	)			33,769
Other asset-backed securities:
Second mortgages/home equity loans			9,183				—				(137	)			(1,102	)			7,944
Credit card receivables			17,237				251				(411	)			—				17,077
Other			10,771				169				(50	)			—				10,890
Total fixed income securities			965,836				13,035				(5,423	)			(11,269	)			962,179
Equity securities			1,546				41				(60	)			—				1,527
Total		$	967,382			$	13,076			$	(5,483	)		$	(11,269	)		$	963,706

						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 or six months ended June 30, 2008. During the second quarter of 2007, the Company recognized other than temporary impairment losses of $0.9 million on 13 fixed income securities of various categories of investments that were in an unrealized loss position. These impairment losses were recognized as significant interest rate changes and a revised outlook on the interest rates resulted in the Company’s intention not to hold these securities to their anticipated recovery.

     As of June 30, 2008, 93 fixed income securities held by the Company were in an unrealized loss position. The Company believes that 87 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 87 securities, 24 were rated AAA by Standard & Poor’s (“S&P”) and Aaa by Moody’s Investor Services (“Moody’s”) and all were investment grade. Of these 87 securities, 16 were in a loss position that exceeded 5% of its book value, with the largest unrealized loss percentage being 8.9% of that security’s book value resulting in an unrealized loss of $0.3 million. The largest unrealized loss was $0.6 million, which was 5.9% of that security’s book value.

     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 19.3% ($0.8 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 14.2% ($0.4 million) of its book value. Another of these securities was an asset-backed security collateralized by sub-prime home loans. This security, rated investment grade by Moody’s but rated below investment grade by S&P, was in an unrealized loss position of 22.0% ($1.1 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 9.0% ($0.5 million), 13.2% ($1.4 million) and 20.4% ($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 June 30,
		2008								2007
		Written				Earned				Written				Earned
Direct		$	95,317			$	88,578			$	95,192			$	87,950
Assumed			28,995				27,741				30,747				27,985
Ceded			(7,935	)			(7,842	)			(9,724	)			(10,248	)
		$	116,377			$	108,477			$	116,215			$	105,687

		Six Months Ended June 30,
		2008								2007
		Written				Earned				Written				Earned
Direct		$	186,377			$	172,924			$	187,747			$	168,624
Assumed			54,560				54,324				56,606				55,867
Ceded			(16,116	)			(16,130	)			(19,363	)			(20,501	)
		$	224,821			$	211,118			$	224,990			$	203,990

     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 and six months ended June 30, 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 June 30,
		2008								2007
		$				Ratio				$				Ratio
Gross losses and loss adjustment expenses		$	31,433				27.0	%		$	30,280				26.1	%
Ceded amounts			(4,043	)			51.6	%			(3,426	)			33.4	%
Net losses and loss adjustment expenses		$	27,390				25.2	%		$	26,854				25.4	%

		Six Months Ended June 30,
		2008								2007
		$				Ratio				$				Ratio
Gross losses and loss adjustment expenses		$	70,538				31.0	%		$	58,573				26.1	%
Ceded amounts			(17,180	)			106.5	%			(6,776	)			33.1	%
Net losses and loss adjustment expenses		$	53,358				25.3	%		$	51,797				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 $4.2 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 June 30, 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 December 31, 2007, the net amount billed and received by the Company under the Stop Loss Contract was $42.3 million. This amount 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. As a result of adverse development of losses subject to the Stop Loss Contract during the six months ended June 30, 2008, the Company billed an additional $7.3 million, of which $0.1 million had been received as of June 30, 2008. The amount received under the Stop Loss Contract includes $24.1 million held by the Company for losses covered by this contract that were incurred but not paid as of June 30, 2008.

     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 June 30, 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 June 30, 2008 and December 31, 2007, CNA Surety had an insurance receivable balance from CCC and CIC of $69.9 million and $62.9 million, respectively. At June 30, 2008, this receivable included $57.8 million of reinsurance recoverables, including the amount due under the Stop Loss Contract discussed above, and $12.0 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 less than $0.1 million as of June 30, 2008 and $0.1 million as of December 31, 2007.

4. Fair Value of Financial Instruments

     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 inputs are observable.

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

		June 30, 2008
		Fair Value Measurements Using
		Level 1				Level 2				Level 3				Assets at Fair Value
Assets:
Fixed income securities at fair value		$	18,342			$	943,837				—			$	962,179
Equity securities at fair value			1,527				—				—				1,527
Short term investments at fair value (a)			74,363				12,486				—				86,849
Total assets		$	94,232			$	956,323				—			$	1,050,555

     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 June 30, 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								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
Reserves at beginning of period:
Gross		$	482,188			$	431,974			$	472,842			$	434,224
Ceded reinsurance			157,547				143,676				150,496				144,858
Net reserves at beginning of period			324,641				288,298				322,346				289,366
Net incurred loss and loss adjustment expenses:
Provision for insured events of current year			27,453				26,878				53,419				51,847
Decrease in provision for insured events of prior years			(63	)			(24	)			(61	)			(50	)
Total net incurred			27,390				26,854				53,358				51,797
Net payments attributable to:
Current year events			1,725				3,299				2,540				5,574
Prior year events			7,561				19,260				30,419				42,996
Total net payments			9,286				22,559				32,959				48,570
Net reserves at end of period			342,745				292,593				342,745				292,593
Ceded reinsurance at end of period			152,296				142,976				152,296				142,976
Gross reserves at end of period		$	495,041			$	435,569			$	495,041			$	435,569

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 also contained certain conditions and limitations on the Company. The Company was in compliance with all covenants as of and for the three and six months ended June 30, 2008 and 2007. The 2005 Credit Facility matured on June 30, 2008.

     The term of borrowings under the 2005 Credit Facility was fixed, at the Company’s option, for a period of one, two, three, or six months. The interest rate was based on, among other rates, the London Interbank Offered Rate (“LIBOR”) plus the applicable margin. The margin, including a utilization fee, varied 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 during the three and six months ended June 30, 2008 and 2007. As such, the Company incurred only the facility fee of 0.300% and 0.325% at June 30, 2008 and 2007, respectively.

     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 June 30, 2008 and 2007, the interest rate on the junior subordinated debenture was 6.051% and 8.735%, 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 June 30,								Six Months Ended June 30,
		2008				2007				2008				2007
Net periodic benefit cost:
Service cost		$	59			$	77			$	118			$	153
Interest cost			145				173				290				346
Amortization of prior service cost			(26	)			(40	)			(53	)			(81	)
Net amortization of actuarial loss			6				81				12				163
Net periodic benefit cost		$	184			$	291			$	367			$	581

     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 June 30, 2008, $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 plan was $0.4 million and $0.5 million for the three months ended June 30, 2008 and 2007, respectively, and $0.9 million and $1.0 million for the six months ended June 30, 2008 and 2007, respectively. The total income tax benefit recognized in the statement of income for stock-based compensation arrangements was $0.1 million for both the three months ended June 30, 2008 and 2007, respectively. The total income tax benefit recognized in the statement of income for stock-based compensation was $0.3 million for both the six months ended June 30, 2008 and 2007, respectively . The amount of cash received from the exercise of stock options was negligible for the three months ended June 30, 2008 and $0.2 million for the three months ended June 30, 2007. For the six months ended June 30, 2008 and 2007, the amount of cash received was $0.2 million and $1.8 million, 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 June 30, 2008, the number of shares available for granting of options under the 2006 Plan was 2,432,005.

     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 six months ended June 30, 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			(19,175	)		$	13.32
Options expired			(590	)		$	14.97
Options exercised			(114,010	)		$	12.18
Outstanding options at June 30, 2007			1,208,850			$	14.38
Outstanding options at January 1, 2008			1,054,588			$	14.53
Options granted			259,380			$	16.35
Options forfeited			(20,060	)		$	16.79
Options expired			(4,700	)		$	12.11
Options exercised			(16,300	)		$	11.32
Outstanding options at June 30, 2008			1,272,908			$	14.92

     A summary of the status of the Company’s non-vested options as of June 30, 2008 and 2007 and changes during the six 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			(12,875	)		$	3.72
Options forfeited			(19,175	)		$	5.13
Non-vested options at June 30, 2007			783,663			$	6.44
Non-vested options at January 1, 2008			554,557			$	7.23
Options granted			259,380			$	6.32
Options vested			(79,085	)		$	9.04
Options forfeited			(20,060	)		$	6.87
Non-vested options at June 30, 2008			714,792			$	6.71

     A summary of the options vested or expected to vest and options exercisable as of June 30, 2008 is presented below:

Options Vested or Expected to Vest

Weighted

Weighted Average

Average

Aggregate

Remaining

Number

Exercise Price

Intrinsic Value

Contractual Life

June 30, 2008

1,182,968

$

14.66

$

733,854

7.2 years

Options Exercisable

Weighted

Weighted Average

Average

Aggregate

Remaining

Number

Exercise Price

Intrinsic Value

Contractual Life

June 30, 2008

558,116

$

12.72

$

690,328

5.9 years

     The total intrinsic value of options exercised was less than $0.1 million and $0.1 million for the three months ended June 30, 2008 and 2007, respectively, and less than $0.1 million and $1.1 million for the six months ended June 30, 2008 and 2007, respectively. The tax benefits recognized by the Company for these exercises were negligible for both the three and six months ended June 30, 2008. Tax benefits recognized by the Company were $0.1 million and $0.4 million for the three and six months ended June 30, 2007, respectively.

     As of June 30, 2008, there was $2.0 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements granted under the Company’s equity compensation plans. That cost is expected to be recognized as follows: 2008 — $0.8 million; 2009 — $0.8 million; 2010 — $0.3 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 June 30, 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		$	103,838			$	207,004			$	310,842
Commercial			110,677				61,676				172,353
Fidelity and other			5,292				6,554				11,846
Total		$	219,807			$	275,234			$	495,041

     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 Company disclosed an indicated reserve as of December 31, 2007 in the Company’s 2007 Form 10-K. 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 an 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 are generally 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.

Intangible Assets

     CNA Surety’s Condensed Consolidated Balance Sheet as of June 30, 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 and Six Months Ended June 30, 2008 and 2007

Analysis of Net Income

     Net income for the three months ended June 30, 2008 was $24.1 million, or $0.54 per diluted share, compared to $21.9 million, or $0.50 per diluted share, for the same period in 2007. The increase in net income reflects higher earned premium, higher investment income and the impact of a lower expense ratio.

     Net income for the six months ended June 30, 2008 was $47.0 million, or $1.06 per diluted share, compared to $42.6 million, or $0.96 per diluted share, in 2007. The increase in net income reflects higher earned premium, higher investment income and the impact of a lower expense ratio.

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

Results of Insurance Operations

     Underwriting components for the Company for the three and six months ended June 30, 2008 and 2007 are summarized in the following table (dollars in thousands):

		Three Months Ended June 30,								Six Months Ended June 30,
		2008				2007				2008				2007
Gross written premiums		$	124,312			$	125,939			$	240.937			$	244,353
Net written premiums		$	116,377			$	116,215			$	224,821			$	224,990
Net earned premiums		$	108,477			$	105,687			$	211,118			$	203,990
Net losses and loss adjustment expenses		$	27,390			$	26,854			$	53,358			$	51,797
Net commissions, brokerage and other expenses		$	57,825			$	57,020			$	113,112			$	110,918
Loss ratio			25.2	%			25.4	%			25.3	%			25.4	%
Expense ratio			53.3				54.0				53.6				54.4
Combined ratio			78.5	%			79.4	%			78.9	%			79.8	%

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 June 30,								Six Months Ended June 30,
		2008				2007				2008				2007
Contract		$	83,396			$	84,873			$	155,348			$	158,016
Commercial			33,266				33,457				68,861				69,687
Fidelity and other			7,650				7,609				16,728				16,650
		$	124,312			$	125,939			$	240,937			$	244,353

     For the quarter ended June 30, 2008, gross written premiums decreased 1.3 percent to $124.3 million compared to $125.9 million for the quarter ended June 30, 2007. Contract surety gross written premiums decreased 1.7 percent to $83.4 million in the second quarter due to lower demand resulting from a smaller number of new construction projects. Commercial surety and fidelity and other gross written premiums decreased slightly to $40.9 million in the quarter as the adverse impacts of the sluggish economy were offset by growth in large commercial written premiums.

     For the six months ended June 30, 2008, gross written premiums decreased 1.4 percent to $240.9 million as compared to the six-month period ended June 30, 2007. Gross written premiums for contract surety decreased 1.7 percent to $155.3 million primarily due to lower demand resulting from a smaller number of new construction projects. Commercial surety and fidelity and other gross written premiums decreased 0.8 percent to $85.6 million in the first half of 2008 due to the adverse impact of the sluggish economy.

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

		Three Months Ended June 30,								Six Months Ended June 30,
		2008				2007				2008				2007
Contract		$	76,206			$	76,073			$	140,798			$	140,520
Commercial			32,521				32,533				67,295				67,820
Fidelity and other			7,650				7,609				16,728				16,650
		$	116,377			$	116,215			$	224,821			$	224,990

     For the quarter ended June 30, 2008, net written premiums increased slightly to $116.4 million from the second quarter of 2007 as the decrease in gross written premium discussed above was more than offset by lower reinsurance costs.

     For the six months ended June 30, 2008, net written premiums decreased slightly to $224.8 million, primarily due to the decrease in gross written premiums described above partially offset by lower reinsurance costs. Ceded written premiums decreased $3.3 million to $16.1 million for the first six months of 2008 compared to the same period last year.

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

		Three Months Ended June 30,								Six Months Ended June 30,
		2008				2007				2008				2007
Contract		$	67,708			$	65,446			$	130,498			$	123,942
Commercial			32,917				32,380				64,994				64,383
Fidelity and other			7,852				7,861				15,626				15,665
		$	108,477			$	105,687			$	211,118			$	203,990

     For the quarter ended June 30, 2008, net earned premiums increased 2.6 percent to $108.5 million as compared to the second quarter of 2007, primarily due to the lower reinsurance costs described above.

     For the six months ended June 30, 2008, net earned premiums increased 3.5 percent to $211.1 million, primarily due to the lower reinsurance costs described above.

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 $4.2 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 June 30, 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 December 31, 2007, the net amount billed and received by the Company under the Stop Loss Contract was $42.3 million. This amount 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. As a result of adverse development of losses subject to the Stop Loss Contract during the six months ended June 30, 2008, the Company billed an additional $7.3 million, of which $0.1 million had been received as of June 30, 2008. The amount received under the Stop Loss Contract includes $24.1 million held by the Company for losses covered by this contract that were incurred but not paid as of June 30, 2008.

     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 June 30, 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 June 30, 2008 and December 31, 2007, CNA Surety had an insurance receivable balance from CCC and CIC of $69.9 million and $62.9 million, respectively. At June 30, 2008, this receivable included $57.8 million of reinsurance recoverables, including the amount due under the Stop Loss Contract discussed above, and $12.0 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 less than $0.1 million as of June 30, 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 25.2% for the three months ended June 30, 2008 compared with 25.4% for the same period in 2007. The net loss ratio was 25.3% for the six months ended June 30, 2008 compared with 25.4% for the same period last year. 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 53.3% for the three months ended June 30, 2008 as compared with 54.0% for the same period in 2007. The expense ratio was 53.6% for the six months ended June 30, 2008 as compared with 54.4% for the same period in 2007. The improvement in the ratio reflects the benefit of lower reinsurance costs on earned premiums and continued focus on expense management.

Investment Income and Realized Investment Gains/Losses

     Net investment income was $11.7 million for the three months ended June 30, 2008 as compared with $10.8 million for the same period in 2007. This increase is due to higher overall invested assets. The annualized pre-tax yield was 4.5% and 4.6% for the three months ended June 30, 2008 and 2007, respectively. The annualized after-tax yield was 3.7% and 3.8% for the three months ended June 30, 2008 and 2007, respectively. The decrease in annualized yields was due to a decline in short-term yields. Net realized investment losses were nominal for the quarter ended June 30, 2008. The net realized investment losses of $0.8 million in the quarter ended June 30, 2007 were due to the recognition of impairment losses on certain fixed income securities, partially offset by net realized investment gains on the sale of other fixed income securities.

     Net investment income was $23.5 million for the six months ended June 30, 2008 as compared with $21.5 million for the same period in 2007. The increase is due to the impact of higher overall invested assets. The annualized pre-tax yields were 4.5% and 4.6% for the six months ended June 30, 2008 and 2007, respectively. The annualized after-tax yields were 3.7% and 3.8% for the six months ended June 30, 2008 and 2007, respectively. Net realized investment losses were nominal for the first six months of 2008. Net realized investment losses in the same period of 2007 were $0.6 million.

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

		Three Months Ended June 30,								Six Months Ended June 30,
		2008				2007				2008				2007
Gross realized investment gains		$	8			$	112			$	11			$	391
Gross realized investment losses			(29	)			(942	)			(41	)			(942	)
Net realized investment losses		$	(21	)		$	(830	)		$	(30	)		$	(551	)