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 SEPTEMBER 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 (I.R.S. Employer Identification No.)
incorporation or organization)
CNA PLAZA, CHICAGO, ILLINOIS 60685
(Address of principal executive offices) (Zip Code)
(312) 822-5000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No | |
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes |X| No | |
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
42,978,052 shares of Common Stock, $.01 par value as of November 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 September 30, 2003 as
filed by the Company on November 13, 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
September 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 September 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 September 30, 2003 (As restated) and
at December 31, 2002 (Unaudited).............................................. 5
Condensed Consolidated Statements of Income for the Three and Nine Months
Ended September 30, 2003 (As restated) and 2002 (Unaudited)................... 6
Condensed Consolidated Statements of Stockholders' Equity for the
Nine Months Ended September 30, 2003 (As restated) and 2002 (Unaudited)....... 7
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2003 (As restated) and 2002 (Unaudited)......................... 8
Notes to Condensed Consolidated Financial Statements
at September 30, 2003 (As restated) (Unaudited) .............................. 9
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations......................................................... 23
Item 4. Controls and Procedures....................................................... 43
Part II. Other Information:
Item 6. Exhibits and Reports on Form 8-K ............................................. 44
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 September 30, 2003, and the related
condensed consolidated statements of income, stockholders' equity and cash flows
for the three and nine month periods ended September 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
November 3, 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)
September 30, December 31,
2003 2002
--------------- ---------------
ASSETS As restated (a) As restated (a)
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $521,400 and $539,364) $ 557,339 $ 570,538
Equity securities, at fair value (cost: $914 and $852) ....................... 910 761
Short-term investments, at cost (approximates fair value) .................... 60,755 50,669
Other investments, at fair value ............................................. 1,117 1,257
Cash ......................................................................... 10,329 14,979
----------- -----------
Total invested assets and cash ........................................... 630,450 638,204
Deferred policy acquisition costs .............................................. 105,943 96,386
Insurance receivables:
Premiums, including $14,583 and $34,097 from affiliates (net of allowance for
doubtful accounts: $1,575 and $1,365) .................................... 32,363 45,423
Reinsurance, including $53,890 and $17,589 from affiliates ................... 161,948 129,964
Intangible assets (net of accumulated amortization: $25,523 and $25,523) ..... 138,785 143,785
Current income taxes receivable ................................................ 25,035 --
Property and equipment, at cost (less accumulated
depreciation: $18,052 and $16,047) ........................................... 16,421 17,260
Prepaid reinsurance premiums ................................................... 7,606 13,337
Receivable for securities sold ................................................. 7,121 3
Other assets ................................................................... 9,270 9,018
----------- -----------
Total assets ............................................................. $ 1,134,942 $ 1,093,380
=========== ===========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses ................................... $ 384,906 $ 303,433
Unearned premiums ............................................................ 229,468 216,213
----------- -----------
Total reserves ........................................................... 614,374 519,646
Debt ........................................................................... 50,418 60,816
Deferred income taxes, net ..................................................... 30,568 30,727
Current income taxes payable ................................................... -- 5,889
Reinsurance and other payables to affiliates ................................... 4,035 23,003
Other liabilities .............................................................. 36,016 32,738
----------- -----------
Total liabilities ........................................................ $ 735,411 $ 672,819
----------- -----------
Commitments and contingencies (See Note 6)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,398 shares
issued and 42,977 shares outstanding at September 30, 2003 and 44,386 shares
issued and 42,947 shares outstanding at December 31, 2002 .................... $ 444 $ 444
Additional paid-in capital ..................................................... 255,795 255,765
Retained earnings .............................................................. 135,190 159,937
Accumulated other comprehensive income ......................................... 23,358 19,861
Treasury stock, at cost ........................................................ (15,256) (15,446)
----------- -----------
Total stockholders' equity ............................................... 399,531 420,561
----------- -----------
Total liabilities and stockholders' equity ............................... $ 1,134,942 $ 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 Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2003 2002 2003 2002
--------------- ---------- --------------- ----------
As restated (a) As restated (a)
Revenues:
Net earned premium.......................................... $ 77,732 $ 79,196 $ 225,784 $ 222,159
Net investment income....................................... 6,429 7,031 19,780 21,258
Net realized investment gains (losses)...................... 1 (698) 1,829 625
---------- ---------- ---------- ----------
Total revenues........................................... 84,162 85,529 247,393 244,042
---------- ---------- ---------- ----------
Expenses:
Net losses and loss adjustment expenses..................... 112,492 35,380 151,333 71,633
Net commissions, brokerage and other underwriting expenses 48,805 46,027 141,041 133,173
Interest expense............................................ 372 407 1,180 1,310
---------- ---------- ---------- ----------
Total expenses........................................... 161,669 81,814 293,554 206,116
---------- ---------- ---------- ----------
Income (loss) before income taxes............................. (77,507) 3,715 (46,161) 37,926
Income tax expense (benefit).................................. (30,088) 1,098 (21,414) 11,850
---------- ---------- ---------- ----------
Net income (loss)............................................. $ (47,419) $ 2,617 $ (24,747) $ 26,076
========== ========== ========== ==========
Earnings per share............................................ $ (1.10) $ 0.06 $ (0.58) $ 0.61
========== ========== ========== ==========
Earnings per share, assuming dilution......................... $ (1.10) $ 0.06 $ (0.58) $ 0.61
========== ========== ========== ==========
Weighted average shares outstanding........................... 42,971 42,945 42,962 42,896
========== ========== ========== ==========
Weighted average shares outstanding, assuming dilution........ 42,994 43,094 42,985 43,048
========== ========== ========== ==========
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 (Loss)
----------- ----- ------- -------------
Balance, December 31, 2001 ......................................... 42,780 $ 442 $ 254,133
Comprehensive income:
Net income ....................................................... -- -- -- $ 26,076
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of $1,190 ......................... -- -- -- 17,148
---------
Total comprehensive income .................................... $ 43,224
=========
Issuance of treasury stock to employee stock purchase program ...... 10 15
Stock options exercised and other .................................. 157 2 1,617
Dividends paid to stockholders ..................................... -- -- --
------- --------- ---------
Balance, September 30, 2002 ........................................ 42,947 $ 444 $ 255,765
======= ========= =========
Balance, December 31, 2002 (As restated (a)) ....................... 42,947 $ 444 $ 255,765
Comprehensive income:
Net income (loss) (As restated (a)) .............................. -- -- -- $ (24,747)
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of $(1,846) ....................... -- -- -- 3,497
---------
Total comprehensive income (loss) (As restated (a)) ........... $ (21,250)
=========
Issuance of treasury stock to employee stock purchase program ...... 18 -- (71)
Stock options exercised and other .................................. 12 -- 101
------- --------- ---------
Balance, September 30, 2003 (As restated (a)) ...................... 42,977 $ 444 $ 255,795
======= ========= =========
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 ....................................................... 26,076 -- -- 26,076
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of $1,190 ......................... -- 17,148 -- 17,148
Total comprehensive income ....................................
Issuance of treasury stock to employee stock purchase program ...... 107 122
Stock options exercised and other .................................. -- -- -- 1,619
Dividends paid to stockholders ..................................... (19,309) -- -- (19,309)
--------- --------- --------- ---------
Balance, September 30, 2002 ........................................ $ 155,895 $ 17,426 $ (15,446) $ 414,084
========= ========= ========= =========
Balance, December 31, 2002 (As restated (a)) ....................... $ 159,937 $ 19,861 $ (15,446) $ 420,561
Comprehensive income:
Net income (loss) (As restated (a)) .............................. (24,747) -- -- (24,747)
Other comprehensive income:
Change in unrealized gains on securities (after income taxes), net
of reclassification adjustment of $(1,846) ....................... -- 3,497 -- 3,497
Total comprehensive income (loss) (As restated (a)) ...........
Issuance of treasury stock to employee stock purchase program ...... 190 119
Stock options exercised and other .................................. -- -- 101
--------- --------- --------- ---------
Balance, September 30, 2003 (As restated (a)) ...................... $ 135,190 $ 23,358 $ (15,256) $ 399,531
========= ========= ========= =========
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)
Nine Months Ended
September 30,
--------------------------------
2003 2002
-------------- ---------
OPERATING ACTIVITIES: As restated (a)
Net income (loss) ........................................................................ $ (24,747) $ 26,076
Adjustments to reconcile net income (loss) to net cash (used in) provided by
operating activities:
Depreciation and amortization ......................................................... 3,094 2,861
Accretion of bond discount, net ....................................................... 1,429 647
Net realized investment gains ......................................................... (1,829) (625)
Changes in:
Insurance receivables ................................................................. (18,924) 10,906
Reserve for unearned premiums ......................................................... 13,255 19,692
Reserve for unpaid losses and loss adjustment expenses ................................ 81,473 22,123
Deferred policy acquisition costs ..................................................... (9,557) (7,345)
Deferred income taxes, net ............................................................ (2,046) 3,027
Reinsurance and other payables to affiliates .......................................... (18,968) 1,838
Prepaid reinsurance premiums .......................................................... 5,731 (4,678)
Current income taxes payable (receivable) ............................................. (25,919) 299
Other assets and liabilities .......................................................... (381) (1,208)
--------- ---------
Net cash provided by operating activities ........................................... 2,611 73,613
--------- ---------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases ............................................................................. (59,144) (137,937)
Maturities ............................................................................ 24,621 105,938
Sales ................................................................................. 53,321 24,305
Purchases of equity securities ........................................................... (359) (22,572)
Proceeds from the sale of equity securities .............................................. 292 2,649
Changes in short-term investments ........................................................ (10,079) (7,187)
Purchases of property and equipment ...................................................... (2,595) (2,675)
Changes in receivables/payables for securities sold/purchased ............................ (3,032) (11,429)
Other, net ............................................................................... (12) (1,733)
--------- ---------
Net cash provided by (used in) investing activities ................................. 3,013 (50,641)
--------- ---------
FINANCING ACTIVITIES:
Principal payments on debt ............................................................... (10,398) (75,379)
Proceeds from long-term debt ............................................................. -- 65,000
Dividends to stockholders ................................................................ -- (12,868)
Employee stock option exercises .......................................................... 5 1,412
Issuance of treasury stock to employee stock purchase plan ............................... 119 122
--------- ---------
Net cash used in financing activities ............................................... (10,274) (21,713)
--------- ---------
Increase (decrease) in cash ............................................................... (4,650) 1,259
Cash at beginning of period ................................................................ 14,979 13,159
--------- ---------
Cash at end of period ...................................................................... $ 10,329 $ 14,418
========= =========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest .............................................................................. $ 942 $ 1,726
Income taxes .......................................................................... $ 6,250 $ 8,000
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
SEPTEMBER 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 (Loss) Per Share
Basic earnings (loss) 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 (loss) 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 (loss) per share is as follows (amounts in
thousands, except for per share data):
Three months ended Nine months ended
September 30, September 30,
------------------------ ------------------------
2003 2002 2003 2002
-------- -------- -------- --------
Net income (loss) .................................................... $(47,419) $ 2,617 $(24,747) $ 26,707
======== ======== ======== ========
Shares:
Weighted average shares outstanding .................................. 42,967 42,914 42,947 42,780
Weighted average shares of options exercised ..................... 4 31 15 116
-------- -------- -------- --------
Total weighted average shares outstanding ............................ 42,971 42,945 42,962 42,896
Effect of dilutive options ....................................... 23 149 23 152
-------- -------- -------- --------
Total weighted average shares outstanding, assuming dilution ......... 42,994 43,094 42,985 43,048
======== ======== ======== ========
Earnings (loss) per share ............................................ $ (1.10) $ 0.06 $ (0.58) $ 0.61
======== ======== ======== ========
Earnings (loss) per share, assuming dilution ......................... $ (1.10) $ 0.06 $ (0.58) $ 0.61
======== ======== ======== ========
9
No adjustments were made to reported net income (loss) in the computation
of earnings per share.
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 provided
for additional disclosure requirements related to guarantees, effective for
financial periods ended after December 15, 2002. Additionally, FIN No. 45
outlined provisions for initial recognition and measurement of the liability
incurred in providing a guarantee. These provisions are applied 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 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 has adopted FIN No. 46
effective January 1, 2003. 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
10
Compensation, Transition and Disclosure" ("SFAS No.148"). SFAS No. 148 provides
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. SFAS No. 148 also
amends the disclosure requirements of SFAS No. 123, "Accounting for Stock-Based
Compensation", to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results. The Company
adopted this standard beginning with the 2002 annual financial statements. The
Company has not adopted fair value accounting in 2003. The Company applies APB
Opinion No. 25, "Accounting for Stock Issued to Employees," and related
interpretations, in accounting for its plans as allowed for under the provisions
of SFAS No. 123. Accordingly, no compensation cost has been recognized for its
stock-based incentive plans as the exercise price of the granted options equals
the market price at the grant date. Had compensation cost for these plans been
determined on the fair value at the grant date for options granted, the
Company's pro forma net loss for the nine months ended September 30, 2003 would
have been $24.9 million and the Company's pro forma net income for the same
period in 2002 would have been $26.1 million, respectively. Diluted net loss per
share would have been $0.58 for the nine months ended September 30, 2003 and
diluted net income per share would have been $0.61 for the nine months ended
September 30, 2002.
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 Nine months ended
September 30, September 30,
------------------------ ------------------------
(in thousands, except per share data) 2003 2002 2003 2002
--------- --------- --------- ---------
Net income (loss) $ (47,419) $ 2,617 $ (24,747) $ 26,076
Adjustment: Total stock based compensation cost
determined under the fair value method, net of tax 59 -- (118) (12)
--------- --------- --------- ---------
Pro forma net income (loss) $ 47,360 $ 2,617 $ (24,865) $ 26,064
========= ========= ========= =========
Basic and diluted earnings (loss) per share, as reported $ (1.10) $ 0.06 $ (0.58) $ 0.61
========= ========= ========= =========
Basic and diluted earnings (loss) per share, pro forma $ (1.10) $ 0.06 $ 0.58 $ 0.61
========= ========= ========= =========
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. Adoption of SFAS No. 149 did not
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.
11
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 began 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 did not have any impact on
the Company's financial position or results of operations.
12
2. INVESTMENTS
The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety at September 30, 2003 and December 31, 2002, by
investment category, were as follows (dollars in thousands):
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
September 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 ....................................... $ 16,847 $ 792 $ -- $ 17,639
U.S. Agencies ....................................... 6,553 218 (54) 6,717
Collateralized mortgage obligations ................. 82 2 -- 84
Mortgage pass-through securities .................... 9,261 448 -- 9,709
Obligations of states and political subdivisions ......... 378,644 24,799 (204) 403,239
Corporate bonds .......................................... 70,173 7,267 (51) 77,389
Non-agency collateralized mortgage obligations ........... 8,490 548 (27) 9,011
Other asset-backed securities:
Second mortgages/home equity loans ..................... 7,480 507 -- 7,987
Credit card receivables ................................ 5,000 72 -- 5,072
Other .................................................. 5,416 300 -- 5,716
Redeemable preferred stock ............................... 13,454 1,322 -- 14,776
-------- -------- -------- --------
Total fixed income securities ....................... 521,400 36,275 (336) 557,339
Equity securities ........................................ 914 -- (4) 910
-------- -------- -------- --------
Total ............................................... $522,314 $ 36,275 $ (340) $558,249
======== ======== ======== ========
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.
13
CNA Surety classifies its fixed income securities and its equity
securities as available-for-sale, and as such, they are carried at fair value.
The amortized cost of fixed income securities is adjusted for amortization of
premiums and accretion of discounts 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 September 30,
--------------------------------------------------------------
2003 2002
-------------------------- ---------------------------
Written Earned Written Earned
--------- --------- --------- ----------
Direct ...................................................... $ 52,623 $ 44,192 $ 38,024 $ 35,891
Assumed ..................................................... 41,599 48,980 59,005 52,862
Ceded ....................................................... (12,084) (15,440) (10,643) (9,557)
--------- --------- --------- ----------
$ 82,138 $ 77,732 $ 86,386 $ 79,196
========= ========= ========= ==========
Nine Months Ended September 30,
-----------------------------------------------------------
2003 2002
-------------------------- ------------------------
Written Earned Written Earned
--------- --------- --------- ----------
Direct ...................................................... $ 141,388 $ 119,707 $ 111,317 $ 100,578
Assumed ..................................................... 141,951 150,385 163,278 154,365
Ceded ....................................................... (38,570) (44,308) (37,421) (32,784)
--------- --------- --------- ----------
$ 244,769 $ 225,784 $ 237,174 $ 222,159
========= ========= ========= ==========
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):
Three Months Ended September 30,
-----------------------------------------------------------
2003 2002
-------------------------- ------------------------
$ Ratio $ Ratio
--------- ----- --------- -----
Gross losses and loss adjustment expenses ................... $ 141,577 152.0% $ 45,733 51.5%
Ceded amounts ............................................... (29,085) 188.4% (10,353) 108.3%
--------- ---------
Net losses and loss adjustment expenses ..................... $ 112,492 144.7% $ 35,380 44.7%
========= =========
Nine Months Ended September 30,
-----------------------------------------------------------
2003 2002
-------------------------- ------------------------
$ Ratio $ Ratio
--------- ----- --------- -----
Gross losses and loss adjustment expenses ................... $ 213,496 79.0% $ 86,889 34.1%
Ceded amounts ............................................... (62,163) 140.3% (15,256) 46.5%
--------- ---------
Net losses and loss adjustment expenses ..................... $ 151,333 67.0% $ 71,633 32.2%
========= =========
Assumed premiums primarily includes all surety business written or
renewed, net of reinsurance, by
14
Continental Casualty Company ("CCC") and The Continental Insurance Company
("CIC"), and their affiliates, that is reinsured by Western Surety Company
("Western Surety") pursuant to intercompany reinsurance and related agreements.
2003 Third Party Reinsurance Compared to 2002 Third Party Reinsurance
Effective January 1, 2003, CNA Surety entered into a new excess of loss
treaty ("2003 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal on new bonds to $15 million with a
5% co-participation in the $45 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $40
million excess of $20 million per principal coverage ("2002 Excess of Loss
Treaty"). The material differences between the new excess of loss reinsurance
program and the Company's 2002 Excess of Loss Treaty are as follows. The annual
aggregate coverage increases from $100 million in 2002 to $110 million in 2003.
The minimum annual premium for the 2003 Excess of Loss Treaty is $38.0 million
compared to $30.0 million of reinsurance premiums paid in 2002. The 2003 Excess
of Loss Treaty provides the Company with coverage on a per principal basis of
95% of $45 million excess of $15 million retained by the Company.
The contract also includes similar special acceptance provisions for
larger contract accounts contained in the 2002 Excess of Loss Treaty. In
addition to the one large national contract principal and the two commercial
principals excluded (based upon class of business in 2002), the Company's
reinsurers have 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 $53 million and is currently rated B by Standard and Poor's
("S&P"). The bonded exposure will decline over the term of the bond which
extends until 2007. The other is a foreign industrial enterprise with an
estimated bonded exposure of $31 million. Management estimates that this
enterprise has an equivalent S&P rating of B+. The remaining $31 million of the
bonded exposure is expected to be discharged by June 30, 2004. With respect to
the three contract principals other than the large national contractor
(described below), 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 went into claim in the second quarter of
2003. Although in claim and experiencing financial difficulties, the contractor
continued to perform substantially all of its contractual obligations underlying
the Company's surety bonds. This contractor recently filed for bankruptcy in
late September, 2003. This filing increased the likelihood that the contractor
will be unable to perform all of its contractual obligations. Based upon
currently available information, management believes its net exposure to loss on
this contractor could be up to $15 million. This loss exposure has been
considered in the Company's $49 million net reserve addition in the third
quarter of 2003 for the 2003 accident year.
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
15
provide loans to the contractor in a maximum aggregate amount of $86.4 million
(the "Credit Facility"). Of the $86.4 million capacity, $74.8 million, including
accrued interest, was outstanding at September 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. 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. As of September 30, 2003 these guarantees amounted to $7.4
million.
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 was 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 were due to expire between May and August of 2003. One of these letters of
credit in the amount of $3.4 million was extended, but on September 30,2003 was
due to expire on November 1, 2003. Any amounts paid by CNAF to the banks as
reimbursements for draws upon the banks' letters of credit would 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 September 30, 2003 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 will be successful and provide sufficient cash flow for
its operations, the contractor's failure to achieve its restructuring plan or
perform its contractual obligations underlying all of the Company's surety bonds
could have a material adverse effect on CNA Surety's future results of
16
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.
17
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 September 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 expense reserves transferred to Western Surety as of September
30, 1997 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 September 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 September 30, 2003, the Company had an estimated
unpaid loss recoverable balance of approximately $37.0 million under the Stop
Loss Contract of which $28.0 million has been billed.
18
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 paid annual reinsurance premiums of $12.5 million in year one to
CCC. Effective October 1, 2003, the $40 million excess of $60 million contract
was amended to extend the year one quarterly premium rate of $3.125 million and
commutation provision for an additional quarter ending December 31, 2003. The
Company is seeking to obtain replacement coverage with third party reinsurers
effective January 1, 2004. The Company will pay CCC a total of $17.5 million in
years two and three, payable quarterly. The Company may commute the contract at
the end of each contract year and at the beginning of each calendar 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 September
30, 2003, the Company has established a return premium receivable of $8.8
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.
Effective October 1, 2003, pending state insurance department regulatory
approval, the Company entered into a $3 million excess of $12 million excess of
loss contract with CCC. The reinsurance premium for the coverage provided by the
$3 million excess of $12 million contract is $0.3 million plus, if applicable,
additional premiums based on paid losses. The contract provides for aggregate
coverage of $12 million. This contract expires on December 31, 2004. This
contract effectively lowers the Company's net retention on new bonds for the
remainder of 2003 to $12 million plus a 5% co-participation in the $45 million
layer of excess reinsurance with third party reinsurers.
As of September 30, 2003 and December 31, 2002, CNA Surety had insurance
receivable balances from CCC and CIC of $68.5 million and $51.7 million,
respectively. CNA Surety had reinsurance
19
payables to CCC and CIC of $1.3 million and $21.3 million as of September 30,
2003 and December 31, 2002, respectively, primarily related to reinsured losses.
4. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the reserves for unpaid losses and loss adjustment expenses
was as follows (dollars in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2003 2002 2003 2002
-------- -------- -------- --------
Reserves at beginning of period:
Gross .................................................................. 277,210 $308,746 $303,433 $315,811
Ceded reinsurance ...................................................... 116,456 148,673 137,301 166,318
-------- -------- -------- --------
Net reserves at beginning of period .................................. $160,754 160,073 166,132 149,493
======== -------- -------- --------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period ....................... 73,531 31,222 112,032 66,566
Increase in provision for insured events of prior periods ............ 38,961 4,158 39,301 5,067
-------- -------- -------- --------
Total net incurred ................................................ 112,492 35,380 151,333 71,633
-------- -------- -------- --------
Net payments attributable to:
Current period events ................................................ 19,753 2,267 19,020 5,340
Prior period events .................................................. 7,039 18,027 51,991 40,627
-------- -------- -------- --------
Total net payments ................................................ 26,792 20,294 71,011 45,967
-------- -------- -------- --------
Net reserves at end of period .......................................... 246,454 175,159 246,454 175,159
Ceded reinsurance at end of period ..................................... 138,452 162,775 138,452 162,775
-------- -------- -------- --------
Gross reserves at end of period ................................... $384,906 $337,934 $384,906 $337,934
======== ======== ======== ========
The Company recorded net unfavorable loss reserve development which
resulted in increases in the estimated liability of $39.3 million for the nine
months ended September 30, 2003. This increase primarily relates to accident
years 2002 and 2001 and changes in estimates of potential additional losses
resulting from material adverse claim activity in the third quarter of 2003.
In addition to the net unfavorable loss reserve development in the third
quarter of 2003, the higher net loss ratio in 2003 primarily relates to net
reserve additions in the quarter of approximately $49.0 million for the current
accident year due to material adverse loss severity in the third quarter of 2003
on the Company's branch commercial and contract business.
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 September 30, 2003, the Company has billed a total of
$37.1 million to its reinsurers. Four reinsurers responsible for payment of 46%
of the treaty proceeds have paid or have agreed to pay 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
20
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 September 30, 2003.
5. DEBT
On September 30, 2002, the Company refinanced $65 million in outstanding
borrowings under its previous credit facility with a new credit facility (the
"2002 Credit Facility"). The 2002 Credit Facility, as amended September 30,
2003, provides an aggregate of up to $50 million in borrowings divided between a
revolving credit facility (the "Revolving Credit Facility") of $30 million and a
term loan facility (the "Term Loan") of $20 million. The Revolving Credit
Facility matures on September 30, 2005. The Revolving Credit Facility may be
increased from time to time by the amount of amortization under the Term Loan
facility up to an additional $10 million. 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 Term Loan. As a result, the current effective interest rate on the term
loan as of September 30, 2003 was 2.83%.
The Term Loan balance was reduced by $10 million through September 30,
2003 according to the scheduled amortization. Further amortization of the Term
Loan will take place at $10 million per year, in equal semi-annual installments
of $5 million on the following dates:
Date Amortization Outstanding Balance
---- ------------ -------------------
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 --
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 Revolving Credit Facility, was 1.30% at September 30, 2003 and can
vary based on CNA Surety's leverage ratio (debt to total capitalization) from
1.15% to 1.45%. The margin on the Term Loan, was 0.625% at September 30, 2003
and can vary based on CNA Surety's leverage ratio (debt to total capitalization)
from 0.48% to 0.80%. As of September 30, 2003, the weighted average interest
rate was 2.7% on the $50 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. At September 30, 2003 and
December 31, 2002, CNA Surety was in compliance with all restrictive debt
covenants, except for the fixed charge coverage ratio for the period ended
September 30, 2003 for which CNA Surety obtained a waiver from the lenders. The
lenders amended the 2002 Credit Facility to replace the fixed charge coverage
ratio requirement for the next three quarters with a minimum earnings
21
requirement.
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 September 30, 2003 was $0.4 million.
The consolidated balance sheet reflects total debt of $50.4 million at
September 30, 2003 and $60.8 million at December 31, 2002. The weighted average
interest rate on outstanding borrowings was 2.5% and 2.0% at September 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 September 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 September 30, 2003. CNA Surety had
not previously established such a receivable, and has restated its 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
FOR THE PERIODS ENDED: (IN THOUSANDS) REPORTED RESTATED REPORTED RESTATED
SEPTEMBER 30, SEPTEMBER 30, DECEMBER 31, DECEMBER 31,
2003 2003 2002 2002
-------------- ------------- ------------- ------------
Consolidated balance sheet:
Insurance receivables: Reinsurance $ 153,196 $ 161,948 $ 127,776 $ 129,964
Current income taxes receivable 28,099 25,035 5,123 5,889
Retained earnings 129,502 135,190 158,515 159,937
AS PREVIOUSLY AS AS PREVIOUSLY AS
REPORTED RESTATED REPORTED RESTATED
2003 2003 2003 2003
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30 ------------- -------- -------------- ----------
(in thousands, except per share data) Three months ended September 30 Nine months ended September 30
------------------------------- ------------------------------
Consolidated statement of income:
Net earned premium $ 75,544 $ 77,732 $ 219,220 $ 225,784
Total revenue 81,974 84,162 240,829 247,393
Loss before income taxes (79,695) (77,507) (52,725) (46,161)
Income tax benefit (30,854) (30,088) (23,712) (21,414)
Net loss (48,841) (47,419) (29,013) (24,747)
Basic and diluted loss per share ($1.14) ($1.10) ($0.68) ($0.58)
22
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 September 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 September 30, 2003. CNA Surety had not previously
established such a receivable, and has restated its 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
23
fair value, with unrealized gains and losses, net of deferred income taxes,
reported as a separate component of stockholders' equity. Cash flows from
purchases, sales and maturities are reported gross in the investing activities
section of the cash flow statement.
The amortized cost of fixed income securities is determined based on cost
and the cumulative effect of amortization of premiums and accretion of discounts
to maturity. Such amortization and accretion are included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective-yield method based on estimated cash flows. All
securities transactions are recorded on the trade date. Investment gains or
losses realized on the sale of securities are determined using the specific
identification method. Investments with an other-than-temporary decline in value
are written down to fair value, resulting in losses that are included in
realized investment gains and losses.
Short-term investments which generally include U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents, are carried at amortized cost which approximates fair value.
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 September 30, 2003 includes
goodwill and identified intangibles of approximately $138.8 million. The
goodwill and intangible balance as of September 30, 2003 reflects a $5 million
reduction in goodwill in the third quarter of 2003 resulting from a change in
estimate with respect to pre-acquisition income taxes. 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
24
claims have not yet been reported and some claims may not be reported for many
years. As a result, the liability for unpaid losses includes significant
estimates for incurred-but-not-reported claims. Additionally, reported claims
are in various stages of the settlement process. Each claim is settled
individually based upon its merits, and certain claim liabilities may take years
to settle, especially if legal action is involved.
The Company uses a variety of techniques to establish the liabilities for
unpaid claims recorded at the balance sheet date. While techniques may vary,
each employs significant judgments and assumptions. Techniques may involve
detailed statistical analysis of past claim reporting, settlement activity,
salvage and subrogation activity, claim frequency and severity data when
sufficient information exists to lend statistical credibility to the analysis.
The analysis may be based upon internal loss experience or industry experience.
Techniques may vary depending on the type of claim being estimated. Liabilities
may also reflect implicit or explicit assumptions regarding the potential
effects of future economic and social inflation, judicial decisions, law
changes, and recent trends in such factors.
Receivables recorded with respect to insurance losses ceded to reinsurers
under reinsurance contracts are estimated in a manner similar to liabilities for
insurance losses and, therefore, are also subject to uncertainty. In addition to
the factors cited above, estimates of reinsurance recoveries may prove
uncollectible if the reinsurer is unable to perform under the contract.
Reinsurance contracts do not relieve the ceding company of its obligations to
indemnify its own policyholders.
CNA Surety's Consolidated Balance Sheet includes estimated liabilities for
unpaid losses and loss adjustment expenses of $384.9 million and reinsurance
receivables related to losses of $138.5 million at September 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
September 30, 2003 net estimate for unpaid losses and loss adjustment expenses
would produce approximately a $24.6 million charge to pre-tax earnings. Future
effects from changes in these estimates will be recorded as a component of
losses incurred in the period such changes are determined to be needed.
FORMATION OF CNA SURETY AND MERGER
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
25
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.
FINANCIAL STRENGTH RATINGS
A.M. BEST COMPANY, INC. ("A.M. BEST")
Western Surety is currently rated A (Excellent) with a negative rating
outlook, by A.M. Best. An A (Excellent) rating is assigned to those companies
which A.M. Best believes have an excellent ability to meet their ongoing
obligations to policyholders. A (Excellent) rated insurers have been shown to be
among the strongest in ability to meet policyholder and other contractual
obligations. The rating outlook indicates the potential direction of a company's
rating for an intermediate period, generally defined as the next 12 to 36
months. 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;
26
- changes in financial markets such as fluctuations in interest rates,
long-term periods of low interest rates, credit conditions and
currency, commodity and stock prices;
- the effects of corporate bankruptcies, such as Enron and WorldCom,
on surety bond claims, as well as on capital markets;
- changes in foreign or domestic political, social and economic
conditions;
- regulatory initiatives and compliance with governmental regulations,
judicial decisions, including interpretation of policy provisions,
decisions regarding coverage, trends in litigation and the outcome
of any litigation involving the Company, and rulings and changes in
tax laws and regulations;
- regulatory limitations, impositions and restrictions upon the
Company, including the effects of assessments and other surcharges
for guaranty funds and other mandatory pooling arrangements;
- the impact of competitive products, policies and pricing and the
competitive environment in which the Company operates, including
changes in the Company's books of business;
- product and policy availability and demand and market responses,
including the level of ability to obtain rate increases and decline
or non-renew underpriced accounts, to achieve premium targets and
profitability and to realize growth and retention estimates;
- development of claims and the impact on loss reserves, including
changes in claim settlement practices;
- the performance of reinsurance companies under reinsurance contracts
with the Company;
- results of financing efforts, including the availability of bank
credit facilities;
- changes in the Company's composition of operating segments;
- the sufficiency of the Company's loss reserves and the possibility
of future increases in reserves;
- the risks and uncertainties associated with the Company's loss
reserves as outlined in the Reserves section of this MD&A; and,
- the possibility of further changes in the Company's ratings by
ratings agencies, including the inability to access certain markets
or distribution channels and the required collateralization of
future payment obligations as a result of such changes, and changes
in rating agency policies and practices;
Any forward-looking statements made in this report are made by the Company
as of the date of this report. The Company does not have any obligation to
update or revise any forward-looking statement contained in this report, even if
the Company's expectations or any related events, conditions or circumstances
change.
RESULTS OF OPERATIONS
Financial Measures
The Management's Discussion and Analysis of Financial Condition and
Results of Operations ("MD&A") discusses certain generally accepted accounting
principles ("GAAP") and non-GAAP financial measures in order to provide
information used by management to monitor the Company's operating performance.
Management utilizes various financial measures to monitor the Company's
insurance operations and investment portfolio. Underwriting results, which are
derived from certain income
27
statement amounts, are considered a non-GAAP financial measure and are used by
management to monitor performance of the Company's insurance operations. The
Company's investment portfolio is monitored through analysis of various
quantitative and qualitative factors and certain decisions related to the sale
or impairment of investments produce realized gains and losses, which is also a
component used in the calculation of net income and is a non-GAAP financial
measure.
Underwriting results are computed as net earned premiums less net loss and
loss adjustment expenses and net commissions, brokerage and other underwriting
expenses. Management uses underwriting results to monitor its insurance
operations' results without the impact of certain factors, including net
investment income, net realized investment gains (losses) and interest expense.
Management excludes these factors in order to analyze the direct relationship
between net earned premiums and the related net loss and loss adjustment
expenses along with net commissions, brokerage and other underwriting expenses.
Operating ratios are calculated using insurance results and are widely
used by the insurance industry and regulators such as state departments of
insurance and the National Association of Insurance Commissioners for financial
regulation and as a basis of comparison among companies. The ratios discussed in
the Company's MD&A are calculated using GAAP financial results and include the
net loss and loss adjustment expense ratio ("loss ratio") as well as the net
commissions, brokerage and other underwriting expense ratio ("expense ratio")
and combined ratio. The loss ratio is the percentage of net incurred claim and
claim adjustment expenses to net earned premiums. The expense ratio is the
percentage of net commissions, brokerage and other underwriting expenses,
including the amortization of deferred acquisition costs, to net earned
premiums. The combined ratio is the sum of the loss and expense ratios.
The Company's investment portfolio is monitored by management through
analyses of various factors including unrealized gains and losses on securities,
portfolio duration and exposure to interest rate, market and credit risk. Based
on such analyses, the Company may impair an investment security in accordance
with its policy, or sell a security. Such activities will produce net realized
investment gains and losses.
While management uses various GAAP and non-GAAP financial measures to
monitor various aspects of the Company's performance, net income is the most
directly comparable GAAP measure and represents a more comprehensive measure of
operating performance. Management believes that its process of evaluating
performance through the use of these non-GAAP financial measures provides a
basis for enhanced understanding of its 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.
28
CNA SURETY RESULTS FOR THREE- AND NINE- MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
Analysis of Net Income (Loss)
The Company had a net loss of $47.4 million for the three months ended
September 30, 2003, as compared to net income of $2.6 million for the comparable
period in the prior year. The principal drivers of the difference in net income
from period to period were an increase in the Company's net losses, commissions
and related expenses, partially offset by increased net earned premiums for the
three months ended September 30, 2003, compared to the three months ended
September 30, 2002.
Net loss for the nine months ended September 30, 2003 was $24.7 million,
compared to net income of $26.1 million for the comparable period last year. As
with the three month period ended September 30, 2003, the principal drivers of
the decrease in net income for the nine month periods were an increase in net
losses, commissions and related expenses, partially offset by increased net
earned premiums.
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 nine months
ended September 30, 2003 and 2002 are summarized in the following table (dollars
in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
2003 2002 2003 2002
--------- --------- --------- ---------
Gross written premiums .......................... $ 94,222 $ 97,029 $ 283,339 $ 274,595
========= ========= ========= =========
Net written premiums ............................ $ 82,138 $ 86,386 $ 244,769 $ 237,174
========= ========= ========= =========
Net earned premiums ............................. $ 77,732 $ 79,196 $ 225,784 $ 222,159
========= ========= ========= =========
Net losses and loss adjustment expenses ......... $ 112,492 $ 35,380 $ 151,333 $ 71,633
========= ========= ========= =========
Net commissions, brokerage and other
underwriting expenses ....................... $ 48,805 $ 46,027 $ 141,041 $ 133,173
========= ========= ========= =========
Loss ratio ...................................... 144.7% 44.7% 67.0% 32.2%
Expense ratio ................................... 62.8 58.1 62.5 60.0
--------- --------- --------- ---------
Combined ratio .................................. 207.5% 102.8% 129.5% 92.2%
========= ========= ========= =========
29
Premiums Written
CNA Surety primarily markets contract and commercial surety bonds.
Contract surety bonds generally secure a contractor's performance and/or payment
obligation with respect to a construction project. Contract surety bonds are
generally required by federal, state and local governments for public works
projects. The most common types include bid, performance and payment bonds.
Commercial surety bonds include all surety bonds other than contract and cover
obligations typically required by law or regulation. The commercial surety
market includes numerous types of bonds categorized as court judicial, court
fiduciary, public official, license and permit and many miscellaneous bonds that
include guarantees of financial performance. The Company also writes fidelity
bonds that cover losses arising from employee dishonesty and other insurance
products.
Gross written premiums are shown in the table below (dollars in
thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ---------------------
2003 2002 2003 2002
-------- -------- -------- --------
Contract ........................... $ 56,863 $ 55,503 $157,651 $148,773
Commercial ......................... 29,970 34,630 103,145 104,615
Fidelity and other ................. 7,389 6,896 22,543 21,207
-------- -------- -------- --------
$ 94,222 $ 97,029 $283,339 $274,595
======== ======== ======== ========
Gross written premiums decreased 2.9%, or $2.8 million, for the three
months ended September 30, 2003 over the comparable period in 2002. Contract
surety gross written premiums increased 2.5%, or $1.4 million, as compared to
2002 primarily due to improving rates. Commercial surety in the third quarter of
2003 decreased by $4.7 million, or 13.5%, due to the Company's ongoing efforts
to reduce aggregate exposures to large commercial accounts. In the third 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
$2.1 billion for the first nine months of 2003 represents approximately $9.5
million in annual premium, assuming an average rate per $1,000 of bond exposure
of $4.52, or 45 basis points. Fidelity and other products increased 7.1%, or
$0.5 million, to $7.4 million for the three months ended September 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 3.2%, or $8.7 million, for the nine
months ended September 30, 2003 over the comparable period in 2002. Gross
written premiums for contract surety increased 6.0%, or $8.9 million and
commercial surety decreased 1.4%, or $1.5 million for the nine months ended
September 30, 2003 reflecting trends comparable to those previously discussed
for the third quarter 2003. Fidelity
30
and other products increased 6.3% to $22.5 million for the nine months ended
September 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 Nine Months Ended
September 30, September 30,
------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Contract...................................... $ 51,492 $ 50,527 $ 140,376 $ 131,709
Commercial.................................... 23,602 29,289 82,873 85,232
Fidelity and other............................ 7,044 6,570 21,520 20,233
---------- ---------- ---------- ----------
$ 82,138 $ 86,386 $ 244,769 $ 237,174
========== ========== ========== ==========
For the three months ended September 30, 2003, net written premiums
decreased 4.9%, or $4.2 million, to $82.1 million as compared to the same period
in 2002, reflecting higher reinsurance costs partially offset by the
aforementioned gross production changes. Ceded written premiums increased $1.4
million to $12.1 million for the third 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 1.9%, or $1.0 million, to $51.5 million. Net written premiums
for commercial surety decreased 19.4%, or $5.7 million, to $23.6 million for the
three months ended September 30, 2003. Fidelity and other products increased
7.2%, or $0.5 million, to $7.0 million for the three months ended September 30,
2003 as compared to the same period in 2002.
For the nine months ended September 30, 2003, net written premiums
increased 3.2% to $244.8 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 increased $1.1
million to $38.6 million for the nine months ended September 30, 2003. Net
written premiums for contract surety business increased 6.6% to $140.4 million.
Net written premiums for commercial surety decreased 2.8% to $82.9 million for
the first nine months in 2003. Fidelity and other products increased 6.4% to
$21.5 million for the first nine 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
31
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 $53 million and is currently rated B by Standard and Poor's
("S&P"). The bonded exposure will decline over the term of the bond which
extends until 2007. The other is a foreign industrial enterprise with an
estimated bonded exposure of $31 million. The remaining $31 million of the
bonded exposure is expected to be discharged by June 30, 2004. With respect to
the three contract principals other than the large national contractor
(described below), 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 went into claim in the second quarter of
2003. Although in claim and experiencing financial difficulties, the contractor
continued to perform substantially all of its contractual obligations underlying
the Company's surety bonds. This contractor recently filed for bankruptcy in
late September, 2003. This filing increased the likelihood that the contractor
will be unable to perform all of its contractual obligations. Based upon
currently available information, management believes its net exposure to loss on
this contractor could be up to $15 million. This loss exposure has been
considered in the Company's $49 million net reserve addition in the third
quarter of 2003 for the 2003 accident year.
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, $74.8 million, including accrued
interest, was outstanding at September 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. 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. As of September 30, 2003 these guarantees amounted to $7.4
million.
32
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 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 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 was 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 were due to expire between May and August of 2003. One of these letters of
credit in the amount of $3.4 million was extended, but on September 30,2003 was
due to expire on November 1, 2003. Any amounts paid by CNAF to the banks as
reimbursements for draws upon the banks' letters of credit would 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 September 30, 2003 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 will be successful and provide sufficient cash flow for
its operations, the contractor's failure to achieve its restructuring plan or
perform its contractual obligations underlying all of the Company's surety bonds
could have a material adverse effect on CNA Surety's future results of
operations, cash flows and capital resources. If such failures occur, the
Company estimates that possible losses, net of indemnification and subrogation
recoveries, but before recoveries under reinsurance contracts, could be up to
$200 million. However, the related party reinsurance treaties discussed below
should limit the Company's per principal exposure to approximately $60 million.
Related Party Reinsurance
Intercompany reinsurance agreements together with the Services and
Indemnity Agreement that are described below provide for the transfer of the
surety business written by CCC and CIC to Western Surety. All these agreements
originally were entered into on September 30, 1997 (the "Merger Date"): (i) the
Surety Quota Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop
Loss Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety
Excess of Loss Reinsurance Contract (the "Excess of Loss Contract"). All of
these contracts have expired. Some have been renewed on different terms as
described below.
33
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 September 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 expense reserves transferred to Western Surety as of September
30, 1997 by agreeing to pay Western Surety, within 30 days following the end of
each calendar quarter, the amount of any adverse development on such reserves,
as re-estimated as of the end of such calendar quarter. There was not any
adverse reserve development for the period from September 30, 1997 (date of
inception) through September 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 September 30, 2003, the Company had an estimated
unpaid loss recoverable balance of approximately $37.0 million under the Stop
Loss Contract of which $28.0 million has been billed.
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
34
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 paid annual reinsurance premiums of $12.5 million in year one to CCC
.. Effective October 1, 2003, the $40 million excess of $60 million contract was
amended to extend the year one quarterly premium rate of $3.125 million and
commutation provision for an additional quarter ending December 31, 2003. The
Company is seeking to obtain replacement coverage with third party reinsurers
effective January 1, 2004. The Company will pay CCC a total of $17.5 million in
years two and three, payable quarterly. The Company may commute the contract at
the end of each contract year and at the beginning of each calendar year under
certain circumstances. If the treaty is commuted, the Company may be entitled to
a return premium payment. Based on the experience of the treaty to September 30,
2003, the Company has established a return premium receivable of $8.8 million in
connection with the restatement described in Note 7 to the accompanying
financial statements. The reinsurance premium for the coverage provided by the
$50 million excess of $100 million contract was $6.0 million. This contract
expires on December 31, 2003.
Effective October 1, 2003, pending state insurance department regulatory
approval the Company entered into a $3 million excess of $12 million excess of
loss contract with CCC. The reinsurance premium for the coverage provided by the
$3 million excess of $12 million contract is $0.3 million plus, if applicable,
additional premiums based on paid losses. The contract provides for aggregate
coverage of $12 million. This contract expires on December 31, 2004. This
contract effectively lowers the Company's net retention on new bonds for the
remainder of 2003 to $12 million plus a 5% co-participation in the $45 million
layer of excess reinsurance with third party reinsurers.
As of September 30, 2003 and December 31, 2002, CNA Surety had
insurance receivable balances from CCC and CIC of $68.5 million and $51.7
million, respectively. CNA Surety had reinsurance payables to CCC and CIC of
$1.3 million and $21.3 million as of September 30, 2003 and December 31, 2002,
respectively, primarily related to reinsured losses.
35
Net Loss Ratio
The net loss ratios for the three months ended September 30, 2003 and 2002
were 144.7% and 44.7%, respectively. The loss ratios included $39.0 million and
$4.2 million of net unfavorable loss reserve development related to prior years
for the three months ended September 30, 2003 and 2002, respectively. The net
adverse development on prior accident years of $39.0 million primarily relates
to accident years 2001 and 2002 and changes in estimates of potential additional
large losses resulting from the material adverse claim activity in the third
quarter of 2003. This change in estimated net losses reflects the recent receipt
of a $5 million payment demand with respect to a $45 million insurance program
bond. The Company estimates its maximum additional net exposure with respect to
this account at $17 million. Net adverse development also includes approximately
$8 million of claims pertaining to self-insured workers' compensation bonds
issued in the 1980's on behalf of companies now in bankruptcy. For the nine
months ended September 30, 2003 and 2002, the net loss ratios were 67.0% and
32.2%, respectively. The loss ratios included $39.3 million and $5.1 million of
net unfavorable reserve development related to prior years for the nine months
ended September 30, 2003 and 2002, respectively.
In addition to the net unfavorable loss reserve development in the third
quarter of 2003, the higher net loss ratio in 2003 primarily relates to net
reserve additions in the quarter of approximately $49.0 million for the current
accident year due to material adverse loss severity in the third quarter of 2003
on the
36
Company's branch commercial and contract business. The net additions to reserves
for the current accident year primarily relate to two large claims totaling $23
million incurred in the quarter and changes in estimates of potential additional
large losses resulting from this significant adverse claim activity.
Approximately $15 million of net additions relate to a net loss with respect to
an insurance program bond for a now bankrupt large commercial account. The other
$8 million relates to a contract claim. A portion of the remaining change in
estimated net losses for the current accident year relates to a contractor that
went into claim in the second quarter of 2003 for which the Company disclosed a
loss contingency of up to $15 million. These net additions to the 2003 accident
year resulted in a 68.6% net loss ratio on the branch commercial and contract
business for the first nine months of 2003. The Company was 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 nine months of 2002.
This business represents about 43% of the Company's gross premiums for the third
quarter of 2003 compared to 59% for the same period of 2002. This decline
primarily reflects the considerable success achieved in shedding the more
volatile and capital intensive large commercial account business.
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 September 30, 2003, the Company has billed at total of
$37.1 million to its reinsurers. Four reinsurers responsible for payment of 46%
of the treaty proceeds have paid or have agreed to pay 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 September 30, 2003.
Within the commercial surety segments, the Company has exposures related
to a small number of accounts, which are now in various stages of bankruptcy
proceedings. In addition, certain other accounts have experienced deterioration
in creditworthiness since the Company issued bonds to them. Given the current
economic climate and its impact on these companies, the Company may experience
an increase in claims and, possibly, incur high severity losses. Such losses
would be recognized in the period in which the claims are filed and determined
to be a valid loss under the provisions of the surety bond issued.
Expense Ratio
The expense ratio increased to 62.8% for the three months ended September
30, 2003 compared to 58.1% for the same period in 2002. For the nine months
ended September 30, 2003, the expense ratio increased to 62.5% from 60.0% for
the same period in 2002. The increase in the expense ratio for the three and
nine months ended September 30, 2003 primarily reflects the impact of higher
reinsurance costs on net earned premiums. Bad debt expense also increased $1.0
million in the third quarter. Net earned premiums declined 1.8% and operating
expenses increased 6.0% for the three months ended September 30, 2003. For
37
the nine months ended September 30, 2003, net earned premiums increased 1.6% and
operating expenses increased at a higher rate of 5.9%.
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 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 37% 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
------------------------------ -----------------------------------------
September 30, December 31, September 30, December 31, %
Commercial Account Exposure 2003 2002 2003 2002 Reduction
--------------------------- ------------- ------------ ------------- ------------ ---------
$100 million and larger 8 14 $ 1.3 $ 2.7 49.5%
$50 to $100 million 8 19 0.6 1.2 55.7
$25 to $50 million 17 16 0.6 0.6 --
$10 to $25 million 70 75 1.1 1.2 13.8
--- --- ------- -------
Total 103 124 $ 3.6 $ 5.7 37.4%
=== === ======= ======= ====
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 September 30, 2003, net investment income was
$6.4 million compared to the three months ended September 30, 2002 of $7.0
million. The decrease in investment income primarily reflects the impact of
lower investment yields and greater investment in tax-exempt securities. The
annualized pretax yields were 4.3% and 4.8% for the three months ended September
30, 2003 and 2002, respectively. The annualized after-tax yields for the
Company's portfolio were 3.6% and 3.8% for the three months ended September 30,
2003 and 2002. Net investment income for the nine months ended September 30,
2003 and 2002 was $19.8 million and $21.3 million, respectively. The annualized
pretax yields were 4.5% and 4.9% for the nine months ended September 30, 2003
and 2002. The annualized after-tax yields were 3.7% and 3.8% for the nine months
ended September 30, 2003 and 2002.
Net realized investment gains were minimal for the three months ended
September 30, 2003 compared to net realized investment losses of approximately
$0.7 million for the same period in 2002. Net realized investment gains were
approximately $1.8 million for the nine months ended September 30, 2003 compared
to net realized investment gains of approximately $0.6 for the same period in
2002.
The following summarizes net realized investment gains (losses) activity:
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- ------------------
2003 2002 2003 2002
------- ------- ------- -------
Gross realized investment gains ........................ $ 2 $ 1,882 $ 2,368 $ 4,253
Gross realized investment losses ....................... (1) (2,580) (539) (3,628)
------- ------- ------- -------
Net realized investment gains (losses) ................. $ 1 $ (698) $ 1,829 $ 625
======= ======= ======= =======
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 September 30, 2003 decreased
8.6% as compared to the third quarter in 2002. Average debt outstanding was
$55.2 million for the third quarter of 2003 compared to $65.9 million in the
third of 2002. The weighted average interest rate for the three months ended
38
September 30, 2003 was 2.3% compared to 2.1% for the same period in 2002.
Interest expense decreased 9.9% for the first nine months of 2003 as compared to
the same period in 2002. Average debt outstanding was $59.0 million for the
first nine months in 2003 compared to $73.8 million in the first nine months of
2002. The weighted average interest rate for the nine months ended September 30,
2003 was 2.4% compared to 2.2% for the same period in 2002. The increases in the
2003 weighted average interest rates are primarily due to the Company's entrance
into an interest rate swap on its $30 million Term Loan. The current effective
interest rate on the term loan after the effect of the interest rate swap was
2.83% as of September 30, 2003.
Income Taxes
The Company's income tax benefit was $30.1 million for the three months
ended September 30, 2003 compared to income tax expense of $1.1 million for the
same period in 2002. The effective income tax rates were 38.8% and 29.6% for the
three months ended September 30, 2003 and 2002, respectively. For the nine
months ended September 30, 2003, the Company's income tax benefit was $21.4
million compared to income tax expense of $11.9 million for the same period in
2002. The effective income tax rates were 46.4% and 31.2%, respectively. The
changes in the estimated effective tax rate in 2003 primarily relates to taxable
losses and greater investments in tax exempt securities in 2003.
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 September 30, 2003, the carrying value of the Company's
insurance subsidiaries' invested assets was comprised of $551.1 million of fixed
income securities, $29.7 million of short-term investments, $1.1 million of
other investments and $3.1 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
September 30, 2003, the parent company's invested assets consisted of $6.2
million of fixed income securities, $0.9 million of equity securities, $31.1
million of short-term investments and $7.2 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 September 30, 2003 and December 31,
2002, parent company short-term investments and
39
cash included $15.2 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 provided by operating activities
was $2.6 million for the nine months ended September 30, 2003 compared to net
cash flow provided by operating activities of $73.6 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, decreases in reinsurance and
other payables to affiliates and increases in income taxes receivable.
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 provides an aggregate of up to $50 million
in borrowings divided between a revolving credit facility (the "Revolving Credit
Facility") of $30 million and a term loan facility (the "Term Loan") of $20
million. The Revolving Credit Facility matures on September 30, 2005. The
Revolving Credit Facility may be increased from time to time by the amount of
amortization under the Term Loan facility up to an additional $10 million. 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 $50 million as
of September 30, 2003, consisting of $30 million under the Revolving Credit
Facility and $20 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
September 30, 2003 was 2.83%.
The Term Loan balance was reduced by $10 million through September 30,
2003 according to the scheduled amortization. Further amortization of the Term
Loan will take place at $10 million per year, in equal semi-annual installments
of $5 million on the following dates:
Date Amortization Outstanding Balance
---- ------------ -------------------
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 --
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 Revolving Credit Facility, was 1.30% at September 30, 2003 and can
vary based on CNA Surety's leverage ratio (debt to total capitalization) from
1.15% to 1.45%. The margin on the Term Loan, was 0.625% at September 30, 2003
and can vary based on CNA Surety's leverage ratio (debt to total capitalization)
from 0.48% to 0.80%. As of September 30, 2003, the weighted average interest
rate was 2.7% on the $50 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
40
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.
At September 30, 2003 and December 31, 2002, CNA Surety was in compliance with
all restrictive debt covenants, except for the fixed charge coverage ratio for
the period ended September 30, 2003 for which CNA Surety obtained a waiver from
the lenders. The lenders amended the 2002 Credit Facility to replace the fixed
charge coverage ratio requirement for the next three quarters with a minimum
earnings before interest, income taxes, depreciation and amortization
requirement.
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 September 30, 2003 was $0.4 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.
Likewise, dividend capacity for 2004 will be based on the statutory earned
surplus at December 31, 2003. 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 $28.5 million and $21.5 million in
dividends from its insurance subsidiaries during the first nine months of 2003
and 2002, respectively.
Combined statutory surplus totaled $161.2 million at September 30, 2003,
resulting in a net written premium to statutory surplus ratio of 1.9 to 1.
Approximately $147 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. Due to the
decline in statutory surplus, effective October 1, 2003, pending state insurance
department regulatory approval, the Company entered into a $3 million excess of
$12 million surety excess of loss contract with CCC which lowers the Company's
net retention on new bonds for the remainder of 2003 to $12 million plus a 5%
co-participation in the $45
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million layer of excess reinsurance with third party reinsurers. 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 $7.4 million for the nine months ended
September 30, 2003 and $9.9 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 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.
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ITEM 4. CONTROLS AND PROCEDURES
The Company maintains a system of disclosure controls and procedures which
are designed to ensure that information required to be disclosed by the Company
in reports that it files or submits to the Securities and Exchange Commission
under the Securities and Exchange Act of 1934, including this report, is
recorded, processed, summarized and reported on a timely basis. These disclosure
controls and procedures include controls and procedures designed to ensure that
information required to be disclosed under the Exchange Act is accumulated and
communicated to the Company's management on a timely basis to allow decisions
regarding required disclosure.
The Company's principal executive officer and its principal financial
officer undertook an evaluation of the Company's disclosure controls and
procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d -15(e)) as of
the end of the period covered by this report and concluded that the Company's
controls and procedures were effective.
There were no changes in the Company's internal control over financial
reporting that occurred during the Company's last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
The Company's management has reviewed the circumstances that led to the
restatement of results reflected in this report and concluded that this was an
isolated incident and not indicative of a systemic failure of the controls over
financial reporting.
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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
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SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the Registrant has duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized.
CNA SURETY CORPORATION
(Registrant)
/s/ John F. Welch
-------------------------------------------------
John F. Welch
President and Chief Executive Officer
/s/ John F. Corcoran
-------------------------------------------------
John F. Corcoran
Senior Vice President and Chief Financial Officer
Date: March 12, 2004
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