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 JUNE 30, 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 incorporation or organization) (I.R.S. Employer Identification No.)
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:
42,967,383 shares of Common Stock, $.01 par value as of August 4, 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 June 30, 2003 as filed
by the Company on August 12, 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 June 30, 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 June 30, 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.
2
CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
Page
----
Part I. Financial Information:
Item 1. Condensed Consolidated Financial Statements:
Independent Accountants' Report............................... 4
Condensed Consolidated Balance Sheets at June 30, 2003
(As restated) and at December 31, 2002 (Unaudited)........... 5
Condensed Consolidated Statements of Income for the Three-
and Six- Months Ended June 30, 2003 (As restated) and 2002
(Unaudited)................................................... 6
Condensed Consolidated Statements of Stockholders' Equity for
the Six-Months Ended June 30, 2003 (As restated) and 2002
(Unaudited)................................................... 7
Condensed Consolidated Statements of Cash Flows for the Six
Months Ended June 30, 2003 (As restated) and 2002
(Unaudited)................................................... 8
Notes to Condensed Consolidated Financial Statements
at June 30, 2003 (As restated) (Unaudited) ................... 9
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................... 21
Item 4. Controls and Procedures....................................... 40
Part II. Other Information:
Item 6. Exhibits and Reports on Form 8-K ...................................... 41
3
ITEM 1. FINANCIAL STATEMENTS
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 June 30, 2003, and the related
condensed consolidated statements of income, stockholders' equity and cash flows
for the three- and six- month periods ended June 30, 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
August 4, 2003
(March 12, 2004 as to the effects of the restatement described in Note 7.)
4
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
June 30, December 31,
2003 2002
-------------- --------------
ASSETS As restated (a) As restated (a)
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $510,383 and $539,364) $ 553,493 $ 570,538
Equity securities, at fair value (cost: $983 and $852) 963 761
Short-term investments, at cost (approximates fair value)..................... 58,455 50,669
Other investments, at fair value.............................................. 1,129 1,257
Cash ......................................................................... 7,796 14,979
-------------- --------------
Total invested assets and cash............................................. 621,836 638,204
Deferred policy acquisition costs................................................. 104,545 96,386
Insurance receivables:
Premiums, including $28,690 and $34,097 from affiliates (net of allowance for
doubtful accounts: $1,582 and $1,365)...................................... 46,790 45,423
Reinsurance, including $43,424 and $17,589 from affiliates.................... 140,459 129,964
Intangible assets (net of accumulated amortization: $25,523 and $25,523)........ 143,785 143,785
Property and equipment, at cost (less accumulated
depreciation: $17,482 and $16,047)............................................ 16,144 17,260
Prepaid reinsurance premiums...................................................... 10,960 13,337
Receivable for securities sold.................................................... 3,034 3
Other assets...................................................................... 8,860 9,018
-------------- --------------
Total assets........................................................... $ 1,096,413 $ 1,093,380
============== ==============
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses.................................... $ 277,210 $ 303,433
Unearned premiums............................................................. 228,416 216,213
-------------- --------------
Total reserves............................................................. 505,626 519,646
Debt.............................................................................. 55,816 60,816
Deferred income taxes, net........................................................ 36,618 30,727
Current income taxes payable...................................................... 7,835 5,889
Reinsurance and other payables to affiliates...................................... 7,028 23,003
Other liabilities................................................................. 32,043 32,738
-------------- --------------
Total liabilities.......................................................... $ 644,966 $ 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 June 30, 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................................................................. 182,610 159,937
Accumulated other comprehensive income............................................ 28,009 19,861
Treasury stock, at cost........................................................... (15,347) (15,446)
-------------- --------------
Total stockholders' equity................................................. 451,447 420,561
-------------- --------------
Total liabilities and stockholders' equity................................. $ 1,096,413 $ 1,093,380
============== ==============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
(a) See Note 7.
5
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------- ----------------------------
2003 2002 2003 2002
--------------------------- ----------------------------
As restated (a) As restated (a)
Revenues:
Net earned premium........................................ $ 76,846 $ 75,742 $ 148,052 $ 142,963
Net investment income..................................... 6,652 7,121 13,351 14,227
Net realized investment gains............................. 1,098 1,601 1,828 1,323
-------------- --------- -------------- -----------
Total revenues......................................... 84,596 84,464 163,231 158,513
-------------- --------- -------------- -----------
Expenses:
Net losses and loss adjustment expenses................... 20,235 19,606 38,841 36,253
Net commissions, brokerage and other underwriting expenses 47,940 45,594 92,236 87,146
Interest expense.......................................... 455 445 808 903
-------------- --------- -------------- -----------
Total expenses......................................... 68,630 65,645 131,885 124,302
-------------- --------- -------------- -----------
Income before income taxes.................................... 15,966 18,819 31,346 34,211
Income taxes.................................................. 4,283 5,917 8,674 10,752
-------------- --------- -------------- -----------
Net income ................................................... $ 11,683 $ 12,902 $ 22,672 $ 23,459
============== ========= ============== ===========
Earnings per share............................................ $ 0.27 $ 0.30 $ 0.53 $ 0.55
============== ========= ============== ===========
Earnings per share, assuming dilution......................... $ 0.27 $ 0.30 $ 0.53 $ 0.55
============== ========= ============== ===========
Weighted average shares outstanding........................... 42,959 42,900 42,958 42,868
============== ========= ============== ===========
Weighted average shares outstanding, assuming dilution........ 42,963 43,066 42,963 43,038
============== ========= ============== ===========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
(a) See Note 7.
6
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......................................................... -- -- -- $ 23,459
Other comprehensive income:
Change in unrealized losses on securities (after income taxes), net
of reclassification adjustment of $428............................. -- -- -- 5,888
-------------
Total comprehensive income...................................... $ 29,347
=============
Issuance of treasury stock to employee stock purchase program.......... 5 6
Stock options exercised and other...................................... 130 2 1,387
Dividends paid to stockholders......................................... -- -- --
----------- ------ ---------
Balance, June 30, 2002 42,915 $ 444 $ 255,526
=========== ====== =========
Balance, December 31, 2002 (As restated (a))........................... 42,947 $ 444 $ 255,765
Comprehensive income:
Net income (As restated (a))....................................... -- -- -- $ 22,672
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of $(1,634)......................... -- -- -- 8,148
-------------
Total comprehensive income (As restated (a)).................... $ 30,820
=============
Issuance of treasury stock to employee stock purchase program.......... 9 -- (38)
Stock options exercised and other...................................... 3 -- 4
----------- ------ -----------
Balance, June 30, 2003 (As restated (a)) 42,959 $ 444 $ 255,731
=========== ====== =========
Accumulated
Other Treasury Total
Retained Comprehensive Stock Stockholders'
Earnings Income (at cost) Equity
--------- ------------- --------- -------------
Balance, December 31, 2001............................................. $ 149,128 $ 278 $ (15,553) $ 388,428
Comprehensive income:
Net income......................................................... 23,459 -- -- 23,459
Other comprehensive income:
Change in unrealized losses on securities (after income taxes), net
of reclassification adjustment of $428............................. -- 5,888 -- 5,888
Total comprehensive income......................................
Issuance of treasury stock to employee stock purchase program.......... 53 59
Stock options exercised and other...................................... -- -- -- 1,389
Dividends paid to stockholders......................................... (12,869) -- -- (12,869)
--------- ------------- --------- -------------
Balance, June 30, 2002 $ 159,718 $ 6,166 $ (15,500) $ 406,354
========= ============= ========= =============
Balance, December 31, 2002 (As restated (a))........................... $ 159,937 $ 19,861 $ (15,446) $ 420,561
Comprehensive income:
Net income (As restated (a))....................................... 22,672 -- -- 22,672
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of $(1,634)......................... -- 8,148 -- 8,148
Total comprehensive income (As restated (a))....................
Issuance of treasury stock to employee stock purchase program.......... 99 61
Stock options exercised and other...................................... 1 -- -- 5
--------- ------------- --------- --------------
Balance, June 30, 2003 (As restated (a)) $ 182,610 $ 28,009 $ (15,347) $ 451,447
========= ============= ========= =============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
(a) See Note 7.
7
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
Six Months Ended
June 30,
-----------------------------
2003 2002
-------------- -----------
As restated (a)
OPERATING ACTIVITIES:
Net income................................................................................. $ 22,672 $ 23,459
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation and amortization........................................................... 2,090 1,929
Accretion of bond discount, net......................................................... 915 410
Net realized investment (gains) losses.................................................. (1,828) (1,323)
Changes in:
Insurance receivables................................................................... (11,862) 20,740
Reserve for unearned premiums........................................................... 12,203 11,412
Reserve for unpaid losses and loss adjustment expenses.................................. (26,223) (7,065)
Deferred policy acquisition costs....................................................... (8,159) (7,360)
Deferred income taxes, net.............................................................. 1,500 2,808
Reinsurance and other payables to affiliates............................................ (15,975) 82
Prepaid reinsurance premiums............................................................ 2,377 (3,586)
Other assets and liabilities............................................................ 1,678 (4,516)
-------------- -----------
Net cash (used in) provided by operating activities................................. (20,612) 36,990
--------------- -----------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases............................................................................... (38,359) (107,363)
Maturities.............................................................................. 15,370 69,426
Sales................................................................................... 53,321 36,382
Purchases of equity securities............................................................. (225) (17,786)
Proceeds from the sale of equity securities................................................ 88 1,465
Changes in short-term investments.......................................................... (7,779) (982)
Purchases of property and equipment........................................................ (1,104) (2,120)
Changes in receivables/payables for securities sold/purchased.............................. (3,031) (10,939)
Other, net................................................................................. 82 118
-------------- -----------
Net cash provided by (used in) investing activities................................. 18,363 (31,799)
-------------- -----------
FINANCING ACTIVITIES:
Principal payments on debt................................................................. (5,000) --
Dividends to stockholders.................................................................. -- (6,431)
Employee stock option exercises............................................................ 5 1,266
Issuance of treasury stock to employee stock purchase plan................................. 61 59
-------------- -----------
Net cash used in financing activities............................................... (4,934) (5,106)
-------------- -----------
Increase (decrease) in cash................................................................... (7,183) 85
Cash at beginning of period.................................................................... 14,979 13,159
-------------- -----------
Cash at end of period.......................................................................... $ 7,796 $ 13,244
============== ===========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest................................................................................ $ 555 $ 1,195
Income taxes............................................................................ $ 5,000 $ 7,000
The accompanying notes are an integral part of these condensed consolidated
financial statements.
(a) See Note 7.
8
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 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 June 30, Six months ended June 30,
----------------------------------------------------------
2003 2002 2003 2002
----------- ------------ ------------ -----------
Net income .................................................... $ 11,683 $ 12,902 $ 22,672 $ 23,459
=========== ============ ============ ===========
Shares:
Weighted average shares outstanding............................ 42,959 42,876 42,947 42,780
Weighted average shares of options exercised............. - 24 11 88
----------- ------------ ------------ -----------
Total weighted average shares outstanding...................... 42,959 42,900 42,958 42,868
Effect of dilutive options............................... 4 166 5 170
----------- ------------ ------------ -----------
Total weighted average shares outstanding, assuming dilution... 42,963 43,066 42,963 43,038
=========== ============ ============ ===========
Earnings per share............................................. $ 0.27 $ 0.30 $ 0.53 $ 0.55
=========== ============ ============ ===========
Earnings per share, assuming dilution.......................... $ 0.27 $ 0.30 $ 0.53 $ 0.55
=========== ============ ============ ===========
No adjustments were made to reported net income in the computation of earnings
per share.
9
Accounting Changes
In August 2001, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting 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
10
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 six months ended June 30, 2003 and 2002 would have been $22.5
million and $23.4 million, respectively. Diluted net income per share would have
been $0.52 and $0.55 for the six months ended June 30, 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 Six months ended
June 30, June 30,
-------------------- ---------------------
(in thousands, except per share data) 2003 2002 2003 2002
-------- -------- --------- ---------
Net income $ 11,683 $ 12,902 $ 22,672 $ 23,459
Less: Total stock based compensation cost
determined under the fair value method, net of tax (73) - (177) (12)
-------- -------- --------- ---------
Pro forma net income $ 11,610 $ 12,902 $ 22,495 $ 23,447
======== ======== ========= =========
Basic and diluted earnings per share, as reported $ 0.27 $ 0.30 $ 0.53 $ 0.55
======== ======== ========= =========
Basic and diluted earnings per share, pro forma $ 0.27 $ 0.30 $ 0.52 $ 0.55
======== ======== ========= =========
In April of 2003, the FASB issued SFAS No. 149 entitled "Amendment of
Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS No.149").
SFAS No. 149 amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under SFAS No. 133 entitled "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 149 is effective
for contracts entered into or modified after June 30, 2003 and for hedging
relationships designated after June 30, 2003. The Company does not anticipate
that the adoption of SFAS No. 149 will have a significant impact on the
Company's financial position or results of operations.
In May of 2003, the FASB issued SFAS No. 150 entitled "Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity" ("SFAS No. 150"). SFAS No. 150 establishes standards for how an issuer
of financial instruments classifies and measures in its statement of financial
position certain instruments with characteristics of both liabilities and
equity. SFAS No. 150 modifies the accounting and financial statement disclosures
of certain financial instruments that, under previous guidance, issuers could
account for as equity. SFAS No. 150 affects the issuer's accounting for three
types of financial instruments that are required to be accounted for as
liabilities.
SFAS No. 150 is effective for all financial instruments entered into or
modified after May 31, 2003. For all financial instruments entered into prior to
May 31, 2003, SFAS 150 is effective at the beginning of the first interim period
beginning after June 15, 2003, which for CNA Surety begins July 1, 2003. The
Company does not have any financial instruments outstanding to which provisions
of SFAS 150 apply, therefore the adoption of SFAS 150 is not expected to have
any impact on the Company's financial position or results of operations.
11
2. INVESTMENTS
The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety at June 30, 2003 and December 31, 2002, by
investment category, were as follows (dollars in thousands):
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
June 30, 2003 or Cost Gains Losses Value
------------------------------------------------- -------------- ---------- ---------- --------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury............................. $ 16,113 $ 1,152 $ -- $ 17,265
U.S. Agencies............................. 6,555 345 (16) 6,884
Collateralized mortgage obligations....... 90 3 -- 93
Mortgage pass-through securities.......... 13,758 714 -- 14,472
Obligations of states and political subdivisions. 360,720 29,762 (87) 390,395
Corporate bonds.................................. 68,317 7,412 (8) 75,721
Non-agency collateralized mortgage obligations... 8,787 634 (35) 9,386
Other asset-backed securities:
Second mortgages/home equity loans........... 10,139 652 -- 10,791
Credit card receivables...................... 5,000 97 -- 5,097
Other........................................ 7,498 945 -- 8,443
Redeemable preferred stock....................... 13,406 1,540 -- 14,946
-------------- ---------- ---------- --------------
Total fixed income securities............. 510,383 43,256 (146) 553,493
Equity securities................................ 983 -- (20) 963
-------------- ---------- ---------- --------------
Total..................................... $ 511,366 $ 43,256 $ (166) $ 554,456
============== ========== =========== ==============
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 fixed income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
CNA Surety classifies its fixed income securities and its equity
securities as available-for-sale, and as
12
such, they are carried at fair value. The amortized cost of fixed income
securities is adjusted for amortization of premiums and accretion of discounts
to maturity, which is included in net investment income. Changes in fair value
are reported as a component of other comprehensive income.
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 June 30,
------------------------------------------------------------
2003 2002
----------------------------- ---------------------------
Written Earned Written Earned
------------- ----------- ------------- ----------
Direct...................................... $ 46,398 $ 39,212 $ 36,521 $ 32,975
Assumed..................................... 51,048 52,718 58,931 51,961
Ceded....................................... (14,149) (15,084) (9,057) (9,194)
------------- ------------ ------------- ----------
$ 83,297 $ 76,846 $ 86,395 $ 75,742
============= ============ ============= ==========
Six Months Ended June 30,
------------------------------------------------------------
2003 2002
----------------------------- ---------------------------
Written Earned Written Earned
------------- ------------ ------------- ----------
Direct...................................... $ 88,765 $ 75,515 $ 73,293 $ 64,688
Assumed..................................... 100,352 101,405 104,273 101,502
Ceded....................................... (26,486) (28,868) (26,778) (23,227)
------------- ------------ ------------- ----------
$ 162,631 $ 148,052 $ 150,788 $ 142,963
============= ============ ============= ==========
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):
Three Months Ended June 30,
------------------------------------------------------------
2003 2002
----------------------------- ---------------------------
$ Ratio $ Ratio
------------- ------------ ------------- ----------
Gross losses and loss adjustment expenses... $ 44,006 47.9% $ 23,092 27.2%
Ceded amounts............................... (23,771) 157.6% (3,486) 37.9%
------------- -------------
Net losses and loss adjustment expenses..... $ 20,235 26.3% $ 19,606 25.9%
============= =============
Six Months Ended June 30,
------------------------------------------------------------
2003 2002
----------------------------- ---------------------------
$ Ratio $ Ratio
------------- ------------ ------------- ----------
Gross losses and loss adjustment expenses... $ 71,919 40.7% $ 41,156 24.8%
Ceded amounts............................... (33,078) 114.6% (4,903) 21.1%
------------- -------------
Net losses and loss adjustment expenses..... $ 38,841 26.2% $ 36,253 25.4%
============= =============
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
13
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 also excluded three other contract principals from the 2003
Excess of Loss Treaty for a total of six excluded principals. Of the two
commercial principals, one is a domestic electric utility with an estimated
bonded exposure of $54 million and is currently rated B by Standard and Poor's
("S&P"). The other is a foreign industrial concern with an estimated bonded
exposure in excess of the Company's $60 million net retention per principal
under the applicable reinsurance contracts. Management estimates that this
concern has an equivalent S&P rating of B+. With respect to the three contract
principals other than the large national contractor, two principals have
substantially completed asset sales, debt reductions and other reorganization
efforts. Each of these four principals continues to perform their contractual
obligations underlying the Company's surety bonds.
The third contract principal is in claim and the claim adjustment
process is in its early stages. Based upon currently available information,
management believes that the reasonably possible net loss ranges from zero to
$15.0 million, or equivalent to the Company's current per principal net
retention under the 2003 Excess of Loss Treaty.
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 a credit
agreement with the large national contractor, which undertakes projects for the
construction of government and private facilities, to provide loans to the
contractor in a maximum aggregate amount of $86.4 million (the "Credit
Facility"). Of the $86.4 million capacity, $62.1 million, including accrued
interest, was outstanding at June 30, 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.
In addition, in June of 2003, CNAF and one of its subsidiaries provided
repayment guarantees to certain creditors of the contractor and a subsidiary of
the contractor amounting to $8.7 million. Such guarantees were provided in order
to allow the contractor to receive financial accommodations from a creditor and
in order to comply with certain regulatory requirements. Under the terms of the
guarantees,
14
any payments made by CNAF, or any of its subsidiaries, would be considered a
draw under the Credit Facility.
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 Corporation ("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, exist that reduce CNA
Surety's exposure to loss. While CNA Surety believes that the contractor's
restructuring efforts are expected to 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.
15
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 June 30, 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.
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 June 30, 2003.
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 June 30, 2003, the Company had an estimated
unpaid loss recoverable balance of approximately $13.3 million under the Stop
Loss Contract.
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
16
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 June 30,
2003, the Company has established a return premium receivable of $6.6 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 June 30, 2003 and December 31, 2002, CNA Surety had insurance
receivable balances from CCC and CIC of $72.1 million and $51.7 million,
respectively. CNA Surety had reinsurance payables to CCC and CIC of $5.9 million
and $21.3 million as of June 30, 2003 and December 31, 2002, respectively,
primarily related to reinsured losses.
17
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 Six Months Ended
June 30, June 30,
----------------------- ------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Reserves at beginning of period:
Gross........................................................ 254,118 $ 312,225 $ 303,433 $ 315,811
Ceded reinsurance............................................ 97,941 154,043 137,301 166,318
---------- ---------- ---------- ----------
Net reserves at beginning of period........................ $ 156,177 158,182 166,132 149,493
========== ---------- ---------- ----------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period............. 19,950 18,679 38,501 35,344
Increase in provision for insured events of prior periods.. 285 927 340 909
---------- ---------- ---------- ----------
Total net incurred...................................... 20,235 19,606 38,841 36,253
---------- ---------- ---------- ----------
Net payments attributable to:
Current period events...................................... (1,238) 1,156 (733) 3,073
Prior period events........................................ 16,896 16,559 44,952 22,600
---------- ---------- ---------- ----------
Total net payments...................................... 15,658 17,715 44,219 25,673
---------- ---------- ---------- ----------
Net reserves at end of period................................ 160,754 160,073 160,754 160,073
Ceded reinsurance at end of period........................... 116,456 148,673 116,456 148,673
---------- ---------- ---------- ----------
Gross reserves at end of period $ 277,210 $ 308,746 $ 277,210 $ 308,746
========== ========== ========== ==========
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 June 30, 2003, the Company has billed a
total of $37.1 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 paid their portions of the claim.
Two other reinsurers have sent the Company letters expressing reservations about
the claim. One reinsurer has denied coverage. Pursuant to the treaty, the
Company has sent a notice demanding arbitration to all the reinsurers that have
not paid. 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 June 30, 2003.
The Company received claims on self insured workers compensation bonds
furnished on behalf of three companies that have either recently filed for
bankruptcy or have affiliates that filed for bankruptcy. The bonds were written
in the 1970s and 1980s. The Company is in the process of investigating the total
bond exposures involved, the underlying workers' claims that may be asserted
against each bond, the ability of the principals to meet their contractual
obligations underlying the Company's surety bonds and available reinsurance
coverage. The Company currently has insufficient information to fully complete
its claim evaluations, but the initial analysis indicates that the gross amount
of exposure consists of
18
approximately $46 million in bonds. Based upon currently available information,
management believes that the ultimate claims made under these bonds will be less
than the total face amount of the bonds and that required claim payments would
occur over a number of years. The resolution of these matters could have a
material adverse impact on the future results of operations and financial
position of the Company.
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. As a result, the current effective interest
rate on the term loan as of June 30, 2003 was 2.58%.
The Term Loan balance was reduced by $5 million on June 30, 2003
according to the scheduled amortization. Further amortization of the Term Loan
will take place at $10,000,000 per year, in equal semi-annual installments of
$5,000,000 on the following dates:
Date Amortization Outstanding Balance
---------------------------------------- ------------ -------------------
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 June 30, 2003 and can vary based
on CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to
0.80%. As of June 30, 2003, the weighted average interest rate was 2.2% on the
$55 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 June 30, 2002, the
Company was in compliance with all restrictions and covenants contained in the
2002 Credit Facility.
19
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 June 30, 2003 was $0.8 million.
The consolidated balance sheet reflects total debt of $55.8 million at
June 30, 2003 and $60.8 million at December 31, 2002. The weighted average
interest rate on outstanding borrowings was 2.3% and 2.0% at June 30, 2003 and
December 31, 2002 respectively.
6. COMMITMENTS AND CONTINGENCIES
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 June 30, 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 June 30, 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
FOR THE PERIODS ENDED: (IN THOUSANDS) JUNE 30, 2003 JUNE 30, 2003 DECEMBER 31, 2002 DECEMBER 31, 2002
---------------- ------------- ----------------- ------------------
Consolidated balance sheet:
Insurance receivables: Reinsurance $ 133,895 $ 140,459 $ 127,776 $ 129,964
Current income taxes payable 5,537 7,835 5,123 5,889
Retained earnings 178,344 182,610 158,515 159,937
AS PREVIOUSLY AS AS PREVIOUSLY AS
REPORTED RESTATED REPORTED RESTATED
2003 2003 2003 2003
FOR THE THREE AND SIX MONTHS ENDED JUNE 30 ---------------- ------------- ----------------- ------------------
(IN THOUSANDS, EXCEPT PER SHARE DATA) Three months ended June 30 Six months ended June 30
-------------------------- ------------------------
Consolidated statement of income:
Net earned premium $ 74,658 $ 76,846 $ 143,676 $ 148,052
Total revenue 82,408 84,596 158,855 163,231
Income before income taxes 13,778 15,966 26,970 31,346
Income tax expense 3,517 4,283 7,142 8,674
Net income 10,261 11,683 19,828 22,672
Basic and diluted earnings per share $ 0.24 $ 0.27 $ 0.46 $ 0.53
20
CNA SURETY CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The following is a discussion and analysis of CNA Surety Corporation
("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 June 30, 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 June 30, 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
21
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.
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 June 30, 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.
22
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 $277.2 million and reinsurance
receivables related to losses of $116.5 million at June 30, 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 June
30, 2003 net estimate for unpaid losses and loss adjustment expenses would
produce approximately a $16.1 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
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 ("Loews") owns
approximately 90% of the outstanding common stock of CNAF. The principal
operating subsidiaries of CNAF that wrote the surety line of business for their
own account prior to the Merger were Continental Casualty Company and its
property and casualty affiliates (collectively, "CCC") and The Continental
Insurance Company and its property and casualty affiliates (collectively,
"CIC"). 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 subsidiary is Western Surety. 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.
23
FINANCIAL STRENGTH RATINGS
A.M. BEST COMPANY, INC. ("A.M. BEST")
Western Surety is currently rated A+ (Superior), by A.M. Best. An A+ (Superior)
rating is assigned to those companies which A.M. Best believes have achieved
superior overall performance when compared to the norms of the property and
casualty insurance industry. A+ (Superior) rated insurers have been shown to be
among the strongest in ability to meet policyholder and other contractual
obligations. Through intercompany reinsurance and related agreements, CNA
Surety's customers have access to CCC's broader underwriting capacity. CCC is
currently rated A (Excellent) by A.M. Best. A.M. Best's letter ratings range
from A++ (Superior) to F (In Liquidation) with A++ being highest.
STANDARD AND POOR'S ("S&P")
CCC and Western Surety are both currently rated A- (Strong), by S&P. On August
7, 2003, S & P placed CCC and Western Surety on credit watch with negative
implications. S&P's letter ratings range from AAA+ (Extremely Strong) to CC
(Extremely Weak) with AAA+ being highest. Ratings from `AA' to `CCC' may be
modified by the addition of a plus or minus sign to show relative standing
within the major rating categories. An insurer rated 'A' has strong financial
security characteristics, but is somewhat more likely to be affected by adverse
business conditions than are insurers with higher ratings.
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;
24
- regulatory initiatives and compliance with governmental
regulations, judicial decisions, including interpretation of
policy provisions, decisions regarding coverage, trends in
litigation and the outcome of any litigation involving the
Company, and rulings and changes in tax laws and regulations;
- regulatory limitations, impositions and restrictions upon the
Company, including the effects of assessments and other
surcharges for guaranty funds and other mandatory pooling
arrangements;
- the impact of competitive products, policies and pricing and
the competitive environment in which the Company operates,
including changes in the Company's books of business;
- product and policy availability and demand and market
responses, including the level of ability to obtain rate
increases and decline or non-renew underpriced accounts, to
achieve premium targets and profitability and to realize
growth and retention estimates;
- development of claims and the impact on loss reserves,
including changes in claim settlement practices;
- the performance of reinsurance companies under reinsurance
contracts with the Company;
- results of financing efforts, including the availability of
bank credit facilities;
- changes in the Company's composition of operating segments; o
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, 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
25
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.
CNA SURETY RESULTS FOR THREE- AND SIX- MONTHS ENDED JUNE 30, 2003 AND
2002
26
Analysis of Net Income
The Company had net income of $11.7 million for the three months ended
June 30, 2003, as compared to $12.9 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 the Company's net losses, commissions and related
expenses, partially offset by increased net earned premiums for the three months
ended June 30, 2003, as compared to the three months ended June 30, 2002.
Net income for the six months ended June 30, 2003 was $22.7 million,
compared to $23.5 million for the comparable period last year. As with the three
month period ended June 30, 2003, the principal driver of the decrease in net
income for the six month periods was an increase in net losses, commissions and
related expenses, partially offset by increased net earned premiums for the six
months ended June 30, 2003 compared to the same period in the prior year.
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 and six months
ended June 30, 2003 and 2002 are summarized in the following table (dollars in
thousands):
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------- -------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Gross written premiums........................ $ 97,446 $ 95,452 $ 189,117 $ 177,566
========== ========== ========== ==========
Net written premiums.......................... $ 83,297 $ 86,395 $ 162,631 $ 150,788
========== ========== ========== ==========
Net earned premiums........................... $ 76,846 $ 75,742 $ 148,052 $ 142,963
========== ========== ========== ==========
Net losses and loss adjustment expenses....... $ 20,235 $ 19,606 $ 38,841 $ 36,253
Net commissions, brokerage and other ========== ========== ========== ==========
underwriting expenses......................... $ 47,940 $ 45,594 $ 92,236 $ 87,146
========== ========== ========== ==========
Loss ratio.................................... 26.3% 25.9% 26.2% 25.4%
Expense ratio................................. 62.4 60.2 62.3 60.9
---------- ---------- ---------- ----------
Combined ratio................................ 88.7% 86.1% 88.5% 86.3%
========== ========== ========== ==========
Premiums Written
CNA Surety primarily markets contract and commercial surety bonds.
Contract surety bonds generally
27
secure a contractor's performance and/or payment obligation with respect to a
construction project. Contract surety bonds are generally required by federal,
state and local governments for public works projects. The most common types
include bid, performance and payment bonds. Commercial surety bonds include all
surety bonds other than contract and cover obligations typically required by law
or regulation. The commercial surety market includes numerous types of bonds
categorized as court judicial, court fiduciary, public official, license and
permit and many miscellaneous bonds that include guarantees of financial
performance. The Company also writes fidelity bonds that cover losses arising
from employee dishonesty and other insurance products.
Gross written premiums are shown in the table below (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------- -------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Contract...................................... $ 59,165 $ 53,890 $ 100,788 $ 93,270
Commercial.................................... 31,160 34,897 73,175 69,985
Fidelity and other............................ 7,121 6,665 15,154 14,311
---------- ---------- ---------- ----------
$ 97,446 $ 95,452 $ 189,117 $ 177,566
========== ========== ========== ==========
Gross written premiums increased 2.1%, or $2.0 million, for the three
months ended June 30, 2003 over the comparable period in 2002. Contract surety
gross written premiums increased 9.8%, or $5.3 million, as compared to 2002
primarily due to improving rates. Commercial surety in the second quarter of
2003 decreased by $3.7 million, or 10.7%, due to the Company's ongoing efforts
to reduce aggregate exposures to large commercial accounts. In the second
quarter of 2003, the Company experienced continued volume growth of small
commercial products along with improving rates on large commercial and contract
bonds. The estimated impact of the Company's large commercial account exposure
reduction of $1.7 billion for the first six months of 2003 represents
approximately $8 million in annual premium, assuming an average rate per $1,000
of bond exposure of $4.51, or 45 basis points. Fidelity and other products
increased 6.8%, or $0.5 million, to $7.1 million for the three months ended June
30, 2003 as compared to the same period in 2002 due primarily to volume growth
in fidelity and E&O products.
Gross written premiums increased 6.5%, or $11.6 million, for the six
months ended June 30, 2003 over the comparable period in 2002. Gross written
premiums for contract surety and commercial surety increased 8.1%, or $7.5
million, and 4.6%, or $3.2 million, respectively for the six months ended June
30, 2003 reflecting trends comparable to the quarter. Fidelity and other
products increased 5.9% to $15.2 million for the six months ended June 30, 2003
as compared to the same period in 2002 due primarily to volume growth in
fidelity and E&O products.
Net written premiums are shown in the table below (dollars in
thousands):
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------- -------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Contract...................................... $ 52,751 $ 49,947 $ 88,884 $ 81,182
Commercial.................................... 23,748 30,094 59,271 55,943
Fidelity and other............................ 6,798 6,354 14,476 13,663
---------- ---------- ---------- ----------
$ 83,297 $ 86,395 $ 162,631 $ 150,788
========== ========== ========== ==========
For the three months ended June 30, 2003, net written premiums
decreased 3.6%, or $3.1 million, to $83.3 million as compared to the same period
in 2002, reflecting higher reinsurance costs partially offset
28
by the aforementioned gross production changes. Ceded written premiums increased
$5.1 million to $14.1 million for the second quarter of 2003 compared to the
same period of last year primarily due to changes in the Company's reinsurance
programs as more fully described below. Net written premiums for contract surety
business increased 5.6%, or $2.8 million, to $52.8 million. Net written premiums
for commercial surety decreased 21.1%, or $6.3 million, to $23.7 million for the
three months ended June 30, 2003. Fidelity and other products increased 7.0%, or
$0.4 million, to $6.8 million for the three months ended June 30, 2003 as
compared to the same period in 2002.
For the six months ended June 30, 2003, net written premiums increased
7.9% to $162.6 million as compared to the same period in 2002, reflecting the
aforementioned gross production changes partially offset by effects of higher
reinsurance costs. Ceded written premiums decreased $0.3 million to $26.5
million for the six months ended June 30, 2003. Net written premiums for
contract surety business increased 9.5% to $88.9 million. Net written premiums
for commercial surety increased 5.9% to $59.3 million for the first six months
in 2003. Fidelity and other products increased 6.0% to $14.5 million for the
first six months in 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
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
29
also excluded three other contract principals from the 2003 Excess of Loss
Treaty for a total of six excluded principals. Of the two commercial principals,
one is a domestic electric utility with an estimated bonded exposure of $54
million and is currently rated B by Standard and Poor's ("S&P"). The other is a
foreign industrial concern with an estimated bonded exposure in excess of the
Company's $60 million net retention per principal under the applicable
reinsurance contracts. Management estimates that this concern has an equivalent
S&P rating of B+. With respect to the three contract principals other than the
large national contractor, two principals have substantially completed asset
sales, debt reductions and other reorganization efforts. Each of these four
principals continues to perform their contractual obligations underlying the
Company's surety bonds.
The third contract principal is in claim and the claim adjustment
process is in its early stages. Based upon currently available information,
management believes that the reasonably possible net loss ranges from zero to
$15.0 million, or equivalent to the Company's current per principal net
retention under the 2003 Excess of Loss Treaty.
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 a credit
agreement with the large national contractor, which undertakes projects for the
construction of government and private facilities, to provide loans to the
contractor in a maximum aggregate amount of $86.4 million (the "Credit
Facility"). Of the $86.4 million capacity, $62.1 million, including accrued
interest, was outstanding at June 30, 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.
In addition, in June of 2003, CNAF and one of its subsidiaries provided
repayment guarantees to certain creditors of the contractor and a subsidiary of
the contractor amounting to $8.7 million. Such guarantees were provided in order
to allow the contractor to receive financial accommodations from a creditor and
in order to comply with certain regulatory requirements. Under the terms of the
guarantees, any payments made by CNAF, or any of its subsidiaries, would be
considered a draw under the Credit Facility.
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 Corporation ("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
30
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, exist that reduce CNA
Surety's exposure to loss. While CNA Surety believes that the contractor's
restructuring efforts are expected to 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 June 30, 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.
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 June 30, 2003.
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
31
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 June 30, 2003, the Company had an estimated
unpaid loss recoverable balance of approximately $13.3 million under the Stop
Loss Contract.
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 June 30,
2003, the Company has established a return premium receivable of $6.6 million in
connection with the restatement described in Note 7 to the accompanying
financial statements. The reinsurance premium for the coverage provided by
32
the $50 million excess of $100 million contract was $6.0 million. This contract
expires on December 31, 2003.
As of June 30, 2003 and December 31, 2002, CNA Surety had an insurance
receivable balance from CCC and CIC of $72.2 million and $51.7 million,
respectively. CNA Surety had reinsurance payables to CCC and CIC of $5.9 million
and $21.3 million as of June 30, 2003 and December 31, 2002, respectively,
primarily related to reinsured losses.
Net Loss Ratio
The net loss ratios for the three months ended June 30, 2003 and 2002
were 26.3% and 25.9%, respectively. The loss ratios included $0.3 million and
$0.9 million of net unfavorable loss reserve
33
development related to prior years for the three months ended June 30, 2003 and
2002, respectively. For the six months ended June 30, 2003 and 2002, the net
loss ratios were 26.2% and 25.4%, respectively. The loss ratios included $0.3
million and $0.9 million of net unfavorable reserve development related to prior
years for the six months ended June 30, 2003 and 2002, respectively. 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 the first six
months of 2002. This business represents about 52% 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 June 30, 2003, the Company has billed a
total of $37.1 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 paid their portions of the claim.
Two other reinsurers have sent the Company letters expressing reservations about
the claim. One reinsurer has denied coverage. Pursuant to the treaty, the
Company has sent a notice demanding arbitration to all the reinsurers that have
not paid. 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 June 30, 2003.
The Company received claims on self insured workers compensation bonds
furnished on behalf of three companies that have either recently filed for
bankruptcy or have affiliates that filed for bankruptcy. The bonds were written
in the 1970s and 1980s. The Company is in the process of investigating the total
bond exposures involved, the underlying workers' claims that may be asserted
against each bond, the ability of the principals to meet their contractual
obligations underlying the Company's surety bonds and available reinsurance
coverage. The Company currently has insufficient information to fully complete
its claim evaluations, but the initial analysis indicates that the gross amount
of exposure consists of approximately $46 million in bonds. Based upon currently
available information, management believes that the ultimate claims made under
these bonds will be less than the total face amount of the bonds and that
required claim payments would occur over a number of years. The resolution of
these matters could have a material adverse impact on the future results of
operations and financial position of the Company.
Expense Ratio
The expense ratio increased to 62.4% for the three months ended June 30, 2003
compared to 60.2% for the same period in 2002. For the six months ended June 30,
2003, the expense ratio increased to 62.3% from 60.9% for the same period in
2002. The increase in the expense ratio for the three and six months ended June
30, 2003 primarily reflects the impact of higher reinsurance costs on net earned
premiums. Net earned premiums increased 1.5% and operating expenses increased
5.2% for the three months ended June
34
30, 2003. For the six months ended June 30, 2003, net earned premiums increased
3.6% and operating expenses increased at a higher rate of 5.8%.
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 30% 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
----------------------- -------------------------------------
June 30, December 31, June 30, December 31, %
Commercial Account Exposure 2003 2002 2003 2002 Reduction
---------------------------- -------- ------------ --------- ------------ ---------
$100 million and larger 8 14 $ 1.4 $ 2.7 46.6%
$50 to $100 million 13 19 0.9 1.2 32.0
$25 to $50 million 18 16 0.6 0.6 -
$10 to $25 million 70 75 1.1 1.2 11.6
--- --- --------- -------
Total 109 124 $ 4.0 $ 5.7 30.1%
=== === ========= ========
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 June 30, 2003, net investment income was
$6.7 million compared to the three months ended June 30, 2002 of $7.1 million.
The decrease in investment income primarily reflects the impact of lower
investment yields and higher investment in tax-exempt securities. The annualized
pretax yields were 4.6% and 5.0% for the three months ended June 30, 2003 and
2002, respectively. The annualized after-tax yields for the Company's portfolio
were 3.8% and 3.9% for the three months ended June 30, 2003 and 2002. Net
investment income for the six months ended June 30, 2003 and 2002 was $13.4
million and $14.2 million, respectively. The annualized pretax yields were 4.6%
and 5.0% for the six months ended June 30, 2003 and 2002. The annualized
after-tax yields were 3.8% for both the six months ended June 30, 2003 and 2002.
Net realized investment gains were approximately $1.1 million for the
three months ended June 30, 2003 compared to net realized investment gains of
approximately $1.6 million for the same period in 2002. Net realized investment
gains were approximately $1.8 million for the six months ended June 30, 2003
compared to net realized investment gains of approximately $1.3 for the same
period in 2002.
The following summarizes net realized investment gains (losses)
activity:
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Gross realized investment gains............ $ 1,105 $ 2,028 $ 2,366 $ 2,371
Gross realized investment losses........... (7) (427) (538) (1,048)
---------- ---------- ---------- ----------
Net realized investment gains.............. $ 1,098 $ 1,601 $ 1,828 $ 1,323
========== ========== ========== ==========
The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality fixed income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.
Invested assets are exposed to various risks, such as interest rate,
market and credit. Due to the level of risk associated with certain of these
invested assets and the level of uncertainty related to changes in the value of
these assets, it is possible that changes in risks in the near term may
significantly affect the amounts reported in the Condensed Consolidated Balance
Sheets and Condensed Consolidated Statements of Income.
Analysis of Other Operations
Interest expense for the three months ended June 30, 2003 increased
2.3% as compared to the second quarter in 2002. Average debt outstanding was
$60.8 million for the second quarter of 2003 compared to $76.2 million in the
2002. The weighted average interest rate for the three months ended June 30,
2003 was 2.4% compared to 2.1% for the same period in 2002. Interest expense
decreased 10.5% for the first six months of 2003 as compared to the same period
in 2002. Average debt outstanding was $60.8 million
35
for the first six months in 2003 compared to $76.2 million in the first six
months of 2002. The weighted average interest rate for the six months ended June
30, 2003 was 2.4% compared to 2.2% for the same period in 2002.
Income Taxes
Income tax expense was $4.3 million and $5.9 million and the effective
income tax rates were 26.8% and 31.4% for the three months ended June 30, 2003
and 2002, respectively. For the six months ended June 30, 2003 and 2002, income
tax expense was $8.7 million and $10.8 million and the effective income tax
rates were 27.7% and 31.4%, respectively. The decrease in the estimated
effective tax rate in 2003 primarily relates to anticipated increases in tax
exempt investment income as a proportion of taxable income.
LIQUIDITY AND CAPITAL RESOURCES
It is anticipated that the liquidity requirements of CNA Surety will be
met primarily by funds generated from operations. The principal sources of
operating cash flows are premiums, investment income, 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 June 30, 2003, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $547.2 million of fixed income
securities, $45.2 million of short-term investments, $1.1 million of other
investments and $1.4 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 June 30,
2003, the parent company's invested assets consisted of $6.3 million of fixed
income securities, $1.0 million of equity securities, $13.3 million of
short-term investments and $6.4 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 June 30, 2003 and December 31, 2002,
parent company short-term investments and cash included $7.7 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 $20.6 million for the six months ended June 30, 2003 compared to net cash
flow provided by operating activities of $37.0 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, and
36
decreases in reinsurance and other payables to affiliates.
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 $55 million as
of June 30, 2003, consisting of $30 million under the Revolving Credit Facility
and $25 million under the Term Loan Facility. Effective January 30, 2003, the
Company entered into an interest rate swap on the $30 million Term Loan. As a
result, the current effective interest rate on the term loan as of June 30, 2003
was 2.58%.
The Term Loan balance was reduced by $5 million on June 30, 2003
according to the scheduled amortization. Further amortization of the Term Loan
will take place at $10,000,000 per year, in equal semi-annual installments of
$5,000,000 on the following dates:
Date Amortization Outstanding Balance
---- ------------ -------------------
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 June 30, 2003 and can vary based
on CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to
0.80%. As of June 30, 2003, the weighted average interest rate was 2.2% on the
$55 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 June 30, 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
37
note. The promissory note matures on July 27, 2004 and has an interest rate of
5.0%. The balance of this promissory note at June 30, 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
received $10.0 million and $12.0 million in dividends from its insurance
subsidiaries during the first six months of 2003 and 2002, respectively. A
dividend of $10.0 million was received by CNA Surety from its insurance
subsidiaries on July 24, 2003.
Combined statutory surplus totaled $240.5 million at June 30, 2003,
resulting in a net written premium to statutory surplus ratio of 1.3 to 1.
Approximately $226 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 received tax
sharing payments from its subsidiaries of $6.2 million for the six months ended
June 30, 2003 and $3.5 million for the same period in 2002.
Western Surety and SBCA 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. The underwriting limitations of Western Surety,
SBCA and USA, based on each insurer's statutory surplus, were $20.7 million,
$0.5 million and $1.3 million, respectively, for the twelve month period ended
June 30, 2003. Effective July 1, 2003 through June 30, 2004, the underwriting
limitations of Western Surety and SBCA are $21.9 million and $0.5 million,
respectively. Through the Surety Quota Share Treaty between CCC and Western
Surety
38
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, 2003 through June 30, 2004, the
underwriting limitations of CCC and its affiliates total $569.6 million. CNA
Surety management believes that the foregoing U.S. Treasury underwriting
limitations are sufficient for the conduct of its business.
Subject to the aforementioned uncertainties concerning the Company's
per principal net retentions, CNA Surety management believes that the Company
has sufficient available resources, including capital protection against large
losses provided by the Company's excess of loss reinsurance arrangements, to
meet its present capital needs.
39
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.
40
CNA SURETY CORPORATION AND SUBSIDIARIES
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
41
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of
1934, the Registrant has duly caused this Report to be signed on its behalf by
the undersigned thereunto duly authorized.
CNA SURETY CORPORATION
(Registrant)
/s/ John F. Welch
--------------------------------------------------
John F. Welch
President and Chief Executive Officer
/s/ John F. Corcoran
--------------------------------------------------
John F. Corcoran
Senior Vice President and Chief Financial Officer
Date: March 12, 2004
42