FORM 10-Q/A
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended MARCH 31, 2003
OR
| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission file number: 1-13277
CNA SURETY CORPORATION
(Exact name of Registrant as specified in its Charter)
DELAWARE 36-4144905
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
CNA PLAZA, CHICAGO, ILLINOIS 60685
(Address of principal executive offices) (Zip Code)
(312) 822-5000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No | |
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes |X| 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:
42,958,957 shares of Common Stock, $.01 par value as of May 2, 2003.
EXPLANATORY NOTE
This Amendment No. 1 on Form 10-Q/A amends the CNA Surety Corporation ("CNA
Surety" or the "Company") Form 10-Q for the period ended March 31, 2003 as filed
by the Company on May 14, 2003 and is being filed to amend and restate Item 1
(Financial Statements), Item 2 (Management's Discussion and Analysis of
Financial Condition and Results of Operations), Item 4 (Controls and Procedures)
and Item 6 (Exhibits and Reports on Form 8-K). Subsequent to the filing of CNA
Surety's Report on Form 10-Q for the fiscal quarter ended March 31, 2003, the
Company revised its accounting for ceded premiums under a multiple year excess
of loss reinsurance treaty with its affiliate, Continental Casualty Company
("CCC"), which has been in place since October 1, 2002. Under the contract CNA
Surety pays a quarterly premium of $3.125 million, of which 70% is added to an
experience account that is reduced by any losses ceded to the treaty. To the
extent CNA Surety commutes the treaty, it is entitled to receive payment from
CCC of its experience account balance. Under Emerging Issues Task Force ("EITF")
Issue 93-6 "Accounting for Multiple-Year Retrospectively Rated Contracts by
Ceding and Assuming Enterprises" ("EITF 93-6"), a receivable for return premium
based on experience under the contract should be established at March 31, 2003.
CNA Surety had not previously established such a receivable, and has restated
its 2003 condensed consolidated financial statements to comply with EITF 93-6.
This report on Form 10-Q/A does not reflect the effect of any events subsequent
to the filing of the original Form 10-Q, except the aforementioned restatement.
CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
PAGE
----
Part I. Financial Information:
Item 1. Condensed Consolidated Financial Statements:............................................. 1
Independent Accountants' Report.......................................................... 1
Condensed Consolidated Balance Sheets at March 31, 2003 (As restated) and at
December 31, 2002 (Unaudited)............................................................ 2
Condensed Consolidated Statements of Income for the Three Months Ended
March 31, 2003 (As restated) and 2002 (Unaudited)........................................ 3
Condensed Consolidated Statements of Stockholders' Equity for the Three
Months Ended March 31, 2003 (As restated) and 2002 (Unaudited)........................... 4
Condensed Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 2003 (As restated) and 2002 (Unaudited)........................................ 5
Notes to Condensed Consolidated Financial Statements
at March 31, 2003 (As restated) (Unaudited).............................................. 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.................................................................... 14
Item 4. Controls and Procedures.................................................................. 27
Part II. Other Information:
Item 6. Exhibits and Reports on Form 8-K......................................................... 28
INDEPENDENT ACCOUNTANTS' REPORT
To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois
We have reviewed the accompanying condensed consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of March 31, 2003, and the related
condensed consolidated statements of income, stockholders' equity and cash flows
for the three-month periods ended March 31, 2003 and 2002. These interim
financial statements are the responsibility of the Corporation's management.
We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures and
making inquiries of persons responsible for financial and accounting matters. It
is substantially less in scope than an audit conducted in accordance with
auditing standards generally accepted in the United States of America, the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to such condensed consolidated interim financial statements for them to
be in conformity with accounting principles generally accepted in the United
States of America.
We have previously audited, in accordance with auditing standards generally
accepted in the United States of America, the consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of December 31, 2002, and the related
consolidated statements of income, stockholders' equity, and cash flows for the
year then ended (not presented herein); and in our report dated February 10,
2003, March 12 2004, as to Note 17, we expressed an unqualified opinion on those
consolidated financial statements (which report included explanatory paragraphs
relating to the change in accounting for goodwill and indefinite-lived
intangible assets in 2002 and the restatement described in Note 17). In our
opinion, the information set forth in the accompanying condensed consolidated
balance sheet as of December 31, 2002 is fairly stated, in all material
respects, in relation to the consolidated balance sheet from which it has been
derived.
As discussed in Note 7 to the condensed consolidated financial statements, the
accompanying 2003 condensed consolidated financial statements have been
restated.
Deloitte & Touche LLP
Chicago, Illinois
May 5, 2003
(March 12, 2004 as to the effects of the restatement described in Note 7.)
1
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
MARCH 31, DECEMBER 31,
2003 2002
--------------- ---------------
ASSETS As restated (a) As restated (a)
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $534,931 and $539,364) .... $ 567,117 $ 570,538
Equity securities, at fair value (cost: $953 and $852) ............................ 849 761
Short-term investments, at cost (approximates fair value) ......................... 23,481 50,669
Other investments, at fair value .................................................. 1,260 1,257
Cash .............................................................................. 14,070 14,979
----------- -----------
Total invested assets and cash ................................................. 606,777 638,204
Deferred policy acquisition costs ................................................... 100,982 96,386
Insurance receivables:
Premiums, including $29,655 and $34,097 from affiliates (net of allowance for
doubtful accounts: $1,730 and $1,365) .......................................... 44,345 45,423
Reinsurance, including $24,104 and $17,589 from affiliates ........................ 135,099 129,964
Intangible assets (net of accumulated amortization: $25,523 and $25,523) ............ 143,785 143,785
Property and equipment, at cost (less accumulated
depreciation: $16,693 and $16,047) ................................................ 16,832 17,260
Prepaid reinsurance premiums ........................................................ 11,893 13,337
Receivable for securities sold ...................................................... -- 3
Other assets ........................................................................ 8,176 9,018
----------- -----------
Total assets ................................................................. $ 1,067,889 $ 1,093,380
=========== ===========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses ........................................ $ 254,118 $ 303,433
Unearned premiums ................................................................. 222,896 216,213
----------- -----------
Total reserves ................................................................. 477,014 519,646
Debt ................................................................................ 60,816 60,816
Deferred income taxes, net .......................................................... 32,156 30,727
Payable for securities purchased .................................................... 2,389 --
Current income taxes payable ........................................................ 9,293 5,889
Reinsurance and other payables to affiliates ........................................ 23,413 23,003
Other liabilities ................................................................... 30,200 32,738
----------- -----------
Total liabilities .............................................................. $ 635,281 $ 672,819
----------- -----------
Commitments and contingencies (See Note 6)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,388
shares issued and 42,959 shares outstanding at March 31, 2003 and 44,386
shares issued and 42,947 shares outstanding at December 31, 2002 .................. 444 444
Additional paid-in capital .......................................................... 255,731 255,765
Retained earnings ................................................................... 170,927 159,937
Accumulated other comprehensive income .............................................. 20,853 19,861
Treasury stock, at cost ............................................................. (15,347) (15,446)
----------- -----------
Total stockholders' equity ..................................................... 432,608 420,561
----------- -----------
Total liabilities and stockholders' equity ..................................... $ 1,067,889 $ 1,093,380
=========== ===========
The accompanying notes are an integral part of these condensed
consolidated financial statements.
(a) See Note 7.
2
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
----------------------
2003 2002
------- --------
As restated (a)
Revenues:
Net earned premium ............................................ $71,206 $ 67,221
Net investment income ......................................... 6,699 7,106
Net realized investment gains (losses) ........................ 730 (278)
------- --------
Total revenues ............................................. 78,635 74,049
------- --------
Expenses:
Net losses and loss adjustment expenses ....................... 18,606 16,647
Net commissions, brokerage and other underwriting expenses .... 44,296 41,552
Interest expense .............................................. 353 458
------- --------
Total expenses ............................................. 63,255 58,657
------- --------
Income before income taxes ...................................... 15,380 15,392
Income taxes .................................................... 4,391 4,835
------- --------
Net income ...................................................... $10,989 $ 10,557
======= ========
Earnings per share .............................................. $ 0.26 $ 0.25
======= ========
Earnings per share, assuming dilution ........................... $ 0.26 $ 0.25
======= ========
Weighted average shares outstanding ............................. 42,957 42,845
======= ========
Weighted average shares outstanding, assuming dilution .......... 42,962 43,025
======= ========
The accompanying notes are an integral part of these condensed
consolidated financial statements.
(a) See Note 7.
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
COMMON
STOCK ADDITIONAL
SHARES COMMON PAID-IN COMPREHENSIVE
OUTSTANDING STOCK CAPITAL INCOME
----------- ------ ---------- -------------
Balance, December 31, 2001 ....................................... 42,780 $442 $ 254,133
Comprehensive income:
Net income ..................................................... -- -- -- $10,557
Other comprehensive income:
Change in unrealized losses on securities (after income
taxes), net of reclassification adjustment of $90 .............. -- -- -- (1,652)
-------
Total comprehensive income .................................. $ 8,905
=======
Issuance of treasury stock to employee stock purchase program .... 6
Stock options exercised and other ................................ 96 1 942
Dividends paid to stockholders ................................... -- -- --
------ ---- ---------
Balance, March 31, 2002 .......................................... 42,876 $443 $ 255,081
====== ==== =========
Balance, December 31, 2002 ....................................... 42,947 $444 $ 255,765
Comprehensive income:
Net income (As restated (a)) ................................... -- -- -- $10,989
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $(958) ........... -- -- -- 992
-------
Total comprehensive income (As restated (a)) ................ $11,981
=======
Issuance of treasury stock to employee stock purchase program .... 9 -- (38)
Stock options exercised and other ................................ 3 -- 4
------ ---- ---------
Balance, March 31, 2003 .......................................... 42,959 $444 $ 255,731
====== ==== =========
ACCUMULATED
OTHER TREASURY TOTAL
RETAINED COMPREHENSIVE STOCK STOCKHOLDERS'
EARNINGS INCOME (LOSS) (AT COST) EQUITY
--------- ------------- --------- -------------
Balance, December 31, 2001 ....................................... $ 149,128 $ 278 $(15,553) $ 388,428
Comprehensive income:
Net income ..................................................... 10,557 -- -- 10,557
Other comprehensive income:
Change in unrealized losses on securities (after income
taxes), net of reclassification adjustment of $90 .............. -- (1,652) -- (1,652)
Total comprehensive income
Issuance of treasury stock to employee stock purchase program .... 52 58
Stock options exercised and other ................................ -- -- -- 943
Dividends paid to stockholders ................................... (6,432) -- -- (6,432)
--------- -------- -------- ---------
Balance, March 31, 2002 .......................................... $ 153,253 $ (1,374) $(15,501) $ 391,902
========= ======== ======== =========
Balance, December 31, 2002 (As restated (a)) ..................... $ 159,937 $ 19,861 $(15,446) $ 420,561
Comprehensive income:
Net income (As restated (a)) ................................... 10,989 -- -- 10,989
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $(958) ........... -- 992 -- 992
Total comprehensive income
Issuance of treasury stock to employee stock purchase program .... 99 61
Stock options exercised and other ................................ 1 -- -- 5
--------- -------- -------- ---------
Balance, March 31, 2003 (As restated (a)) ........................ $ 170,927 $ 20,853 $(15,347) $ 432,608
========= ======== ======== =========
The accompanying notes are an integral part of these condensed
consolidated financial statements.
(a) See Note 7.
4
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
---------------------------
2003 2002
--------------- --------
As restated (a)
OPERATING ACTIVITIES:
Net income .................................................................................... $ 10,989 $ 10,557
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation and amortization .............................................................. 1,047 977
Accretion of bond discount, net ............................................................ 394 195
Net realized investment (gains) losses ..................................................... (730) 278
Changes in:
Insurance receivables ...................................................................... (4,057) 5,279
Reserve for unearned premiums .............................................................. 6,683 892
Reserve for unpaid losses and loss adjustment expenses ..................................... (49,315) (3,586)
Deferred policy acquisition costs .......................................................... (4,596) (3,337)
Deferred income taxes, net ................................................................. 891 1,433
Reinsurance and other payables to affiliates ............................................... 410 (622)
Prepaid reinsurance premiums ............................................................... 1,444 (3,720)
Other assets and liabilities ............................................................... 1,789 (2,338)
-------- --------
Net cash (used in) provided by operating activities ...................................... (35,051) 6,008
-------- --------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases .................................................................................. (29,097) (63,399)
Maturities ................................................................................. 27,055 30,008
Sales ...................................................................................... 7,335 22,121
Purchases of equity securities ................................................................ (123) (14,829)
Proceeds from the sale of equity securities ................................................... 18 557
Changes in short-term investments ............................................................. 27,195 26,304
Purchases of property and equipment ........................................................... (683) (1,491)
Changes in receivables/payables for securities sold/purchased ................................. 2,392 (4,290)
Other, net .................................................................................... (16) (33)
-------- --------
Net cash provided by (used in) investing activities ...................................... 34,076 (5,052)
-------- --------
FINANCING ACTIVITIES:
Employee stock option exercises ............................................................... 5 823
Issuance of treasury stock to employee stock purchase plan .................................... 61 58
-------- --------
Net cash provided by financing activities ................................................ 66 881
-------- --------
Increase (decrease) in cash ..................................................................... (909) 1,837
Cash at beginning of period ..................................................................... 14,979 13,159
-------- --------
Cash at end of period ........................................................................... $ 14,070 $ 14,996
======== ========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest ................................................................................... $ 121 $ 793
Income taxes ............................................................................... $ -- $ --
The accompanying notes are an integral part of these condensed
consolidated financial statements.
(a) See Note 7.
5
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2003
(UNAUDITED)
1. SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of CNA Surety
Corporation ("CNA Surety" or the "Company") and all majority-owned subsidiaries.
Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America ("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 2002 10-K/A. Certain financial information that is
included in annual financial statements prepared in accordance with GAAP, is not
required for interim reporting and has been condensed or omitted. The
accompanying unaudited Condensed Consolidated Financial Statements reflect, in
the opinion of management, all adjustments necessary for a fair presentation of
the interim financial statements. All such adjustments are of a normal and
recurring nature. The financial results for interim periods may not be
indicative of financial results for a full year. Certain reclassifications have
been made to the 2002 Financial Statements to conform with the presentation in
the 2003 Condensed Consolidated Financial Statements.
Earnings Per Share
Basic earnings per common share is computed by dividing income available
to common stockholders by the weighted average number of common shares
outstanding for the period. Diluted earnings per common share is computed based
on the weighted average number of shares outstanding plus the dilutive effect of
common stock equivalents which is computed using the treasury stock method.
The computation of earnings per share is as follows (amounts in thousands,
except for per share data):
Three months ended March 31,
----------------------------
2003 2002
------- -------
Net income ...................................................... $10,989 $10,557
======= =======
Shares:
Weighted average shares outstanding ............................. 42,947 42,780
Weighted average shares of options exercised ............... 10 65
------- -------
Total weighted average shares outstanding ....................... 42,957 42,845
Effect of dilutive options ................................. 5 180
------- -------
Total weighted average shares outstanding, assuming dilution .... 42,962 43,025
======= =======
Earnings per share .............................................. $ 0.26 $ 0.25
======= =======
Earnings per share, assuming dilution ........................... $ 0.26 $ 0.25
======= =======
No adjustments were made to reported net income in the computation of
earnings per share.
Accounting Changes
In August 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting
6
Standards ("SFAS") No. 143 entitled "Accounting for Asset Retirement
Obligations" ("SFAS No 143"). SFAS No. 143 addresses accounting and reporting
for obligations associated with the retirement of tangible long-lived assets and
the associated asset retirement costs. The Company adopted the provisions of
SFAS No. 143 effective January 1, 2003. The adoption of SFAS No. 143 did not
have an impact on the Company's financial position or results of operations.
In November of 2002, the FASB issued FASB Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (an interpretation of FASB
statements Nos. 5, 57, and 107 and rescission of FASB Interpretation No. 34)"
("FIN No. 45"). FIN No. 45 clarifies the requirements of SFAS No. 5, "Accounting
for Contingencies" ("SFAS No. 5") relating to a guarantor's accounting for, and
disclosure of, the issuance of certain types of guarantees. FIN No. 45 provides
for additional disclosure requirements related to guarantees, effective for
financial periods ending after December 15, 2002. Additionally, FIN No. 45
outlines provisions for initial recognition and measurement of the liability
incurred in providing a guarantee. These provisions are to be applied on a
prospective basis to guarantees issued or modified after December 31, 2002. The
Company has adopted the disclosure requirements of FIN No. 45 and the provisions
for initial recognition and measurement for all guarantees issued or modified
after December 31, 2002. The adoption of FIN No. 45 did not have a significant
impact on the Company's financial position or results of operations.
In January of 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51 ("ARB No. 51")" ("FIN No. 46"). As a general rule,
ownership by the parent, either directly or indirectly, of over fifty percent of
the outstanding voting shares of a subsidiary is a condition pointing toward
preparation of consolidated financial statements of the parent and its
subsidiary. FIN No. 46 clarifies the exceptions to this general rule, as
enunciated in paragraph 2 of ARB No. 51. FIN No. 46 requires an entity to
consolidate a variable interest entity ("VIE") even though the entity does not,
either directly or indirectly, own over fifty percent of the outstanding voting
shares.
FIN No. 46 defines a VIE as one in which a) the equity investment is not
sufficient to permit the entity to finance its activities without additional
subordinated financial support from other parties which is provided through
other interests that will absorb some or all of the expected losses of the
entity or b) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest i) direct or indirect
ability to make decisions about the entity's activities through voting rights or
similar rights or ii) the obligation to absorb the expected losses of the
entity, if they occur or receive residual returns of the entity, if they occur
or iii) the right to receive the expected residual returns of the entity if they
occur. The primary beneficiary of a VIE is required to consolidate the results
of operations of the VIE. Financial statements issued after January 31, 2003 are
required to disclose the nature, purpose, activities and size of the VIE and
maximum exposure to loss as a result of its involvement with the VIE. The
Company reviewed FIN No. 46 and is of the opinion that the Company is neither a
primary beneficiary of a VIE nor does it have a significant involvement with a
VIE.
In December 2002, the FASB issued SFAS No. 148 entitled "Accounting for
Stock-Based Compensation, Transition and Disclosure" ("SFAS No. 148"). SFAS No.
148 provides alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation.
SFAS No. 148 also amends the disclosure requirements of SFAS No. 123,
"Accounting for Stock-Based Compensation", to require prominent disclosures in
both annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The Company adopted this standard beginning with the 2002 annual
financial statements. The Company has not adopted fair value accounting in 2003.
The Company applies APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations, in accounting for its plans as allowed
for under the provisions of SFAS No. 123. Accordingly, no compensation cost has
been recognized for its stock-based incentive plans as the exercise price of the
granted options equals the market price at the grant date. Had compensation cost
for these plans been determined on the fair value at the grant date for options
granted, the Company's pro forma net income for the three months ended March 31,
2003 and 2002 would have been $10.9 million and $10.5 million, respectively.
Diluted net income per share would have been $0.25 and $0.25 for the three
months ended March 31, 2003 and 2002, respectively.
The following table illustrates the effect on net income and earnings per
share data if the Company had applied the fair value recognition provisions of
SFAS No. 123 to stock based compensation under the Company's stock-based
compensation plan.
Three months ended March 31
---------------------------
(in thousands, except per share data) 2003 2002
-------- --------
Net income $ 10,989 $ 10,557
Less: Total stock based compensation cost determined under
the fair value method, net of tax (104) (12)
-------- --------
Pro forma net income $ 10,885 $ 10,545
======== ========
Basic and diluted earnings per share, as reported $ 0.26 $ 0.25
======== ========
Basic and diluted earnings per share, pro forma $ 0.25 $ 0.25
======== ========
7
2. INVESTMENTS
The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety at March 31, 2003 and December 31, 2002, by
investment category, were as follows (dollars in thousands):
GROSS GROSS
AMORTIZED COST UNREALIZED UNREALIZED ESTIMATED FAIR
MARCH 31, 2003 OR COST GAINS LOSSES VALUE
-------------- ---------- ---------- --------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury .................................. $ 16,127 $ 921 $ -- $ 17,048
U.S. Agencies .................................. 21,225 389 -- 21,614
Collateralized mortgage obligations ............ 111 5 -- 116
Mortgage pass-through securities ............... 17,721 910 -- 18,631
Obligations of states and political subdivisions .... 358,877 20,963 (62) 379,778
Corporate bonds ..................................... 74,441 6,210 (358) 80,293
Non-agency collateralized mortgage obligations ...... 8,989 597 (51) 9,535
Other asset-backed securities:
Second mortgages/home equity loans ................ 11,279 713 -- 11,992
Credit card receivables ........................... 4,999 98 -- 5,097
Other ............................................. 7,751 734 -- 8,485
Redeemable preferred stock .......................... 13,411 1,117 -- 14,528
-------- ------- ----- --------
Total fixed income securities .................. 534,931 32,657 (471) 567,117
Equity securities ................................... 953 -- (104) 849
-------- ------- ----- --------
Total .......................................... $535,884 $32,657 $(575) $567,966
======== ======= ===== ========
GROSS GROSS
AMORTIZED COST UNREALIZED UNREALIZED ESTIMATED FAIR
DECEMBER 31, 2002 OR COST GAINS LOSSES VALUE
-------------- ---------- ---------- --------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury .................................. $ 16,140 $ 960 $ -- $ 17,100
U.S. Agencies .................................. 29,396 537 (3) 29,930
Collateralized mortgage obligations ............ 156 7 -- 163
Mortgage pass-through securities ............... 20,981 1,066 -- 22,047
Obligations of states and political subdivisions .... 347,918 20,099 (83) 367,934
Corporate bonds ..................................... 76,181 6,154 (190) 82,145
Non-agency collateralized mortgage obligations ...... 10,497 477 (58) 10,916
Other asset-backed securities:
Second mortgages/home equity loans ................ 11,842 614 -- 12,456
Credit card receivables ........................... 5,000 87 -- 5,087
Other ............................................. 7,838 653 -- 8,491
Redeemable preferred stock .......................... 13,415 854 -- 14,269
-------- ------- ----- --------
Total fixed income securities .................. 539,364 31,508 (334) 570,538
Equity securities ................................... 852 -- (91) 761
-------- ------- ----- --------
Total .......................................... $540,216 $31,508 $(425) $571,299
======== ======= ===== ========
The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
CNA Surety classifies its fixed maturity securities and its equity
securities as available-for-sale, and as such, they are carried at fair value.
The amortized cost of fixed maturity securities is adjusted for amortization of
premiums and accretion of discounts to maturity, which is included in net
investment income. Changes in fair value are reported as a
8
component of other comprehensive income.
Invested assets are exposed to various risks, such as interest rate,
market and credit. Due to the level of risk associated with certain of these
invested assets and the level of uncertainty related to changes in the value of
these assets, it is possible that changes in risks in the near term may
significantly affect the amounts reported in the Consolidated Balance Sheets and
Consolidated Statements of Income.
3. REINSURANCE
The effect of reinsurance on the Company's written and earned premium was
as follows (dollars in thousands):
THREE MONTHS ENDED MARCH 31,
--------------------------------------------------------
2003 2002
--------------------------------------------------------
WRITTEN EARNED WRITTEN EARNED
-------- -------- -------- --------
Direct .......... $ 42,367 $ 36,303 $ 36,772 $ 31,713
Assumed ......... 49,304 48,687 45,342 49,541
Ceded ........... (12,337) (13,784) (17,721) (14,033)
-------- -------- -------- --------
$ 79,334 $ 71,206 $ 64,393 $ 67,221
======== ======== ======== ========
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):
THREE MONTHS ENDED MARCH 31,
-------------------------------------------------
2003 2002
--------------------- ---------------------
$ RATIO $ RATIO
-------- ----- -------- -----
Gross losses and loss adjustment expenses .... $ 27,913 32.8% $ 18,064 22.2%
Ceded amounts ................................ (9,307) 67.5% (1,417) 10.1%
-------- --------
Net losses and loss adjustment expenses ...... $ 18,606 26.1% $ 16,647 24.8%
======== ========
Assumed premiums primarily includes all surety business written or
renewed, net of reinsurance, by Continental Casualty Company ("CCC") and The
Continental Insurance Company ("CIC"), and their affiliates, that is reinsured
by Western Surety Company ("Western Surety") pursuant to intercompany
reinsurance and related agreements.
2003 Third Party Reinsurance Compared to 2002 Third Party Reinsurance
Effective January 1, 2003, CNA Surety entered into a new excess of loss
treaty ("2003 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal on new bonds to $15 million with a
5% co-participation in the $45 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $40
million excess of $20 million per principal coverage ("2002 Excess of Loss
Treaty"). The material differences between the new excess of loss reinsurance
program and the Company's 2002 Excess of Loss Treaty are as follows. The annual
aggregate coverage increases from $100 million in 2002 to $110 million in 2003.
The minimum annual premium for the 2003 Excess of Loss Treaty is $38.0 million
compared to $30.0 million of reinsurance premiums paid in 2002. The 2003 Excess
of Loss Treaty provides the Company with coverage on a per principal basis of
95% of $45 million excess of $15 million retained by the Company. The contract
also includes similar special acceptance provisions for larger contract accounts
contained in the 2002 Excess of Loss Treaty. In addition to the one large
national contract principal and the two commercial principals excluded (based
upon class of business in 2002), the Company's reinsurers have initially
excluded three other contract principals from the 2003 Excess of Loss Treaty.
The three additional contract principals are in the process of completing asset
sales and other reorganization efforts that management believes will result in
the reinsurers' acceptance of two of the accounts in the treaty. The third
contract principal is in run-off and the Company will not be providing
additional surety bonding support.
In December 2002 and January 2003, CNAF provided loans in an aggregate
amount of approximately $45 million to the large national contractor that
undertakes projects for the construction of government and private facilities.
CNA Surety has provided significant surety bond protection for this contractor's
projects through surety bonds underwritten by CCC or its affiliates. The loans
were provided by CNAF to help the contractor meet its liquidity needs. The loans
are evidenced by demand notes and, until replaced by the credit facility
described below, accrue interest at 10%. The owners of the contractor have
pledged to CNAF substantially all the assets of the contractor as collateral for
these loans.
In March 2003, CNA Financial Corporation ("CNAF") entered into an
agreement to provide a credit facility with
9
the large national contractor to provide loans to the contractor in a maximum
aggregate amount of $86.4 million (the "Credit Facility"). Of the $86.4 million,
$57 million was outstanding at March 31, 2003. The Credit Facility and all
related loans will mature in March 2006. Advances under the Credit Facility bear
interest at the prime rate plus 6%. Payment of 3% of the interest is deferred
until the Credit Facility matures, and the remainder is to be paid monthly in
cash. Loans under the Credit Facility are secured by a pledge of substantially
all of the assets of the contractor and certain affiliates. CNA Surety has
provided significant surety bond protection for projects by this contractor
through surety bonds underwritten by CCC or its affiliates. The loans were
provided by CNAF to help the contractor meet its liquidity needs.
In March of 2003, CNAF also purchased the contractor's outstanding bank
debt for $16.4 million. The contractor retired the bank debt by paying CNAF
$16.4 million, with $11.4 million of the payoff amount being funded under the
new Credit Facility and $5 million from money loaned to the contractor by its
shareholders. Under its purchase agreement with the banks, CNAF is also required
to reimburse the banks for any draws upon approximately $6.5 million in
outstanding letters of credit issued by the banks for the contractor's benefit
that expire between May and August of 2003. Any amounts paid by CNAF to the
banks as reimbursements for draws upon the banks' letters of credit will become
obligations of the contractor to CNAF as draws upon the Credit Facility.
Loews has purchased a participation interest in one-third of the loans and
commitments under the new Credit Facility, on a dollar-for-dollar basis, up to a
maximum of $25 million. Although Loews does not have rights against the
contractor directly under the participation agreement, it shares recoveries and
certain fees under the credit facility proportionally with CNAF. The contractor
has initiated a restructuring plan that is intended to reduce costs and improve
cash flow, and a chief restructuring officer has been appointed to manage
execution of the plan. CNA Surety intends to continue to provide surety bonds on
behalf of the contractor during this restructuring period, subject to the
contractor's initial and ongoing compliance with CNA Surety's underwriting
standards. Any losses arising from bonds issued or assumed by the insurance
subsidiaries of CNA Surety to the contractor are excluded from CNA Surety's 2003
Excess of Loss Treaty. As a result, CNA Surety retains the first $60 million of
losses on bonds written with an effective date of September 30, 2002 and prior,
and CCC will incur 100% of losses above that retention level on bonds with
effective dates prior to September 30, 2002. Through facultative reinsurance
contracts with CCC, CNA Surety's exposure on bonds written from October 1, 2002
through December 31, 2002 has been limited to $20 million per bond.
Indemnification and subrogation rights, including rights to contract
proceeds on construction projects in the event of default, reduce CNA Surety's
exposure to loss. While CNA Surety believes that the contractor's restructuring
efforts will be successful and provide sufficient cash flow for its operations,
the contractor's failure to achieve its restructuring plan or perform its
contractual obligations underlying all of the Company's surety bonds could have
a material adverse effect on CNA Surety's future results of operations, cash
flows and capital resources. If such failures occur, the Company estimates that
possible losses, net of indemnification and subrogation recoveries, but before
recoveries under reinsurance contracts, could be up to $200 million. However,
the related party reinsurance treaties discussed below should limit the
Company's per principal exposure to approximately $60 million.
Related Party Reinsurance
Intercompany 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 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 expires on December 31, 2003; and is
annually renewable thereafter. There was no amount due to the CNA Surety
insurance subsidiaries as of March 31, 2003.
Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all
surety business written or renewed by CCC and CIC after the Merger Date. CCC and
CIC transfer the related liabilities of such business and pay to Western Surety
an amount in cash equal to CCC's and CIC's net written premiums written on all
such business, minus a quarterly ceding commission to be retained by CCC and CIC
equal to $50,000 plus 28% of net written premiums written on such business.
10
Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and
loss adjustment expenses transferred to Western Surety 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 reestimated as of the end
of such calendar quarter. There was not any adverse reserve development for the
period from September 30, 1997 (date of inception) through December 31, 2002.
The Quota Share Treaty had an original term of five years from the Merger
Date and was renewed on October 1, 2002 on substantially the same terms with an
expiration date of December 31, 2003; and is annually renewable thereafter. The
ceding commission paid to CCC and CIC by Western Surety remained at 28% of net
written premiums and contemplates an approximate 4% override commission for
fronting fees to CCC and CIC on their actual direct acquisition costs.
The Stop Loss Contract terminated on December 31, 2000 and was not
renewed. The Stop Loss Contract protected the insurance subsidiaries 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 1997 through 2000 on certain insured accounts (the
"Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end of each
calendar quarter following the Merger Date, to pay to the insurance subsidiaries
a dollar amount equal to (i) the amount, if any, by which their actual accident
year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii)
the applicable net earned premiums. In consideration for the coverage provided
by the Stop Loss Contract, the insurance subsidiaries paid to CCC an annual
premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all
required annual premiums. As of March 31, 2003, the Company billed and received
approximately $25 million from CCC under the Stop Loss Contract. This amount
exceeds the Company's current estimate of incurred loss recoverable under this
agreement by $5.9 million, which is reflected as reinsurance payable to CCC at
March 31, 2003.
The Excess of Loss Contracts provided the insurance subsidiaries of CNA
Surety with the capacity to underwrite large surety bond exposures by providing
reinsurance support from CCC. The Excess of Loss Contract provides $75 million
of coverage for losses in excess of the $60 million per principal. Subsequent to
the Merger Date, the Company entered into a second excess of loss contract with
CCC ("Second Excess of Loss Contract"). The Second Excess of Loss Contract
provides additional coverage for principal losses that exceed the foregoing
coverage of $75 million per principal provided by the Excess of Loss Contract,
or aggregate losses per principal in excess of $135 million. In consideration
for the reinsurance coverage provided by the Excess of Loss Contracts, the
insurance subsidiaries paid to CCC, on a quarterly basis, a premium equal to 1%
of the net written premiums applicable to the Excess of Loss Contract, subject
to a minimum premium of $20,000 and $5,000 per quarter under the Excess of Loss
Contract and Second Excess of Loss Contract, respectively. The two Excess of
Loss Contracts collectively provided coverage for losses discovered on surety
bonds in force as of the Merger Date and for losses discovered on new and
renewal business written during the term of the Excess of Loss Contracts. Both
Excess of Loss Contracts commenced following the Merger Date and continued until
September 30, 2002. The discovery period for losses covered by the Excess of
Loss Contracts extends until September 30, 2005.
Effective October 1, 2002, the Company secured replacement excess of loss
protection from CCC for per principal losses that exceed $60 million in two
parts - a) $40 million excess of $60 million and b) $50 million excess of $100
million. This excess of loss protection is primarily necessary to support
contract surety accounts with bonded backlogs or work-in-process in excess of
$60 million. The Company generally limits support to large commercial surety
accounts to $25 million. In addition to the foregoing structural changes in its
high layer excess of loss reinsurance programs, the cost for these protections
increased significantly as compared to the cost of the previous two Excess of
Loss Contracts. The $40 million excess of $60 million contract is for a three
year term beginning October 1, 2002 and provides annual aggregate coverage of
$80 million and $120 million aggregate coverage for the entire three year term.
The Company will pay CCC annual reinsurance premiums of $12.5 million in year
one and $17.5 million in years two and three, payable quarterly. The Company may
commute the contract at the end of each contract year under certain
circumstances. If the treaty is commuted, the Company may be entitled to a
return premium payment. Based on the experience under the treaty to March 31,
2003, the Company has established a return premium receivable of $4.4 million in
connection with the restatement described in Note 7. The reinsurance premium for
the coverage provided by the $50 million excess of $100 million contract was
$6.0 million. This contract expires on December 31, 2003.
As of March 31, 2003 and December 31, 2002, CNA Surety had insurance
receivable balances from CCC and CIC of $53.8 million and $51.7 million,
respectively. CNA Surety had reinsurance payables to CCC and CIC of $20.7
million and $21.3 million as of March 31, 2003 and December 31, 2002,
respectively, primarily related to reinsured losses.
11
4. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the reserves for unpaid losses and loss adjustment expenses
was as follows (dollars in thousands):
THREE MONTHS ENDED MARCH 31,
----------------------------
2003 2002
-------- ---------
Reserves at beginning of period:
Gross ..................................................................... $303,433 $ 315,811
Ceded reinsurance ......................................................... 137,301 166,318
-------- ---------
Net reserves at beginning of period ..................................... 166,132 149,493
-------- ---------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period .......................... 18,551 16,665
Increase (decrease) in provision for insured events of prior periods .... 55 (18)
-------- ---------
Total net incurred ................................................... 18,606 16,647
-------- ---------
Net payments attributable to:
Current period events ................................................... 505 1,917
Prior period events ..................................................... 28,056 6,041
-------- ---------
Total net payments ................................................... 28,561 7,958
-------- ---------
Net reserves at end of period ............................................. 156,177 158,182
Ceded reinsurance at end of period ........................................ 97,941 154,043
-------- ---------
Gross reserves at end of period ...................................... $254,118 $ 312,225
======== =========
On January 2, 2003, CNA Surety settled litigation brought by J.P. Morgan
Chase & Co. ("Chase") in connection with three surety bonds issued on behalf of
Enron Corporation subsidiaries. The penal sums of the three bonds totaled
approximately $78 million. Although the Company believed it had valid defenses
to the litigation, based on the uncertainty and risk of an adverse jury verdict,
pursuant to the settlement agreement, the Company paid Chase approximately $40.7
million and assigned its recovery rights in the Enron bankruptcy to Chase in
exchange for a full release of its obligations under the bonds. The Company has
no other exposure related to the Enron Corporation. CNA Surety's net loss
related to the settlement, after anticipated recoveries under excess of loss
reinsurance treaties, was previously fully reserved. Immediately upon execution
of the settlement documents, the Company sent written notice for reimbursement
to its reinsurers.As of March 31, 2003, the Company has billed a total of $33.9
million to its reinsurers. A number of those reinsurers have requested a variety
of documents and reserved their rights before making a decision concerning
coverage of the settlement under the reinsurance treaties. The Company has
provided all requested information. Three reinsurers responsible for payment of
34% of the treaty proceeds have either paid or committed to pay 100% of their
portions of the claim. Two other reinsurers have sent the Company letters
expressing reservations about the claim. Pursuant to the treaty, the Company has
sent a notice demanding arbitration to those reinsurers. Management believes
none of the reinsurers have valid defenses under the reinsurance treaties to
avoid payment, and that the Company will fully recover all reinsurance
recoverables recorded related to this settlement. As such, the Company has not
recorded a reduction with respect to these reinsurance recoverables as of March
31, 2003.
5. DEBT
On September 30, 2002, the Company refinanced $65 million in outstanding
borrowings under its previous credit facility with a new credit facility (the
"2002 Credit Facility"). The 2002 Credit Facility provided an aggregate of up to
$65 million in initial borrowings divided between a 364-day revolving credit
facility (the "Revolving Credit Facility") of $35 million and a three-year term
loan facility (the "Term Loan") of $30 million. The Revolving Credit Facility
may be extended, with the consent of lenders, for up to two additional periods
of up to 364 days each, but in no case shall the Revolving Credit Facility be
extended to mature on a date later than three years from the effective date of
the Revolving Credit Facility. The Revolving Credit Facility may be increased
from time to time by the amount of amortization under the Term Loan facility.
Such increase is subject to consent by each Revolving Credit Bank, and will take
place upon receipt by the Banks of the respective installment payments under the
Term Loan facility.
Effective January 30, 2003, the Company entered into an interest rate swap
on the $30 million Term Loan that fixed the interest rate at 2.75%.
Amortization of the Term Loan will take place at $10,000,000 per year, in
equal installments of $5,000,000 on the following dates:
DATE AMORTIZATION OUTSTANDING BALANCE
------------ -------------------
June 30, 2003 ..................... $5,000,000 $25,000,000
September 30, 2003 ................ 5,000,000 20,000,000
March 31, 2004 .................... 5,000,000 15,000,000
September 30, 2004 ................ 5,000,000 10,000,000
March 31, 2005 .................... 5,000,000 5,000,000
September 30, 2005 ................ 5,000,000 0
12
The interest rate on borrowings under the 2002 Credit Facility may be
fixed, at CNA Surety's option, for a period of one, two, three, or six months
and is based on, among other rates, the London Interbank Offered Rate ("LIBOR"),
plus the applicable margin. The margin, including a facility fee and utilization
fee on the 2002 Credit Facility, was 0.625% at March 31, 2003 and can vary based
on CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to
0.80%. As of March 31, 2003, the weighted average interest rate was 2.4% on the
$60 million of outstanding borrowings. As of December 31, 2002, the weighted
average interest rate on the 2002 Credit Facility was 2.0% on the $60 million of
outstanding borrowings.
The 2002 Credit Facility contains, among other conditions, limitations on
CNA Surety with respect to the incurrence of additional indebtedness and
maintenance of a rating of at least "A" by A.M. Best Company Inc. for each of
the Company's insurance subsidiaries. The 2002 Credit Facility also requires the
maintenance of certain financial ratios as follows: a) maximum funded debt to
total capitalization ratio of 25%, b) minimum net worth of $350.0 million and c)
minimum fixed charge coverage ratio of 2.5 times. As of December 31, 2002, the
Company was in compliance with all restrictions and covenants contained in the
2002 Credit Facility.
In 1999 CNA Surety acquired certain assets of Clark Bonding Company, Inc.,
a Charlotte, North Carolina, insurance agency and brokerage doing business as
The Bond Exchange, for $5.9 million. As part of this acquisition, the Company
incurred an additional $1.9 million of debt in the form of a promissory note.
The promissory note matures on July 27, 2004 and has an interest rate of 5.0%.
The balance of this promissory note at March 31, 2003 was $0.8 million.
The consolidated balance sheet reflects total debt of $60.8 million at
March 31, 2003 and December 31, 2002. The weighted average interest rate on
outstanding borrowings was 2.4% and 2.1% at March 31, 2003 and December 31, 2002
respectively.
6. LEGAL PROCEEDINGS
The Company is party to various lawsuits arising in the normal course of
business, some seeking material damages. The Company believes the resolution of
these lawsuits will not have a material adverse effect on its financial
condition or its results of operations.
7. RESTATEMENT
Subsequent to the filing of CNA Surety's Report on Form 10-Q for the
fiscal quarter ended March 31, 2003, the Company revised its accounting for
ceded premiums under a multiple year excess of loss reinsurance treaty with its
affiliate, Continental Casualty Company, which has been in place since October
1, 2002. Under the contract CNA Surety pays a quarterly premium of $3.125
million, of which 70% is added to an experience account that is reduced by any
losses ceded to the treaty. On dates specified under the contract, CNA Surety
can commute the treaty and receive payment of the experience account balance.
Under Emerging Issues Task Force ("EITF") Issue 93-6 "Accounting for
Multiple-Year Retrospectively Rated Contracts by Ceding and Assuming
Enterprises" ("EITF 93-6"), a receivable for return premium based on experience
under the contract should be established at March 31,2003. CNA Surety had not
previously established such a receivable, and has restated its 2003 condensed
consolidated financial statements to comply with EITF 93-6. A summary of the
significant effects of the restatement is as follows:
As Previously As As Previously As
Reported Restated Reported Restated
-------- -------- -------- --------
As of and for the period ended: March 31, 2003 March 31, 2003 December 31, 2002 December 31, 2002
(in thousands, except per share data)
Consolidated balance sheets:
Insurance receivables: Reinsurance $130,723 $135,099 $127,776 $129,964
Current income taxes payable 7,761 9,293 5,123 5,889
Retained earnings 168,083 170,927 158,515 159,937
Consolidated statements of income:
Net earned premium $ 69,018 $ 71,206
Total revenue 76,447 78,635
Income before income taxes 13,192 15,380
Income taxes 3,625 4,391
Net income 9,567 10,989
Basic and Diluted earnings per share $ 0.22 $ 0.26
13
CNA SURETY CORPORATION AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
GENERAL
The following is a discussion and analysis of CNA Surety Corporation ("CNA
Surety" or the "Company") and its subsidiaries' operating results, liquidity and
capital resources, and financial condition. This discussion should be read in
conjunction with the Condensed Consolidated Financial Statements of CNA Surety
and notes thereto.
RESTATEMENT
Subsequent to the filing of CNA Surety's Report on Form 10-Q for the
fiscal quarter ended March 31, 2003, the Company revised its accounting for
ceded premiums under a multiple year excess of loss reinsurance treaty with its
affiliate, Continental Casualty Company, which has been in place since October
1, 2002 (this treaty is discussed in greater detail in Note 3 (Reinsurance)).
Under the contract CNA Surety pays a quarterly premium of $3.125 million, of
which 70% is added to an experience account that is reduced by any losses ceded
to the treaty. On dates specified under the contract, CNA Surety can commute the
treaty and receive payment of the experience account balance. Under Emerging
Issues Task Force ("EITF") Issue 93-6 "Accounting for Multiple-Year
Retrospectively Rated Contracts by Ceding and Assuming Enterprises" ("EITF
93-6"), a receivable for return premium based on experience under the contract
should be established at March 31, 2003. CNA Surety had not previously
established such a receivable, and has restated its 2003 condensed consolidated
financial statements to comply with EITF 93-6. See Note 7 to the Condensed
Consolidated Financial Statements. This Management's Discussion and Analysis
reflects the effects of the restatement.
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 investments, deferred acquisition costs,
goodwill and other intangible assets, reserves for unpaid losses and loss
adjustment expenses and reinsurance. The Company's accounting policies related
to reserves for unpaid losses and loss adjustment expenses and related estimates
of reinsurance recoverables, are particularly critical to an assessment of the
Company's financial results. These areas are highly subjective and require
management's most complex judgments because of the need to make estimates about
the effects of matters that are inherently uncertain.
Investments
Management believes the Company has the ability to hold all fixed income
securities to maturity. However, the Company may dispose of securities prior to
their scheduled maturity due to changes in interest rates, prepayments, tax and
credit considerations, liquidity or regulatory capital requirements, or other
similar factors. As a result, the Company considers all of its fixed income
securities (bonds and redeemable preferred stocks) and equity securities as
available-for-sale. These securities are reported at fair value, with unrealized
gains and losses, net of deferred income taxes, reported as a separate component
of stockholders' equity. Cash flows from purchases, sales and maturities are
reported gross in the investing activities section of the cash flow statement.
The amortized cost of fixed income securities is determined based on cost
and the cumulative effect of amortization of premiums and accretion of discounts
to maturity. Such amortization and accretion are included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective-yield method based on estimated cash flows. All
securities transactions are recorded on the trade date. Investment gains or
losses realized on the sale of securities are determined using the specific
identification method. Investments with an other-than-temporary decline in value
are written down to fair value, resulting in losses that are included in
realized investment gains and losses.
Short-term investments which generally include U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents, are carried at amortized cost which approximates fair value.
14
Deferred Policy Acquisition Costs
Policy acquisition costs, consisting of commissions, premium taxes and
other underwriting expenses which vary with, and are primarily related to, the
production of business, net of reinsurance commissions, are deferred and
amortized as a charge to income as the related premiums are earned. Anticipated
investment income is considered in the determination of the recoverability of
deferred acquisition costs.
Goodwill and Other Intangible Assets
CNA Surety's Consolidated Balance Sheet as of March 31, 2003 includes
goodwill and identified intangibles of approximately $143.8 million. These
amounts represent goodwill and identified intangibles arising from the
acquisition of Capsure Holdings Corp. ("Capsure"). Prior to 2002, goodwill from
this and other acquisitions was generally amortized as a charge to earnings over
periods not exceeding 30 years. Under Statement of Financial Accounting
Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets"
("SFAS No. 142"), which was adopted by CNA Surety as of January 1, 2002,
periodic amortization ceased, in accordance with an impairment-only accounting
model.
A significant amount of judgment is required in performing goodwill
impairment tests. Such tests include periodically determining or reviewing the
estimated fair value of CNA Surety's reporting units. Under SFAS No. 142, fair
value refers to the amount for which the entire reporting unit may be bought or
sold. There are several methods of estimating fair value, including market
quotations, asset and liability fair values and other valuation techniques, such
as discounted cash flows and multiples of earnings or revenues. If the carrying
amount of a reporting unit, including goodwill, exceeds the estimated fair
value, then individual assets, including identifiable intangible assets, and
liabilities of the reporting unit are estimated at fair value. The excess of the
estimated fair value of the reporting unit over the estimated fair value of net
assets would establish the implied value of goodwill. The excess of the recorded
amount of goodwill over the implied value of goodwill is recorded as an
impairment loss.
Reserves for Unpaid Losses and Loss Adjustment Expenses and Reinsurance
CNA Surety accrues liabilities for unpaid losses and loss adjustment
expenses 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. As of any balance sheet
date, all claims have not yet 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 claims. Additionally,
reported claims are in various stages of the settlement process. Each claim is
settled individually based upon its merits, and certain claim liabilities may
take years to settle, especially if legal action is involved.
The Company uses a variety of techniques to establish the liabilities for
unpaid claims recorded at the balance sheet date. While techniques may vary,
each employs significant judgments and assumptions. Techniques may involve
detailed statistical analysis of past claim reporting, settlement activity,
salvage and subrogation activity, claim frequency and severity data when
sufficient information exists to lend statistical credibility to the analysis.
The analysis may be based upon internal loss experience or industry experience.
Techniques may vary depending on the type of claim being estimated. Liabilities
may also reflect implicit or explicit assumptions regarding the potential
effects of future economic and social inflation, judicial decisions, law
changes, and recent trends in such factors.
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.
CNA Surety's Consolidated Balance Sheet includes estimated liabilities for
unpaid losses and loss adjustment expenses of $254.1 million and reinsurance
receivables related to losses of $97.9 million at March 31, 2003. Due to the
inherent uncertainties in the process of establishing these amounts, the actual
ultimate claims amounts will differ from the currently recorded amounts. An
incremental percentage change in estimates of this magnitude could result in a
material effect on reported earnings. For example, a 10% increase in the March
31, 2003 net estimate for unpaid losses and loss adjustment expenses would
produce approximately a $15.6 million charge to pre-tax earnings. Future effects
from changes in these estimates will be recorded as a component of losses
incurred in the period such changes are determined to be needed.
FORMATION OF CNA SURETY AND MERGER
15
In December 1996, CNA Financial Corporation ("CNAF") and Capsure agreed to
merge (the "Merger") the surety business of CNAF with Capsure's insurance
subsidiaries, Western Surety Company ("Western Surety") and Universal Surety of
America ("USA"), into CNA Surety. CNAF, through its operating subsidiaries,
writes multiple lines of property and casualty insurance, including surety
business that is reinsured by Western Surety. CNAF owns approximately 64% of the
outstanding common stock of CNA Surety. Loews Corporation 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"). CIC was acquired by CNAF
on May 10, 1995. The combined surety operations of CCC and CIC are referred to
herein as CCC Surety Operations.
BUSINESS
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 34,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety and
USA. The insurance subsidiaries write, on a direct basis or as business assumed
from CCC and CIC, small fidelity and non-contract surety bonds, referred to as
commercial bonds; small, medium and large contract bonds; and errors and
omissions ("E&O") liability insurance. Western Surety is a licensed insurer in
all 50 states, the District of Columbia and Puerto Rico. USA is licensed in 44
states and the District of Columbia. Western Surety's affiliated company, Surety
Bonding Company of America ("SBCA"), is licensed in 28 states and the District
of Columbia.
FORWARD-LOOKING STATEMENTS
This report includes a number of statements which relate to anticipated
future events (forward-looking statements) rather than actual present conditions
or historical events. You can identify forward-looking statements because
generally they include words such as "believes," "expects," "intends,"
"anticipates," "estimates," and similar expressions. Forward-looking statements
in this report include expected developments in the Company's insurance
business, including losses and loss reserves; the impact of routine ongoing
insurance reserve reviews being conducted by the Company; the ongoing state
regulatory examinations of the Company's primary insurance company subsidiaries,
and the Company's responses to the results of those reviews and examinations;
the Company's expectations concerning its revenues, earnings, expenses and
investment activities; expected cost savings and other results from the
Company's expense reduction and restructuring activities; and the Company's
proposed actions in response to trends in its business.
Forward-looking statements, by their nature, are subject to a variety of
inherent risks and uncertainties that could cause actual results to differ
materially from the results projected. Many of these risks and uncertainties
cannot be controlled by the Company. Some examples of these risks and
uncertainties are:
- general economic and business conditions;
- changes in financial markets such as fluctuations in interest rates,
long-term periods of low interest rates, credit conditions and
currency, commodity and stock prices;
- the effects of corporate bankruptcies, such as Enron and WorldCom,
on surety bond claims, as well as on capital markets;
- changes in foreign or domestic political, social and economic
conditions;
- regulatory initiatives and compliance with governmental regulations,
judicial decisions, including interpretation of policy provisions,
decisions regarding coverage, trends in litigation and the outcome
of any litigation involving the Company, and rulings and changes in
tax laws and regulations;
- regulatory limitations, impositions and restrictions upon the
Company, including the effects of assessments and other surcharges
for guaranty funds and other mandatory pooling arrangements;
- the impact of competitive products, policies and pricing and the
competitive environment in which the Company operates, including
changes in the Company's books of business;
- product and policy availability and demand and market responses,
including the level of ability to obtain rate increases and decline
or non-renew underpriced accounts, to achieve premium targets and
profitability and to realize growth and retention estimates;
- development of claims and the impact on loss reserves, including
changes in claim settlement practices;
- the performance of reinsurance companies under reinsurance contracts
with the Company;
16
- results of financing efforts, including the availability of bank
credit facilities;
- changes in the Company's composition of operating segments;
- the sufficiency of the Company's loss reserves and the possibility
of future increases in reserves;
- the risks and uncertainties associated with the Company's loss
reserves as outlined in the Reserves section of this MD&A; and,
- the possibility of further changes in the Company's ratings by
ratings agencies, including the inability to access certain markets
or distribution channels and the required collateralization of
future payment obligations as a result of such changes, and changes
in rating agency policies and practices;
Any forward-looking statements made in this report are made by the Company
as of the date of this report. The Company does not have any obligation to
update or revise any forward-looking statement contained in this report, even if
the Company's expectations or any related events, conditions or circumstances
change.
RESULTS OF OPERATIONS
Financial Measures
The Management's Discussion and Analysis of Financial Condition and
Results of Operations ("MD&A") discusses certain generally accepted accounting
principles ("GAAP") and non-GAAP financial measures in order to provide
information used by management to monitor the Company's operating performance.
Management utilizes various financial measures to monitor the Company's
insurance operations and investment portfolio. Underwriting results, which are
derived from certain income statement amounts, are considered a non-GAAP
financial measure and are used by management to monitor performance of the
Company's insurance operations. The Company's investment portfolio is monitored
through analysis of various quantitative and qualitative factors and certain
decisions related to the sale or impairment of investments produce realized
gains and losses, which is also a component used in the calculation of net
income and is a non-GAAP financial measure.
Underwriting results are computed as net earned premiums less net loss and
loss adjustment expenses and net commissions, brokerage and other underwriting
expenses. Management uses underwriting results to monitor 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 claim and
claim adjustment expenses to net earned premiums. The expense ratio is the
percentage of net commissions, brokerage and other underwriting expenses,
including the amortization of deferred acquisition costs, to net earned
premiums. The combined ratio is the sum of the loss and expense ratios.
The Company's investment portfolio is monitored by management through
analyses of various factors including unrealized gains and losses on securities,
portfolio duration and exposure to interest rate, market and credit risk. Based
on such analyses, the Company may impair an investment security in accordance
with its policy, or sell a security. Such activities will produce net realized
investment gains and losses.
While management uses various GAAP and non-GAAP financial measures to
monitor various aspects of the Company's performance, net income is the most
directly comparable GAAP measure and represents a more comprehensive measure of
operating performance. Management believes that its process of evaluating
performance through the use of these non-GAAP financial measures provides a
basis for enhanced understanding of the operating performance and the impact to
net income as a whole. Management also believes that investors may find these
widely used financial measures described above useful in interpreting the
underlying trends and performance, as well as to provide visibility into the
significant components of net income.
17
CNA SURETY RESULTS FOR THREE MONTHS ENDED MARCH 31, 2003 AND 2002
Analysis of Net Income
The Company had net income of $11.0 million for the three months ended
March 31, 2003, as compared to $10.6 million for the comparable period in the
prior year. The principal drivers of the difference in net income from period to
period were an increase in net realized investment gains of $1.0 million and
higher net earned premiums, partially offset by an increase in the Company's net
losses, commissions and related expenses.
Analysis of the components of net income are discussed in the following
sections.
Results of Insurance Operations
Underwriting components for the Company for the three months ended
March 31, 2003 and 2002 are summarized in the following table (dollars in
thousands):
THREE MONTHS ENDED MARCH 31,
2003 2002
------- -------
Gross written premiums ........................... $91,671 $82,114
======= =======
Net written premiums ............................. $79,334 $64,393
======= =======
Net earned premiums .............................. $71,206 $67,221
======= =======
Net losses and loss adjustment expenses .......... $18,606 $16,647
======= =======
Net commissions, brokerage and other expenses .... $44,296 $41,552
======= =======
Loss ratio ....................................... 26.1% 24.8%
Expense ratio .................................... 62.2 61.8
------- -------
Combined ratio ................................... 88.3% 86.6%
======= =======
Premiums Written
CNA Surety primarily markets contract and commercial surety bonds.
Contract surety bonds generally secure a contractor's performance and/or payment
obligation with respect to a construction project. Contract surety bonds are
generally required by federal, state and local governments for public works
projects. The most common types include bid, performance and payment bonds.
Commercial surety bonds include all surety bonds other than contract and cover
18
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.
Gross written premiums are shown in the table below (dollars in
thousands):
THREE MONTHS ENDED MARCH 31,
2003 2002
------- -------
Contract ................ $41,623 $39,380
Commercial .............. 42,015 35,088
Fidelity and other ...... 8,033 7,646
------- -------
$91,671 $82,114
======= =======
Gross written premiums increased 11.6%, or $9.6 million, for the three
months ended March 31, 2003 over the comparable period in 2002. Commercial
surety accounted for most of this increase with growth of 19.7%, or $6.9
million, in gross written premiums as compared to 2002. In the first quarter of
2003, the Company experienced continued volume growth of small commercial
products and improving rates on large commercial bonds partially offset by the
impacts of the Company's ongoing efforts to reduce aggregate exposures on large
commercial accounts. The estimated impact of the Company's exposure reduction of
$900 million for the first quarter of 2003 represents approximately $4 million
in annual premium, assuming an average rate per $1,000 of bond exposure of
$4.70, or 47 basis points. Contract surety increased 5.7%, or $2.2 million, for
the three months ended March 31, 2003 reflecting improving rates. Fidelity and
other products increased 5.1%, or $0.4 million, to $8.0 million for the three
months ended March 31, 2003 as compared to the same period in 2002 due primarily
to an increase in fidelity business.
Net written premiums are shown in the table below (dollars in thousands):
THREE MONTHS ENDED MARCH 31,
2003 2002
------- -------
Contract ......................................... $36,133 $31,235
Commercial ....................................... 35,523 25,849
Fidelity and other ............................... 7,678 7,309
------- -------
$79,334 $64,393
======= =======
For the three months ended March 31, 2003, net written premiums increased
23.2%, or $14.9 million, to $79.3 million as compared to the same period in
2002, reflecting the aforementioned gross production changes and lower ceded
written premiums. Ceded written premiums decreased $5.4 million to $12.3 million
for the first quarter of 2003 compared to the same period of last year primarily
due to changes in the Company's reinsurance programs. Ceded written premiums in
first quarter 2002 included $8.5 million for the purchase of extended discovery
coverage on the Company's $55 million excess of $5 million per principal excess
of loss coverage that was in place for 2001. Net written premiums for commercial
surety increased 37.4%, or $9.7 million, to $35.5 million for the three months
ended March 31, 2003. Net written premiums for contract surety business
increased 15.7%, or $4.9 million, to $36.1 million. Fidelity and other products
increased 5.0%, or $0.4 million, to $7.7 million for the three months ended
March 31, 2003 as compared to the same period in 2002.
Excess of Loss Reinsurance
Beginning in 1999, the Company has experienced an increase in claim
severity and frequency in the most recent accident years. CNA Surety is paying
higher costs for reinsurance as a result of this loss experience.
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.
2003 Third Party Reinsurance Compared to 2002 Third Party Reinsurance
19
Effective January 1, 2003, CNA Surety entered into a new excess of loss
treaty ("2003 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal on new bonds to $15 million with a
5% co-participation in the $45 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $40
million excess of $20 million per principal coverage ("2002 Excess of Loss
Treaty"). The material differences between the new excess of loss reinsurance
program and the Company's 2002 Excess of Loss Treaty are as follows. The annual
aggregate coverage increases from $100 million in 2002 to $110 million in 2003.
The minimum annual premium for the 2003 Excess of Loss Treaty is $38.0 million
compared to $30.0 million of reinsurance premiums paid in 2002. The 2003 Excess
of Loss Treaty provides the Company with coverage on a per principal basis of
95% of $45 million excess of $15 million retained by the Company. The contract
also includes similar special acceptance provisions for larger contract accounts
contained in the 2002 Excess of Loss Treaty. In addition to the one large
national contract principal and the two commercial principals excluded (based
upon class of business in 2002), the Company's reinsurers have initially
excluded three other contract principals from the 2003 Excess of Loss Treaty.
The three additional contract principals are in the process of completing asset
sales and other reorganization efforts that management believes will result in
the reinsurers' acceptance of two of the accounts in the treaty. The third
contract principal is in run-off and the Company will not be providing
additional surety bonding support.
In December 2002 and January 2003, CNAF provided loans in an aggregate
amount of approximately $45 million to the large national contractor that
undertakes projects for the construction of government and private facilities.
CNA Surety has provided significant surety bond protection for this
contractor's projects through surety bonds underwritten by CCC or its
affiliates. The loans were provided by CNAF to help the contractor meet its
liquidity needs. The loans are evidenced by demand notes and, until replaced by
the credit facility described below, accrue interest at 10%. The owners of the
contractor have pledged to CNAF substantially all the assets of the contractor
as collateral for these loans.
In March 2003, CNA Financial Corporation ("CNAF") entered into an
agreement to provide a credit facility with the large national contractor to
provide loans to the contractor in a maximum aggregate amount of $86.4 million
(the "Credit Facility"). Of the $86.4 million, $57 million was outstanding at
March 31, 2003. The Credit Facility and all related loans will mature in March
2006. Advances under the Credit Facility bear interest at the prime rate plus
6%. Payment of 3% of the interest is deferred until the Credit Facility matures,
and the remainder is to be paid monthly in cash. Loans under the Credit Facility
are secured by a pledge of substantially all of the assets of the contractor and
certain affiliates. CNA Surety has provided significant surety bond protection
for projects by this contractor through surety bonds underwritten by CCC or its
affiliates. The loans were provided by CNAF to help the contractor meet its
liquidity needs.
In March of 2003, CNAF also purchased the contractor's outstanding bank
debt for $16.4 million. The contractor retired the bank debt by paying CNAF
$16.4 million, with $11.4 million of the payoff amount being funded under the
new Credit Facility and $5 million from money loaned to the contractor by its
shareholders. Under its purchase agreement with the banks, CNAF is also required
to reimburse the banks for any draws upon approximately $6.5 million in
outstanding letters of credit issued by the banks for the contractor's benefit
that expire between May and August of 2003. Any amounts paid by CNAF to the
banks as reimbursements for draws upon the banks' letters of credit will become
obligations of the contractor to CNAF as draws upon the Credit Facility.
Loews has purchased a participation interest in one-third of the loans and
commitments under the new Credit Facility, on a dollar-for-dollar basis, up to a
maximum of $25 million. Although Loews does not have rights against the
contractor directly under the participation agreement, it shares recoveries and
certain fees under the credit facility proportionally with CNAF. The contractor
has initiated a restructuring plan that is intended to reduce costs and improve
cash flow, and a chief restructuring officer has been appointed to manage
execution of the plan. CNA Surety intends to continue to provide surety bonds on
behalf of the contractor during this restructuring period, subject to the
contractor's initial and ongoing compliance with CNA Surety's underwriting
standards. Any losses arising from bonds issued or assumed by the insurance
subsidiaries of CNA Surety to the contractor are excluded from CNA Surety's 2003
Excess of Loss Treaty. As a result, CNA Surety retains the first $60 million of
losses on bonds written with an effective date of September 30, 2002 and prior,
and CCC will incur 100% of losses above that retention level on bonds with
effective dates prior to September 30, 2002. Through facultative reinsurance
contracts with CCC, CNA Surety's exposure on bonds written from October 1, 2002
through December 31, 2002 has been limited to $20 million per bond.
Indemnification and subrogation rights, including rights to contract
proceeds on construction projects in the event of default, reduce CNA Surety's
exposure to loss. While CNA Surety believes that the contractor's restructuring
efforts will be successful and provide sufficient cash flow for its operations,
the contractor's failure to achieve its restructuring plan or perform its
contractual obligations underlying all of the Company's surety bonds could have
a material adverse effect on CNA Surety's future results of operations, cash
flows and capital resources. If such failures occur, the Company estimates that
possible losses, net of indemnification and subrogation recoveries, but before
recoveries under reinsurance contracts, could be up to $200 million. However,
the related party reinsurance treaties discussed below should limit the
Company's per principal exposure to approximately $60 million.
20
Related Party Reinsurance
Intercompany 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 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 had an original term of five years that
expired on September 30, 2002 and was renewed on October 1, 2002 on
substantially the same terms with an expiration date of December 31, 2003; 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. 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 28% of net written premiums written on such business.
The Quota Share Treaty was renewed on October 1, 2002 on substantially the
same terms with an expiration date of December 31, 2003; and is annually
renewable thereafter. The ceding commission paid to CCC and CIC by Western
Surety remained at 28% of net written premiums and contemplates an approximate
4% override commission for fronting fees to CCC and CIC on top of their actual
direct acquisition costs.
The Stop Loss Contract terminated on December 31, 2000 and was not
renewed. The Stop Loss Contract protected the insurance subsidiaries 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 1997 through 2000 on certain insured accounts (the
"Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end of each
calendar quarter following the Merger Date, to pay to the insurance subsidiaries
a dollar amount equal to (i) the amount, if any, by which their actual accident
year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii)
the applicable net earned premiums. In consideration for the coverage provided
by the Stop Loss Contract, the insurance subsidiaries paid to CCC an annual
premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all
required annual premiums.
The Excess of Loss Contracts provided the insurance subsidiaries of CNA
Surety with the capacity to underwrite large surety bond exposures by providing
reinsurance support from CCC. The Excess of Loss Contract provides $75 million
of coverage for losses in excess of the $60 million per principal. Subsequent to
the Merger Date, the Company entered into a second excess of loss contract with
CCC ("Second Excess of Loss Contract"). The Second Excess of Loss Contract
provides additional coverage for principal losses that exceed the foregoing
coverage of $75 million per principal provided by the Excess of Loss Contract,
or aggregate losses per principal in excess of $135 million. In consideration
for the reinsurance coverage provided by the Excess of Loss Contracts, the
insurance subsidiaries paid to CCC, on a quarterly basis, a premium equal to 1%
of the net written premiums applicable to the Excess of Loss Contract, subject
to a minimum premium of $20,000 and $5,000 per quarter under the Excess of Loss
Contract and Second Excess of Loss Contract, respectively. The two Excess of
Loss Contracts collectively provided coverage for losses discovered on surety
bonds in force as of the Merger Date and for losses discovered on new and
renewal business written during the term of the Excess of Loss Contracts. Both
Excess of Loss Contracts commenced following the Merger Date and continued until
September 30, 2002. The discovery period for losses covered by the Excess of
Loss Contracts extends until September 30, 2005.
Effective October 1, 2002, the Company secured replacement excess of loss
protection from CCC for per principal losses that exceed $60 million in two
parts - a) $40 million excess of $60 million and b) $50 million excess of $100
million. This excess of loss protection is primarily necessary to support
contract surety accounts with bonded backlogs or work-in-process in excess of
$60 million. The Company generally limits support to large commercial surety
accounts to $25 million. In addition to the foregoing structural changes in its
high layer excess of loss reinsurance programs, the cost for these protections
increased significantly as compared to the cost of the previous two Excess of
Loss Contracts. The $40 million excess of $60 million contract is for a three
year term beginning October 1, 2002 and
21
provides annual aggregate coverage of $80 million and $120 million aggregate
coverage for the entire three year term. The Company will pay CCC annual
reinsurance premiums of $12.5 million in year one and $17.5 million in years two
and three, payable quarterly. The Company may commute the contract at the end of
each contract year under certain circumstances. If the treaty is commuted, the
Company may be entitled to a return premium payment. Based on the experience
under the treaty to March 31, 2003, the Company has established a return premium
receivable of $4.4 million in connection with the restatement described in Note
7 to the accompanying financial statements. The reinsurance premium for the
coverage provided by the $50 million excess of $100 million contract was $6.0
million. This contract expires on December 31, 2003.
Net Loss Ratio
The net loss ratios for the three months ended March 31, 2003 and 2002
were 26.1% and 24.8%, respectively. The 2003 loss ratio included $0.1 million of
net unfavorable loss reserve development related to prior years for the three
months ended March 31, 2003. The increase in the adjusted loss ratio in 2003
resulted from the Company's increased expected baseline accident year net loss
ratio of branch contract and commercial business due to recent adverse loss
trends together with uncertainties with respect to the economy and credit
markets. The Company is using an initial 2003 accident year net loss ratio of
36.0% for the medium to large commercial and contract branch business compared
to 30.0% in first quarter of 2002. This business represents about 53% of the
Company's 2003 gross premiums.
On January 2, 2003, CNA Surety settled litigation brought by J.P. Morgan
Chase & Co. ("Chase") in connection with three surety bonds issued on behalf of
Enron Corporation subsidiaries. The penal sums of the three bonds totaled
approximately $78 million. Although the Company believed it had valid defenses
to the litigation, based on the uncertainty and risk of an adverse jury verdict,
pursuant to the settlement agreement, the Company paid Chase approximately $40.7
million and assigned its recovery rights in the Enron bankruptcy to Chase in
exchange for a full release of its obligations under the bonds. The Company has
no other exposure related to the Enron Corporation. CNA Surety's net loss
related to the settlement, after anticipated recoveries under excess of loss
reinsurance treaties, was previously fully reserved. Immediately upon execution
of the settlement documents, the Company sent written notice for reimbursement
to its reinsurers. As of March 31, 2003, the Company has billed a total of $33.9
million to its reinsurers. A number of those reinsurers have requested a variety
of documents and reserved their rights before making a decision concerning
coverage of the settlement under the reinsurance treaties. The Company has
provided all
22
requested information. Three reinsurers responsible for payment of 34% of the
treaty proceeds have either paid or committed to pay 100% of their portions of
the claim. Two other reinsurers have sent the Company letters expressing
reservations about the claim. Pursuant to the treaty, the Company has sent a
notice demanding arbitration to those reinsurers. Management believes none of
the reinsurers have valid defenses under the reinsurance treaties to avoid
payment, and that the Company will fully recover all reinsurance recoverables
recorded related to this settlement. As such, the Company has not recorded a
reduction with respect to these reinsurance recoverables as of March 31, 2003.
Expense Ratio
The expense ratio increased to 62.2% for the three months ended March 31,
2003 compared to 61.8% for the same period in 2002. The increase in the expense
ratio for the three months ended March 31, 2003 primarily reflects the impact of
higher reinsurance costs on net earned premiums. Although ceded written premiums
declined $5.4 million, net earned premiums increased 5.9% and operating expenses
increased at a higher rate of 6.6%.
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
continued with various exposure management initiatives, particularly to reduce
its risks on large commercial accounts. As the following table depicts, the
Company has reduced its exposure, before the effects of reinsurance, by 16% in
2003 on large commercial accounts, which are defined as accounts with exposures
in excess of $10 million:
NUMBER OF ACCOUNTS TOTAL EXPOSURE (DOLLARS IN BILLIONS)
AS OF AS OF
------------------------- ------------------------------------------
MARCH 31, DECEMBER 31, MARCH 31, DECEMBER 31, %
COMMERCIAL ACCOUNT EXPOSURE 2003 2002 2003 2002 REDUCTION
--------- ------------ --------- ------------ ---------
$100 million and larger 12 13 $2.2 $2.5 13.9%
$50 to $100 million 12 19 0.7 1.2 40.2
$25 to $50 million 16 16 0.6 0.6 --
$10 to $25 million 73 75 1.1 1.2 5.2
--- --- ---- ----
Total 113 123 $4.6 $5.5 16.3%
=== === ==== ====
With respect to contract surety, the Company's portfolio is predominantly
comprised of contractors with work programs of less than $50 million. "Work
program" is the estimated contract value of uncompleted bonded and unbonded
work. Bonded backlog is a measure of the Company's exposure in the event of
default before indemnification, salvage and subrogation recoveries.
The Company continues to manage its exposure to any one contract credit
and aggressively looks for co-surety, shared accounts and other means to support
or reduce larger exposures. Reinsurance, indemnification and subrogation rights,
including rights to contract proceeds on construction projects in the event of
default, exist that substantially reduce CNA Surety's exposure to loss.
Investment Income
For the three months ended March 31, 2003, net investment income was $6.7
million compared to the three months ended March 31, 2002 of $7.1 million. The
decrease in investment income primarily reflects the impact of lower investment
yields. The annualized pretax yields were 4.7% and 5.1% for the three months
ended March 31, 2003 and 2002, respectively. The annualized after-tax yields
were 3.9% for both the three months ended March 31, 2003 and 2002.
Net realized investment gains were approximately $0.7 million for the
three months ended March 31, 2003 compared to net realized investment losses of
approximately $0.3 million for the same period in 2002.
The following summarizes net realized investment gains (losses) activity:
THREE MONTHS ENDED MARCH 31,
----------------------------
2003 2002
------- -----
Gross realized investment gains ............ $ 1,261 $ 343
Gross realized investment losses ........... (531) (621)
------- -----
Net realized investment gains (losses) ..... $ 730 $(278)
======= =====
The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
Invested assets are exposed to various risks, such as interest rate,
market and credit. Due to the level of risk associated with certain of these
invested assets and the level of uncertainty related to changes in the value of
these assets, it is possible that changes in risks in the near term may
significantly affect the amounts reported in the Condensed Consolidated Balance
Sheets and Condensed Consolidated Statements of Income.
Analysis of Other Operations
Interest expense for the three months ended March 31, 2003 decreased $0.1
million, or 22.9%, as compared to the first quarter in 2002, primarily due to
lower outstanding debt levels and lower interest rates. Average debt outstanding
was $60.8 million for the first quarter of 2003 compared to $76.2 million in the
first quarter of 2002. The weighted average interest rate for the three months
ended March 31, 2003 was 2.3% compared to 2.4% for the same period in 2002.
Income Taxes
Income tax expense was $4.4 million and $4.8 million and the effective
income tax rates were 28.6% and 31.4% for the three months ended March 31, 2003
and 2002, respectively. This decrease in the estimated effective tax rate in
first quarter 2003 primarily relates to anticipated increases in tax exempt
investment income as a proportion of taxable income.
LIQUIDITY AND CAPITAL RESOURCES
23
It is anticipated that the liquidity requirements of CNA Surety will be
met primarily by funds generated from operations. The principal sources of
operating cash flows are premiums, investment income, and sales and maturities
of investments. CNA Surety also may generate funds from additional borrowings
under the credit facility described below. The primary cash flow uses are
payments for claims, operating expenses, federal income taxes, debt service, as
well as dividends to CNA Surety stockholders. In general, surety operations
generate premium collections from customers in advance of cash outlays for
claims. Premiums are invested until such time as funds are required to pay
claims and claims adjusting expenses.
The Company believes that total invested assets, including cash and
short-term investments, are sufficient in the aggregate and have suitably
scheduled maturities to satisfy all policy claims and other operating
liabilities, including dividend and income tax sharing payments of its insurance
subsidiaries. At March 31, 2003, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $561.4 million of fixed income
securities, $16.0 million of short-term investments, $1.3 million of other
investments and $9.0 million of cash. At December 31, 2002, the carrying value
of the Company's insurance subsidiaries' invested assets was comprised of $564.8
million of fixed income securities, $41.9 million of short-term investments,
$1.3 million of other investments and $10.7 million of cash.
Cash flow at the parent company level is derived principally from dividend
and tax sharing payments from its insurance subsidiaries. The principal
obligations at the parent company level are to service debt, pay operating
expenses, including income taxes, and pay dividends to stockholders. At March
31, 2003, the parent company's invested assets consisted of $5.7 million of
fixed income securities, $0.8 million of equity securities, $7.5 million of
short-term investments and $5.1 million of cash. At December 31, 2002, the
parent company's invested assets consisted of $5.7 million of fixed income
securities, $0.8 million of equity securities, $8.8 million of short-term
investments and $4.3 million of cash. As of March 31, 2003 and December 31,
2002, parent company short-term investments and cash included $5.6 million and
$4.8 million, respectively, of restricted cash related to premium receipt
collections ultimately due to the Company's insurance subsidiaries.
The Company's consolidated net cash flow used by operating activities was
$35.1 million for the three months ended March 31, 2003 compared to net cash
flow provided by operating activities of $6.0 million for the comparable period
in 2002. The decrease in net cash flow provided by operating activities
primarily relates to increased net loss payments, primarily related to
settlement of litigation brought by Chase in connection with three surety bonds
issued on behalf of Enron Corporation subsidiaries.
The Company refinanced $65 million in outstanding borrowings under its
previous credit facility under a new credit facility (the "2002 Credit
Facility"). The 2002 Credit Facility provided an aggregate of up to $65 million
in initial borrowings divided between a 364-day revolving credit facility (the
"Revolving Credit Facility") of $35 million and a three-year term loan facility
(the "Term Loan") of $30 million. The Revolving Credit Facility may be extended,
with the consent of lenders, for up to two additional periods of up to 364 days
each, but in no case shall the Revolving Credit Facility be extended to mature
on a date later than three years from the effective date of the Revolving Credit
Facility. The Revolving Credit Facility may be increased from time to time by
the amount of amortization under the Term Loan facility. Such increase is
subject to consent by each Revolving Credit Bank, and will take place upon
receipt by the Banks of the respective installment payments under the Term Loan
facility.
Outstanding borrowings under the 2002 Credit Facility were $60 million as
of March 31, 2003, consisting of $30 million under the Revolving Credit Facility
and $30 million under the Term Loan Facility. Effective January 28, 2003, the
Company entered into an interest rate swap on the $30 million Term Loan that
fixed the interest rate at 2.75%.
Amortization of the Term Loan will take place at $10,000,000 per year, in
equal installments of $5,000,000 on the following dates:
DATE AMORTIZATION OUTSTANDING BALANCE
------------ -------------------
June 30, 2003 .......... $5,000,000 $25,000,000
September 30, 2003 ..... 5,000,000 20,000,000
March 31, 2004 ......... 5,000,000 15,000,000
September 30, 2004 ..... 5,000,000 10,000,000
March 31, 2005 ......... 5,000,000 5,000,000
September 30, 2005 ..... 5,000,000 0
The interest rate on borrowings under the 2002 Credit Facility may be
fixed, at CNA Surety's option, for a period of one, two, three, or six months
and is based on, among other rates, the London Interbank Offered Rate ("LIBOR"),
plus the applicable margin. The margin, including a facility fee and utilization
fee on the 2002 Credit Facility, was 0.625% at March 31, 2003 and can vary based
on CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to
0.80%. As of March 31, 2003, the weighted average interest rate was 2.4% on the
$60 million of outstanding borrowings. As of December 31, 2002, the weighted
average interest rate on the 2002 Credit Facility was 2.0% on the
24
$60 million of outstanding borrowings.
The 2002 Credit Facility contains, among other conditions, limitations on
CNA Surety with respect to the incurrence of additional indebtedness and
maintenance of a rating of at least "A" by A.M. Best Company Inc. for each of
the Company's insurance subsidiaries. The 2002 Credit Facility also requires the
maintenance of certain financial ratios as follows: a) maximum funded debt to
total capitalization ratio of 25%, b) minimum net worth of $350.0 million and c)
minimum fixed charge coverage ratio of 2.5 times. As of March 31, 2003, the
Company was in compliance with all restrictions and covenants contained in the
2002 Credit Facility.
In 1999 CNA Surety acquired certain assets of Clark Bonding Company, Inc.,
a Charlotte, North Carolina, insurance agency and brokerage doing business as
The Bond Exchange for $5.9 million. As part of this acquisition, the Company
incurred an additional $1.9 million of debt in the form of a promissory note.
The promissory note matures on July 27, 2004 and has an interest rate of 5.0%.
The balance of this promissory note at March 31, 2003 was $0.8 million.
As an insurance holding company, CNA Surety is dependent upon dividends
and other permitted payments from its insurance subsidiaries to pay operating
expenses, meet debt service requirements, as well as to pay cash dividends. The
payment of dividends by the insurance subsidiaries is subject to varying degrees
of supervision by the insurance regulatory authorities in South Dakota and
Texas. In South Dakota, where Western Surety and SBCA are domiciled, insurance
companies may only pay dividends from earned surplus excluding surplus arising
from unrealized capital gains or revaluation of assets. In Texas, where USA is
domiciled, an insurance company may only declare or pay dividends to
stockholders from the insurer's earned surplus. The insurance subsidiaries may
pay dividends without obtaining prior regulatory approval only if such dividend
or distribution (together with dividends or distributions made within the
preceding 12-month period) is less than, as of the end of the immediately
preceding year, the greater of (i) 10% of the insurer's surplus to policyholders
or (ii) statutory net income. In South Dakota, net income includes net realized
capital gains in an amount not to exceed 20% of net unrealized capital gains.
All dividends must be reported to the appropriate insurance department prior to
payment.
The dividends that may be paid without prior regulatory approval are
determined by formulas established by the applicable insurance regulations, as
described above. The formulas that determine dividend capacity in the current
year are dependent on, among other items, the prior year's ending statutory
surplus and statutory net income. Dividend capacity for 2003 is based on
statutory surplus and income at and for the year ended December 31, 2002.
Without prior regulatory approval in 2003, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $32.1 million in the aggregate. CNA Surety did
not receive a dividend from its insurance subsidiaries during the first three
months of 2003 compared to the $12.0 million dividend received during the first
three months of 2002. A dividend of $10.0 million was received by CNA Surety
from its insurance subsidiaries on April 15, 2003.
Combined statutory surplus totaled $240.8 million at March 31, 2003,
resulting in a net written premium to statutory surplus ratio of 1.3 to 1.
Approximately $227 million of the combined surplus relates to Western Surety.
Insurance regulations restrict Western Surety's maximum net retention on a
single surety bond to 10 percent of statutory surplus. Under the 2003 Excess of
Loss Treaty, the Company's net retention on new bonds would generally be $15
million plus a 5% co-participation in the $45 million layer of excess
reinsurance above the Company's retention and this regulation would require
minimum statutory surplus of $172.5 million at Western Surety. This surplus
constraint may limit the amount of future dividends Western Surety could
otherwise pay to CNA Surety.
In accordance with the provisions of intercompany tax sharing agreements
between CNA Surety and its subsidiaries, the tax of each subsidiary shall be
determined based upon each subsidiary's separate return liability. Intercompany
tax payments are made at such times as estimated tax payments would be required
by the Internal Revenue Service ("IRS"). CNA Surety did not receive any tax
sharing payments from its subsidiaries for the three months ended March 31, 2003
and 2002, respectively.
Western Surety, SBCA and USA each qualify as an acceptable surety for
federal and other public works project bonds pursuant to U.S. Department of
Treasury regulations. U.S. Treasury underwriting limitations are based on an
insurer's statutory surplus. Effective July 1, 2002 through June 30, 2003, the
underwriting limitations of Western Surety, SBCA and USA are $20.7 million, $0.5
million and $1.3 million, respectively. Through the Surety Quota Share Treaty
between CCC and Western Surety Company, CNA Surety has access to CCC and its
affiliates' U.S. Department of Treasury underwriting limitations. The Surety
Quota Share Treaty had an original term of five years from the Merger Date and
was renewed on October 1, 2002 on substantially the same terms. Effective July
1, 2002 through June 30, 2003, the underwriting limitations of CCC and its
affiliates total $382.9 million. CNA Surety management believes that the
foregoing U.S. Treasury underwriting limitations are sufficient for the conduct
of its business.
25
Subject to the aforementioned uncertainties concerning the Company's per
principal net retentions, CNA Surety management believes that the Company has
sufficient available resources, including capital protection against large
losses provided by the Company's excess of loss reinsurance arrangements, to
meet its present capital needs.
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ITEM 4. CONTROLS AND PROCEDURES
The Company maintains a system of disclosure controls and procedures which
are designed to ensure that information required to be disclosed by the Company
in reports that it files or submits to the Securities and Exchange Commission
under the Securities and Exchange Act of 1934, including this report, is
recorded, processed, summarized and reported on a timely basis. These disclosure
controls and procedures include controls and procedures designed to ensure that
information required to be disclosed under the Exchange Act is accumulated and
communicated to the Company's management on a timely basis to allow decisions
regarding required disclosure.
The Company's principal executive officer and its principal financial
officer undertook an evaluation of the Company's disclosure controls and
procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d -15(e)) as of
the end of the period covered by this report and concluded that the Company's
controls and procedures were effective.
There were no changes in the Company's internal control over financial
reporting that occurred during the Company's last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
The Company's management has reviewed the circumstances that led to the
restatement of results reflected in this report and concluded that this was an
isolated incident and not indicative of a systemic failure of the controls over
financial reporting.
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PART II - OTHER INFORMATION
ITEM 6. Exhibits and Reports on Form 8-K:
(a) Exhibits: -
31(1) Certification pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002-Chief Executive
Officer.
31(2) Certification pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002--Chief Financial
Officer.
32(1) Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002-Chief Executive Officer.
32(2) Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002-Chief Financial Officer
(b) Reports on Form 8-K:
None
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SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the Registrant has duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized.
CNA SURETY CORPORATION (Registrant)
/s/ John F. Welch
----------------------------------------
John F. Welch President and Chief
Executive Officer
/s/ John F. Corcoran
----------------------------------------
John F. Corcoran Vice President and
Chief Financial Officer
Date: March 12, 2004
29