1
EXHIBIT 13
Fidelity and other
$24.6
Net written premiums by product ------------------------ Total premiums
In millions $299.0
Commercial
$128.8
------------------------
A Well-balanced Product Portfolio Contract
$145.6
CNA Surety Corporation, the largest
publicly traded surety company in the
United States, provides a full range
of surety and fidelity bonds in all
50 states through a combined network
of approximately 37,000 independent
agents. CNA Surety's balanced product
mix supports earnings consistency
under various economic conditions.
FINANCIAL HIGHLIGHTS
In millions, except per share data
----------------------------------------------------------------------
Net written premium $ 299.0 $ 270.6 10
Underwriting income* 71.9 61.8 16
Net investment income and realized gains 25.9 25.1 3
Pretax income 85.9 73.8 16
Net income 56.5 45.5 24
Net income per share 1.28 1.04 23
Net operating income per share 1.28 1.03 24
----------------------------------------------------------------------
*Includes the effect of recording favorable revisions of prior year
reserves which were $13.1 million and $4.4 million for the periods
presented, respectively.
BALANCE SHEETS
In millions, except per share data
----------------------------------------------------------------------
Invested assets and cash $ 499.4 $ 505.4 -1
Intangible assets 156.0 156.1 0
Total assets 851.6 819.4 4
Insurance reserves 357.2 333.7 7
Debt 101.9 113.0 -10
Total liabilities 525.3 509.5 3
Stockholders' equity 326.3 309.9 5
Book value per share 7.59 7.03 8
Tangible book value per share 4.11 3.64 13
Debt to total capitalization 24% 27%
----------------------------------------------------------------------
2
CNA Surety Corporation 1999 AR 13
Management's Discussion and Analysis of Financial Condition and Results of
Operations
The following is a discussion and analysis of CNA Surety Corporation ("CNA
Surety" or the "Company") and its insurance subsidiaries' operating results,
liquidity and capital resources and financial condition. This discussion should
be read in conjunction with the Consolidated Financial Statements of CNA Surety
and notes thereto.
FORMATION OF CNA SURETY CORPORATION AND MERGER
In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings Corp.
("Capsure") agreed to merge (the "Merger") the surety business of CNAF with
Capsure's insurance subsidiaries, Western Surety Company ("Western Surety") and
Universal Surety of America ("USA"), into CNA Surety Corporation ("CNA Surety"
or the "Company"). CNAF, through its operating subsidiaries, writes multiple
lines of property and casualty insurance, including surety business that is
reinsured by Western Surety. CNAF owns approximately 63% of the outstanding
common stock of CNA Surety. Loews Corporation owns approximately 86% 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 ("Predecessor").
Pursuant to a reorganization agreement, CCC Surety Operations and Capsure
merged their respective operations at the close of business on September 30,
1997 ("Merger Date"). CNAF, through its property and casualty subsidiaries, CCC
and CIC, contributed $52.25 million of capital to CNA Surety. Through
reinsurance agreements, CCC and CIC ceded to Western Surety all of their net
unearned premiums and loss and loss adjustment expense reserves, as of the
Merger Date, and will cede to Western Surety all surety business written or
renewed by CCC and CIC for a period of five years thereafter. Further, CCC and
CIC have agreed to assume the obligation for any adverse development on recorded
reserves for CCC Surety Operations as of the Merger Date, to limit the loss
ratio on certain defined business written by CNA Surety through December 31,
2000 and to provide certain additional excess of loss reinsurance. CCC also
agreed to provide certain administrative services at specified rates, subject to
inflationary increases, for three years after the Merger, if CNA Surety chooses
to purchase such services.
BUSINESS
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all 50
states through a combined network of approximately 37,000 independent agencies.
CNA Surety's principal insurance subsidiaries are Western Surety and USA. The
insurance subsidiaries write, on a direct basis or as business assumed from CCC
and CIC, small fidelity and non-contract surety bonds, referred to as commercial
bonds; small, medium and large contract bonds; international surety and credit
insurance; and errors and omissions ("E&O") liability insurance. Western Surety
is a licensed insurer in all 50 states and the District of Columbia. 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 24 states.
The Company's corporate objective is to be the leading provider of surety
and surety-related products in the United States and in select international
markets and to be the surety of choice for its customers and independent agents
and brokers.
Western Surety and USA are currently rated A+ (Superior) and A
(Excellent), respectively, by A.M. Best Company, Inc. ("A.M. Best"). Through
intercompany reinsurance and related agreements, CNA Surety's customers will
continue to have access to CCC's broader underwriting capacity. CCC is currently
rated A by A.M. Best. A.M. Best's letter ratings range from A++ (Superior) to D
(Poor) with A++ being highest. An A+ (Superior) rating is assigned to those
companies which A.M. ▇▇▇▇ believes have achieved superior overall performance
when compared to the norms of the property and casualty insurance industry. A+
(Superior) rated insurers have been shown to be among the strongest in ability
to meet policyholder and other contractual obligations. A rating of A
(Excellent) is assigned to those companies which A.M. ▇▇▇▇ believes have
achieved excellent overall performance when compared to the norms of the
property and casualty insurance industry and generally have demonstrated a
strong ability to meet their respective policyholder and other contractual
obligations.
3
14
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Western Surety and USA are both currently rated A (Strong), by
Standard and Poor's ("S&P"). CCC is currently rated A by S&P. S&P's letter
ratings range from AAA+ (Extremely Strong) to CC (Extremely Weak) with AAA+
being highest. 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.
RESULTS OF OPERATIONS
Comparison of CNA Surety Actual Results for the Years Ended December 31, 1999
and 1998 and Pro Forma Results for the Year Ended December 31, 1997
As set forth in Note 1 to the Consolidated Financial Statements, the
results of operations of the Predecessor do not reflect investment income and
investment gains and losses. Additionally, certain general and administrative
expenses, which were indirect or overhead in nature, were not allocated to the
Predecessor by CNAF or its subsidiaries. As a result of these factors and
because the merger with Capsure significantly affected the combined
organization, it is not useful to compare CNA Surety operations to Predecessor
operations in 1997. Accordingly, the remainder of this discussion and analysis
is formatted to compare 1999 and 1998 operating information for CNA Surety to
pro forma results for the 1997 period.
The 1997 pro forma financial information gives effect to the following:
(i) adjustment to the Capsure statement of operations for the year ended
December 31, 1996, as reported, to reflect the income effects as if the $10 per
share special distribution was made on January 1, 1996; (ii) consummation of the
Merger and the related transactions and the contribution of capital to and the
incurrence of additional debt by CNA Surety; (iii) purchase accounting
adjustments to reflect Capsure's assets and liabilities at fair value; (iv)
estimated indirect and overhead expenses for the CCC Surety Operations; and (v)
estimated interest expense related to the additional debt. The pro forma
financial information does not include the estimated net investment income
resulting from investment of merger-related cash flows, including (i) the $50
million debt proceeds, (ii) the $52.25 million capital contribution from CCC,
and (iii) collection of the receivable from CCC.
The components of income for the Company for the years ended December 31,
1999, 1998 and 1997 are summarized as follows:
Pro Forma
In thousands 1999 1998 1997
-------------------------------------------------------------------------------
Total revenues $309,405 $283,840 $258,682
===============================================================================
Underwriting income $ 71,894 $ 61,773 $ 87,146
Net investment income 25,850 24,259 14,534
Net realized investment gains 15 844 723
Interest expense 5,846 7,218 7,232
Non-recurring charges and merger costs -- -- 12,087
Amortization of intangible assets 5,982 5,900 5,788
-------------------------------------------------------------------------------
Income before income taxes 85,931 73,758 77,296
Income taxes 29,433 28,243 42,921
-------------------------------------------------------------------------------
Net income $ 56,498 $ 45,515 $ 34,375
===============================================================================
Net income per share $ 1.28 $ 1.04 $ 0.79
===============================================================================
4
CNA Surety Corporation 1999 AR 15
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Insurance Underwriting
Underwriting results for the Company for the years ended December 31, 1999,
1998 and 1997 are summarized in the following table:
Pro Forma
In thousands 1999 1998 1997
------------------------------------------------------------------------------
Gross written premium $306,859 $278,224 $266,418
==============================================================================
Net written premiums $298,987 $270,602 $257,067
==============================================================================
Net earned premiums $283,540 $258,737 $243,425
Net losses and loss adjustment expenses 44,672 44,998 5,648
Net commissions, brokerage and other 166,974 151,966 150,631
------------------------------------------------------------------------------
Underwriting income $ 71,894 $ 61,773 $ 87,146
==============================================================================
Loss ratio 15.7% 17.4% 2.3%
Expense ratio 58.9 58.7 61.9
------------------------------------------------------------------------------
Combined ratio 74.6% 76.1% 64.2%
==============================================================================
Premiums Written
CNA Surety primarily markets contract and commercial surety bonds. Contract
surety bonds secure a contractor's performance and/or payment obligation
generally 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 which cover losses arising from employee dishonesty and other insurance
products.
Gross written premiums for the years ended December 31, 1999, 1998 and
1997 are shown in the table below:
Pro Forma
In thousands 1999 1998 1997
------------------------------------------------------------------------------
Contract $150,022 $132,242 $123,014
Commercial 130,502 121,046 119,662
Fidelity and other 26,335 24,936 23,742
$306,859 $278,224 $266,418
Gross written premiums increased 10.3%, or $28.6 million, for the year ended
December 31, 1999 over the comparable period in 1998. Gross written premiums for
contract surety increased 13.4%, or $17.8 million, as compared to 1998. This
increase reflects volume growth from new account activity, generally favorable
economic conditions for public construction nationwide and an increase of $8.0
million of direct international premium. The highway/bridge sector has shown
particular strength in new account and bid activity since the United States
Congressional passage of the Transportation Equity Act for the 21st Century
("TEA-21"). TEA-21 authorizes a 40% increase in total Federal funding for
highway and transit systems to over $200 billion in the six-year period from
1998 to 2004. Commercial surety, excluding international reinsurance business
assumed from CNA Reinsurance Company, Limited (London) ("CNA Re"), increased
7.4%, or $8.2 million, for the year ended December 31, 1999 reflecting positive
new and renewal activity on larger accounts during the fourth quarter and the
addition of $1.0 million in non-recurring premiums associated with large court
bond obligations. CNA Surety assumed $11.3 million and $10.0 million of
international surety and credit business in 1999 and 1998, respectively, through
a quota share reinsurance treaty with CNA Re, an affiliate of CCC. Fidelity and
other products increased 5.6%, or $1.4 million, to $26.3 million for the year
ended December 31, 1999.
5
16
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Gross written premiums increased 4.4%, or $11.8 million, for the year
ended December 31, 1998 over the comparable pro forma period in 1997. This
increase was primarily attributable to a 7.5%, or $9.2 million, increase in
contract surety. This increase reflected volume growth from new account activity
and generally favorable economic conditions for public construction nationwide
due to the previously mentioned passage of TEA-21. Commercial surety, exclusive
of international reinsurance business assumed, increased 1.4% in 1998 reflecting
increased competition in this business, particularly on Fortune 1000 and large
accounts. Fidelity and other products increased 5.0%, or $1.2 million, to $24.9
million for the year ended December 31, 1998.
Net written premiums for the years ended December 31, 1999, 1998 and 1997
are shown in the table below:
Pro Forma
In thousands 1999 1998 1997
-------------------------------------------------------------------------------
Contract $145,616 $127,114 $118,138
Commercial 128,834 120,638 117,162
Fidelity and other 24,537 22,850 21,767
-------------------------------------------------------------------------------
$298,987 $270,602 $257,067
===============================================================================
For the year ended December 31, 1999, net written premiums increased 10.5%, or
$28.4 million, over the comparable period in 1998 consistent with the changes in
gross written premiums described above and changes in reinsurance. Net written
premiums increased 14.6%, or $18.5 million, for the contract surety business.
Commercial surety net written premiums, excluding international reinsurance
business assumed, increased 6.3%, or $6.9 million, in 1999. Fidelity and other
products increased 7.4%, or $1.7 million, in 1999.
For the year ended December 31, 1998, net written premiums increased 5.3%,
or $13.5 million, over the comparable pro forma period in 1997. Net written
premiums increased 7.6%, or $9.0 million, for contract surety. Commercial surety
net written premiums increased 3.0%, or $3.5 million, in 1998 with domestic
commercial surety up 3.4%, reflecting a full year of increased net retentions.
Effective September 30, 1997, the Company renegotiated its reinsurance
agreements with its reinsurers, increasing the Company's net retention to $5
million per bonded principal on its commercial surety business. Fidelity and
other products increased 5.0%, or $1.1 million, in 1998.
Underwriting Income
Underwriting income increased 16.4% to $71.9 million for the year ended December
31, 1999 compared to 1998. Underwriting income for 1998 decreased 29.1% compared
to pro forma 1997. The period to period changes in underwriting income were due
to fluctuations in both the loss and expense ratios as more fully described
below.
Loss Ratio
The loss ratios for the years ended December 31, 1999, 1998 and pro forma 1997
were 15.7%, 17.4% and 2.3%, respectively. The loss ratios included $13.1
million, $4.4 million and $40.9 million in favorable reserve development for the
years ended December 31, 1999, 1998 and pro forma 1997, respectively. The
foregoing 1999 favorable development primarily relates to accident years prior
to 1997 and reflects increased salvage and subrogation recoveries received.
Approximately $35.0 million in favorable reserve development in 1997 relates to
the Predecessor as more fully described in Note 8 to the Consolidated Financial
Statements. Excluding the impact of the favorable reserve development, the loss
ratio would have been 20.4% for the year ended December 31, 1999 and 19.1% for
both 1998 and 1997. The increase in the adjusted loss ratio in 1999 relates
primarily to changes in business mix.
In the second half of calendar year 1999, the Company experienced an
increase in claim severity in the most recent accident years, primarily with
respect to large commercial risks. This contributed to an increase in net claim
payments in 1999 over a relatively moderate 1998 calendar year.
6
CNA Surety Corporation 1999 AR 17
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Expense Ratio
The expense ratio increased slightly to 58.9% for the year ended December 31,
1999 as compared to 58.7% for 1998. The 1999 increase is primarily due to the
additional costs to support technology investments and related back-office
integration efforts and expansion in select international and domestic markets.
Net earned premiums increased 9.6% in 1999 and operating expenses increased at a
slightly higher rate of 9.9%. The expense ratio decreased to 58.7% for the year
ended December 31, 1998 compared to 61.9% for pro forma 1997. The 1998 decline
is primarily due to the increased scale of the Company as net earned premiums
increased 6% and operating expenses increased a modest 1%. In addition, the
Company consolidated certain administrative and back-office processing
functions in 1998. The most significant of those consolidation activities was
the fourth quarter 1998 migration to a common premium processing platform,
including billing and collection functions.
Investment Income
For the year ended December 31, 1999, net investment income was $25.9 million
compared to net investment income for the years ended December 31, 1998 and pro
forma 1997 of $24.3 million and $14.5 million, respectively. The increase in
investment income for the year ended December 31, 1999 is attributable to higher
average invested assets and general interest rate increases offset by the
effects of a higher proportion of the portfolio being invested in tax exempt
securities. The annualized pretax yield was 5.2% and 5.4% for the years ended
December 31, 1999 and 1998, respectively. The annualized after-tax yield was
4.0% and 3.8% for the years ended December 31, 1999 and 1998, respectively.
The increase in investment income for the year ended December 31, 1998 is
the result of a higher actual invested cash balance which reflects an increase
from underwriting cash flow and the investment of merger-related cash flow in
the fourth quarter of 1997. However, pro forma investment income for the period
prior to the Merger does not include the pro forma effects of estimated net
investment income resulting from investment of merger-related cash flows as
described below.
The above unaudited pro forma financial information does not include the
estimated net investment income resulting from investment of merger-related cash
flows, including (i) the $50 million debt proceeds, (ii) the $52.25 million
capital contribution from CCC, and (iii) collection of the receivable from CCC.
Investment earnings are an integral part of an insurance entity's operations. If
proceeds from these sources of funds were assumed to have been invested in
high-quality, taxable fixed income securities with an average duration of
approximately three years, yielding 6.4%, net investment income would increase
approximately $11.3 million ($7.3 million net of tax, or $0.17 in pro forma
earnings per share) for the pro forma year ended December 31, 1997.
Net realized investment gains were $15,000 for the year ended December 31,
1999 compared to net realized investment gains of $0.8 million and $0.7 million
for the years ended December 31, 1998 and pro forma 1997, respectively.
Analysis of Other Operations
Amortization expense was $6.0 million for the year ended December 31, 1999
compared to $5.9 million and $5.8 million for the years ended December 31, 1998
and pro forma 1997, respectively. Intangible assets represent goodwill and
identified intangibles arising from the acquisition of Capsure, goodwill arising
from the May 1995 acquisition of CIC by CNAF that was allocated to the surety
business of CIC and goodwill arising from a subsequent acquisition. Intangible
assets are generally amortized over 30 years.
On July 28, 1999, CNA Surety acquired certain assets of ▇▇▇▇▇ Bonding
Company, Inc., a Charlotte, North Carolina, insurance agency and brokerage doing
business as The Bond Exchange. The Bond Exchange specializes in the distribution
of surety and fidelity bonds with 1999 premium production of approximately $4
million. Goodwill arising from this acquisition was $5.9 million and will be
amortized over 30 years.
7
18
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Interest expense decreased 19.0% for the year ended December 31, 1999 compared
to the same period in 1998, primarily due to lower debt levels. Average debt
outstanding was $103.7 million in 1999 compared to $117.6 million and $119.2
million in 1998 and pro forma 1997, respectively. The weighted average interest
rate for the year ended December 31, 1999 was 5.4% compared to 5.9% and 5.8% for
periods ended December 31, 1998 and pro forma 1997, respectively.
Income Taxes
Income tax expense was $29.4 million, $28.2 million and $42.9 million and the
effective income tax rates were 34.3%, 38.3% and 55.5% for the years ended
December 31, 1999, 1998 and pro forma 1997, respectively. The decrease in the
effective tax rate in 1999 primarily relates to increased tax exempt interest
income. The effective rate for the full year 1997 reflects the effects of
limitations on the Company's ability to utilize Capsure's available net
operating losses to offset future taxable income.
LIQUIDITY AND CAPITAL RESOURCES
It is anticipated that the liquidity requirements of CNA Surety will be met
primarily by funds generated from operations. The principal operating cash flow
sources 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 for the credit facility,
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 December 31, 1999, the carrying value of the Company's
insurance subsidiaries' invested assets was comprised of $418.0 million of fixed
income securities, $25.9 million of equity securities, $31.4 million of
short-term investments, $5.3 million of other investments and $5.8 million of
cash. At December 31, 1998, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $423.9 million of fixed income
securities, $43.4 million of short-term investments, $5.8 million of other
investments and $1.8 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 and pay dividends to stockholders. At December 31, 1999, the parent
company's invested assets consisted of $11.6 million of short-term investments
and $1.4 million of cash. At December 31, 1998, the parent company's invested
assets consisted of $14.5 million of short-term investments and $15.9 million of
cash.
The Company's consolidated net cash flow provided by operating activities
was $67.6 million for the year ended December 31, 1999, $88.7 million for the
year ended December 31, 1998 and $29.0 million for the three months ended
December 31, 1997. The decrease in net cash flow provided by operating
activities in 1999 primarily relates to an increase in insurance receivables
associated with increased premiums written and reinsured losses.
CNA Surety's bank borrowings are under a five-year unsecured revolving
credit facility (the "Credit Facility") that provides for borrowings of up to
$130.0 million. CNA Surety borrowed $105.0 million as of September 30, 1997 and
used the proceeds to retire the existing Capsure debt of approximately $54.0
million and to make a $50.0 million capital contribution to Western Surety. On
October 6, 1997, CNA Surety borrowed an additional $13.0 million to pay the
$10.6 million closing dividend to Capsure stockholders and other merger-related
costs. As of December 31, 1999, CNA Surety has repaid $18.0 million of this debt
and has unused capacity under the revolver of approximately $30 million.
8
CNA Surety Corporation 1999 AR 19
Management's Discussion and Analysis of Financial Condition and Results of
Operations
The interest rate on borrowings under the 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 the facility fee, varies based on CNA
Surety's leverage ratio (debt to total capitalization) and ranges from 0.25% to
0.40%. As of December 31, 1999, the weighted average interest rate was 6.4% on
the $100.0 million of outstanding borrowings. As of December 31, 1998, the
weighted average interest rate was 5.5% on the $113.0 million of outstanding
borrowings.
The Credit Facility contains, among other conditions, limitations on CNA
Surety with respect to the incurrence of additional indebtedness and requires
the maintenance of certain financial ratios. As of December 31, 1999, the
Company was in compliance with all restrictions and covenants contained in the
Credit Facility agreement. The Credit Facility provides for the payment of all
outstanding principal balances after five years with no required principal
payments prior to such time. Principal prepayments, if any, and interest
payments are expected to be funded primarily through dividends from CNA Surety's
insurance subsidiaries.
On July 28, 1999, CNA Surety acquired certain assets of ▇▇▇▇▇ 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%.
As an insurance holding company, CNA Surety is dependent upon dividends
and other permitted payments from its insurance subsidiaries to pay cash
dividends, as well as to pay operating expenses and meet debt service
requirements. 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 2000 will be based on
statutory surplus and income at and for the year ended December 31, 1999.
Without prior regulatory approval in 2000, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $60.5 million in the aggregate. CNA Surety
received $33.3 million in dividends from its insurance subsidiaries in 1999 and
$6.6 million in 1998.
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 $28.7 million for the year ended December 31,
1999 and $28.5 million for the year ended through December 31, 1998.
CNA Surety management believes that the Company has sufficient available
resources to meet its present capital needs.
9
20
Management's Discussion and Analysis of Financial Condition and Results of
Operations
FINANCIAL CONDITION
Investment Portfolio
The following table summarizes the distribution of the Company's fixed income
and equity portfolios at estimated fair values as of December 31, 1999
and 1998:
Estimated Estimated
Fair Value Fair Value
December 31 December 31
1999 Percent 1998 Percent
------------------------------------------------------------------------------
Fixed income securities:
U.S. Treasury securities and
obligations of U.S. Government
and agencies:
U.S. Treasury $ 17,452 3.9% $ 19,421 4.5%
U.S. Agencies 48,080 10.8 71,111 16.8
Collateralized mortgage
obligations 2,116 0.5 17,743 4.2
Mortgage pass-through
securities 45,091 10.2 25,005 5.9
Obligations of states and
political subdivisions 218,153 49.2 208,238 49.1
Corporate bonds 40,464 9.1 36,759 8.7
Non-agency collateralized
mortgage obligations 12,567 2.8 18,694 4.4
Other asset-backed securities:
Second mortgages/home
equity loans 18,820 4.2 12,387 2.9
Credit card receivables 7,779 1.8 4,898 1.2
Other 7,434 1.7 9,658 2.3
------------------------------------------------------------------------------
Total fixed income
securities 417,956 94.2% 423,914 100.0%
Equity securities 25,897 5.8 -- --
------------------------------------------------------------------------------
Total $443,853 100.0% $423,914 100.0%
==============================================================================
The Company's investment portfolio is managed to maximize after-tax investment
return while minimizing credit risk with investments concentrated in high
quality fixed income securities to support its insurance underwriting
operations. The Company's investment policies emphasize high credit quality and
diversification by industry, issue and issuer.
The following table sets forth the ratings assigned by The Standard &
Poor's Corporation ("S&P") or ▇▇▇▇▇'▇ Investor Services, Inc. ("Moody's") of the
fixed income securities portfolio of the Company as of December 31, 1999 and
1998:
In thousands 1999 1998
------------------------------------------------------------------------------
Credit Rating Fair Value Percent Fair Value Percent
------------------------------------------------------------------------------
AAA/Aaa $275,488 65.9% $278,792 65.8%
AA/Aa 92,811 22.2 89,090 21.0
A/A 24,574 5.9 34,676 8.2
BBB 25,083 6.0 21,356 5.0
------------------------------------------------------------------------------
Total $417,956 100.0% $423,914 100.0%
==============================================================================
As of December 31, 1999 and 1998, 100% of the Company's fixed income securities
were considered investment grade by S&P or ▇▇▇▇▇'▇ and 88% and 87% were rated at
least AA by those agencies for 1999 and 1998, respectively. The Company's
investments in fixed income securities do not contain any industry concentration
of credit risk.
Municipal securities of the State of Texas and related political
subdivisions represent 8% of the estimated fair value of the Company's fixed
income portfolio. Municipal securities of each other state individually
represent less than 6% of the Company's fixed income portfolio.
10
CNA Surety Corporation 1999 AR 21
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Market Risk
CNA Surety's investment portfolio is subject to economic losses due to adverse
changes in the fair value of its financial instruments, or market risk. Interest
rate risk represents the largest market risk factor affecting the Company's
consolidated financial condition due to its significant level of investments in
fixed income securities. Increases and decreases in prevailing interest rates
generally translate into decreases and increases in the fair value of the
Company's fixed income portfolio. The fair value of these interest rate
sensitive instruments may also be affected by the creditworthiness of the
issuer, prepayment options, relative value of alternative investments, the
liquidity of the instrument, income tax considerations and general market
conditions. The Company manages its exposure to interest rate risk primarily
through an asset/liability matching strategy. The Company's exposure to interest
rate risk is mitigated by the relative short-term nature of its insurance and
other liabilities. The targeted effective duration of the Company's investment
portfolio is approximately 4.75 years consistent with the expected duration of
its insurance and other liabilities.
The table below summarizes the estimated effects of certain hypothetical
increases and decreases in interest rates. It is assumed that the changes occur
immediately and uniformly across each investment category. The hypothetical
changes in market interest rates selected reflect the Company's expectations of
the reasonably possible best or worst case scenarios over a one-year period. The
hypothetical fair values are based upon the same prepayment assumptions that
were utilized in computing fair values as of December 31, 1999. Significant
variations in market interest rates could produce changes in the timing of
repayments due to ~prepayment options available. The fair value of such
instruments could be affected and, therefore, actual results might differ from
those reflected in the following table.
Hypothetical
Estimated Fair Percentage
Hypothetical Value after Increase
Fair Value at Change in Hypothetical (Decrease) in
December 31 Interest Rate Change in Stockholders'
1999 (bp=basis points) Interest Rate Equity
----------------------------------------------------------------------------------------------
Fixed Income Securities:
U.S. Government and government
agencies and authorities $112,739 200 bp increase $104,108 (1.7)%
100 bp increase 107,847 (1.0)
100 bp decrease 117,220 0.9
200 bp decrease 120,561 1.6
States, municipalities
and political subdivisions 218,153 200 bp increase 198,855 (3.8)
100 bp increase 207,697 (2.1)
100 bp decrease 228,990 2.2
200 bp decrease 241,474 4.6
Corporate bonds and all other 87,064 200 bp increase 79,573 (1.5)
------------------------------------------ 100 bp increase 82,805 (0.8)
100 bp decrease 91,790 0.9
200 bp decrease 95,862 1.8
Total fixed income securities $417,956 200 bp increase 382,536 (7.1)
========================================== 100 bp increase 398,349 (3.9)
100 bp decrease 438,000 4.0
200 bp decrease 457,897 8.0
11
22
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Hypothetical
Estimated Fair Percentage
Hypothetical Value after Increase
Fair Value at Change in Hypothetical (Decrease) in
December 31 Interest Rate Change in Stockholders'
1998 (bp=basis points) Interest Rate Equity
----------------------------------------------------------------------------------------------
Fixed Income Securities:
U.S. Government and government
agencies and authorities $133,280 200 bp increase $126,416 (1.4)%
100 bp increase 129,964 (0.7)
100 bp decrease 136,484 0.7
200 bp decrease 139,790 1.4
States, municipalities
and political subdivisions 208,238 200 bp increase 186,658 (4.5)
100 bp increase 196,769 (2.4)
100 bp decrease 221,119 2.7
200 bp decrease 235,014 5.6
Corporate bonds and all other 82,396 200 bp increase 76,436 (1.3)
------------------------------------------ 100 bp increase 79,453 (0.6)
100 bp decrease 86,794 0.9
200 bp decrease 93,296 2.3
Total fixed income securities $423,914 200 bp increase 389,510 (7.2)
========================================== 100 bp increase 406,186 (3.7)
100 bp decrease 444,397 4.3
200 bp decrease 468,100 9.3
The Company is also exposed to equity price risk as a result of its investment
in equity securities. Equity price risk results from changes in the level or
volatility of equity prices which affect the value of equity securities. The
carrying values of investments subject to equity price risk are based on quoted
market prices or management's estimates of fair value as of the balance sheet
dates. Market prices are subject to fluctuation and, consequently, the amount
realized in the subsequent sale of an investment may significantly differ from
the reported market value. Fluctuation in the market price of a security may
result from perceived changes in the underlying economic characteristics of the
investee, the relative price of alternative investments and general market
conditions. Furthermore, amounts realized in the sale of a particular security
may be affected by the relative quantity of the security being sold.
The table below summarizes the Company's equity price risk as of December
31, 1999 and shows the effects of a hypothetical 25% increase and a 25% decrease
in market prices as of those dates. The selected hypothetical change does not
reflect what could be considered the best or worst case scenarios.
Hypothetical
Estimated Fair Percentage
Value after Increase
Fair Value at Hypothetical (Decrease) in
December 31 Hypothetical Change in Stockholders'
1999 Price Change Price Equity
----------------------------------------------------------------------------------------------
Equity Securities $25,897 25% increase $32,371 1.3%
25% decrease $19,423 (1.3)
The Company did not hold any investments in equity securities as of December 31,
1998.
12
CNA Surety Corporation 1999 AR 23
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Reserves for Unpaid Losses and Loss Adjustment Expenses
CNA Surety's insurance subsidiaries employ generally accepted reserving
approaches in establishing the estimated liability for unpaid loss and loss
adjustment expenses that give consideration to the inherent difficulty and
variability in the estimation process. In addition, CNA Surety utilizes
independent actuarial firms of national standing to conduct periodic reviews of
claim procedures and loss reserving practices, and annually obtains actuarial
certification as to the reasonableness of actuarial assumptions used and the
sufficiency of year-end reserves for each of its principal insurance
subsidiaries.
The estimated liability for unpaid losses and loss adjustment expenses
includes, on an undiscounted basis, estimates of (a) the ultimate settlement
value of reported claims, (b) incurred but not reported ("IBNR") claims, (c)
future expenses to be incurred in the settlement of claims and (d) claim
recoveries, exclusive of reinsurance recoveries which are reported as an asset.
These estimates are determined based on the Company's and surety industry loss
experience, as well as consideration of current trends and conditions. The
estimated liability for unpaid losses and loss adjustment expenses is an
estimate and there is the potential that actual future loss payments will differ
significantly from initial estimates. The methods of determining such estimates
and the resulting estimated liability are regularly reviewed and updated.
Changes in the estimated liability are reflected in operating income in the year
in which such changes are determined to be needed.
The Company recorded net favorable reserve development which resulted in
reductions in the estimated liability of $13.1 million for the year ended
December 31, 1999, $4.4 million for the year ended December 31, 1998 and $0.6
million for the period from inception through December 31, 1997. On a pro forma
basis, favorable development was $40.9 million ($35.0 million related to the
Predecessor) for the year ended December 31, 1997. Note 8 to the accompanying
Consolidated Financial Statements presents a table of the activity in the
reserves for unpaid losses and loss adjustment expenses for the Company and the
Predecessor. This table highlights the impact of revisions to the estimated
liability established in prior years.
Risk Based Capital ("RBC") and Other Regulatory Ratios
The National Association of Insurance Commissioners ("NAIC") has promulgated RBC
requirements for property and casualty insurance companies to evaluate the
adequacy of statutory capital and surplus in relation to investment and
insurance risks such as asset quality, loss reserve adequacy and other business
factors. The RBC information is used by state insurance regulators as an early
warning mechanism to identify insurance companies that potentially are
inadequately capitalized. In addition, the formula defines new minimum capital
standards that supplement the current system of fixed minimum capital and
surplus requirements on a state-by-state basis. Regulatory compliance is
determined by a ratio (the "Ratio") of the enterprise's regulatory total
adjusted capital, as defined by the NAIC, to its authorized control level RBC,
as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized
control level RBC requires no corrective actions on behalf of the Company or
regulators. As of December 31, 1999, each of CNA Surety's insurance subsidiaries
had a Ratio that was in compliance with minimum RBC requirements.
CNA Surety's insurance subsidiaries require capital to support premium
writings. In accordance with industry and regulatory guidelines, the net written
premiums to surplus ratio of a property and casualty insurer should not exceed 3
to 1 (the terms of the Credit Facility also limit this ratio to 3 to 1 for
Western Surety and USA). On December 31, 1999, the Company had a combined
statutory surplus of $193.5 million. The combined statutory surplus of Western
Surety and SBCA was $177.2 million and its net written premiums to surplus ratio
was 1.6 to 1. USA's statutory surplus was $16.3 million and the net written
premiums to surplus ratio was ~1.3 to 1. On December 31, 1998, the Company had a
combined statutory surplus of $169.9 million. The combined statutory surplus of
Western Surety and SBCA was $153.2 million and its net written premiums to
surplus ratio was 1.6 to 1. USA's statutory surplus was $16.7 million and its
net written premiums to surplus ratio was 1.4 to 1. The Company believes that
each insurance company's statutory surplus is sufficient to support its current
and anticipated premium levels.
13
24
The NAIC has also developed a rating system, the Insurance Regulatory
Information System ("IRIS"), primarily intended to assist state insurance
departments in overseeing the financial condition of all insurance companies
operating within their respective states. IRIS consists of eleven key financial
ratios that address various aspects of each insurer's financial condition and
stability. In 1999, USA's and SBCA's IRIS ratios were within all the "usual"
ranges as defined by the NAIC. Western failed the Agents Balance to Surplus
ratio, primarily due to increased premiums written. In 1998, USA's IRIS ratios
were within all the "usual" ranges as defined by the NAIC. Western and its
affiliated company SBCA failed one ratio each; Agents Balance to Surplus and
Change in Net Writings, respectively. Due to the Merger that occurred on
September 30, 1997, and related reinsurance transactions, Western Surety's
agents balances increased significantly, causing this ratio to be outside the~
"usual" range.
IMPACT OF YEAR 2000 ON THE COMPANY
The widespread use of computer programs, both in the United States and
internationally, that rely on two digit date fields to perform computations and
decision making functions was identified as a possible cause for computer
systems malfunctions when processing information involving dates beginning after
1999. Such malfunctions could lead to business delays and disruptions. The
Company experienced minimal disruptions in its business activities with respect
to the Year 2000 date change.
As of December 31, 1999, approximately $538,000 was incurred in Year 2000
related expenditures. This amount includes expenses incurred for third party
remediation and testing and additional equipment hardware purchased to
facilitate further testing.
Although the Company has not received any claims based on alleged losses
resulting from the Year 2000 issues, there can be no assurance that bond
obligees or insureds will not suffer losses of this type and seek compensation
under the Company's bonds or policies. If any claims are made, the Company's
obligations, if any, will depend upon the facts and circumstances of the claims
and provisions of the bond or policy. At this time, the Company is unable to
determine whether the adverse impact, if any, in connection with the foregoing
circumstances would be material to the Company's results of operations,
financial condition and liquidity.
IMPACT OF ADOPTING ACCOUNTING PRONOUNCEMENTS
In March 1998, the American Institute of Certified Public Accountants'
Accounting Standards Executive Committee ("AcSEC") issued Statement of Position
("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use," which provides guidance on accounting for costs of
computer software developed or obtained for internal use and for determining
whether computer software is for internal use. For the purposes of the SOP,
internal-use software is software acquired, internally developed or modified
solely to meet the entity's internal needs for which no substantive plan exists
or is being developed to market the software externally during the software's
development or modification. Accounting treatment for costs associated with
software developed or obtained for internal use, as defined by this SOP, is
based upon a number of factors, including the point in time during the project
that costs are incurred, as well as the types of costs incurred. The Company has
adopted SOP 98-1 in the accompanying Consolidated Financial Statements. The
adoption of which did not have a material effect on the Company's financial
position and results of operations.
In April 1998, ▇▇▇▇▇ issued SOP 98-5, "Reporting on the Costs of Start-Up
Activities," which provides guidance on the financial reporting of start-up
costs and organization costs. It requires costs of start-up activities and
organization costs, as defined, to be expensed as incurred. The Company has
adopted SOP 98-5 in the accompanying Consolidated Financial Statements. The
adoption of which did not have a material effect on the Company's financial
position and results of operations.
14
CNA Surety Corporation 1999 AR 25
In October 1998, ▇▇▇▇▇ issued SOP 98-7, "Deposit Accounting: Accounting for
Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk," which
provides accounting guidance for insurance and reinsurance contracts that do not
transfer insurance risk, excluding long-duration life and health insurance
contracts. The Company has adopted SOP 98-7 in the accompanying Consolidated
Financial Statements. The adoption of which did not have a material effect on
the Company's financial position and results of operations.
IMPACT OF ACCOUNTING PRONOUNCEMENTS NOT YET ADOPTED
In June 1998, the FASB issued SFAS 133, "Accounting for Derivative Instruments
and Hedging Activities," which establishes standards for the accounting and
reporting for derivative instruments and for hedging activities. It requires
that an entity recognize all derivatives as either assets or liabilities in the
statement of financial position and measure those instruments at fair value. If
certain conditions are met, a derivative may be specifically designated as (a) a
hedge of the exposure to changes in the fair value of a recognized asset or
liability or an unrecognized firm commitment, (b) a hedge of the exposure to
variable cash flows of a forecasted transaction or (c) a hedge of the foreign
currency exposure of a net investment in a foreign operation, an unrecognized
firm commitment, and available-for-sale security, or a
foreign-currency-denominated forecasted transaction. The accounting for changes
in the fair value of a derivative depends on the intended use of the derivative
and the resulting designation. This Statement, which is not required until 2001,
is still being assessed by the Company, but is not anticipated to have a
material impact on the financial position and results of operations of the
Company.
"SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT
OF 1995
The statements which are not historical facts contained in this Annual Report
to Shareholders are forward-looking statements that involve risks and
uncertainties, including, but not limited to, product and policy demand and
market response risks, the effect of economic conditions, the impact of
competitive products, policies and pricing, product and policy development,
regulatory changes and conditions, rating agency policies and practices,
development of claims and the effect on loss reserves, the performance of
reinsurance companies under reinsurance contracts with the Company, investment
portfolio developments and reaction to market conditions, the results of
financing efforts, the actual closing of contemplated transactions and
agreements, the effect of the Company's accounting policies, and other risks
detailed in the Company's Securities and Exchange Commission filings. No
assurance can be given that the actual results of operations and financial
condition will conform to the forward-looking statements contained herein.
15
26
Consolidated Balance Sheets
In thousands, except per share data December 31 1999 1998
------------------------------------------------------------------------------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value
(amortized cost: $436,690 and $418,866) $417,956 $423,914
Equity securities, at fair value
(cost: $23,968 and $0) 25,897 --
Short-term investments, at cost
(approximates fair value) 43,033 57,865
Other investments, at fair value 5,277 5,830
Cash 7,237 17,746
------------------------------------------------------------------------------
Total invested assets and cash 499,400 505,355
Deferred policy acquisition costs 84,924 74,488
Insurance receivables:
Premiums 9,822 8,950
Reinsurance, including $57,129 and
$47,175 from affiliates 76,158 55,350
Intangible assets, net of accumulated amortization
of $13,329 and $7,347 at December 31, 1999
and 1998, respectively 155,980 156,062
Prepaid reinsurance premiums 2,302 2,157
Property and equipment, at cost (less accumulated
depreciation: $11,094 and $9,593) 14,769 9,979
Other assets 8,220 7,029
------------------------------------------------------------------------------
Total assets $851,575 $819,370
==============================================================================
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses $157,933 $150,020
Unearned premiums 199,300 183,708
------------------------------------------------------------------------------
Total reserves 357,233 333,728
Debt 101,900 113,000
Deferred income taxes, net 10,447 10,649
Payable for securities purchased 7,487 8,517
Current income taxes payable 7,076 6,726
Reinsurance payables to affiliates 6,882 1,424
Other liabilities 34,246 35,429
------------------------------------------------------------------------------
Total liabilities $525,271 $509,473
------------------------------------------------------------------------------
Commitments and contingencies (See Note 9)
STOCKHOLDERS' EQUITY
Preferred stock, par value $.01 per share,
20,000 shares authorized; none issued and
outstanding -- --
Common stock, par value $.01 per share, 100,000
shares authorized; 44,123 shares issued and
43,006 shares outstanding at December 31,
1999 and 44,093 issued and outstanding at
December 31, 1998 441 441
Additional paid-in capital 253,366 253,215
Retained earnings 95,419 52,984
Accumulated other comprehensive income (loss) (11,150) 3,257
Treasury stock, at cost (11,772) --
------------------------------------------------------------------------------
Total stockholders' equity 326,304 309,897
------------------------------------------------------------------------------
Total liabilities and stockholders' equity $851,575 $819,370
==============================================================================
The accompanying notes are an integral part of these financial statements.
16
CNA Surety Corporation 1999 AR 27
Consolidated Statements of Income
and Statement of Certain Revenues and Direct Operating Expenses of Predecessor
September 30
(Date of Predecessor
Inception) Nine Months
Year Ended Year Ended through Ended
December 31 December 31 December 31 September 30
In thousands, except per share data 1999 1998 1997 1997
--------------------------------------------------------------------------------------------------------
Revenues:
Net earned premium $283,540 $258,737 $65,433 $108,564
Net investment income 25,850 24,259 5,766 --
Net realized investment gains 15 844 85 --
--------------------------------------------------------------------------------------------------------
Total revenues 309,405 283,840 71,284 108,564
--------------------------------------------------------------------------------------------------------
Expenses:
Net losses and loss adjustment expenses 44,672 44,998 12,134 (11,516)
Net commissions, brokerage and other underwriting 166,974 151,966 38,213 59,674
Interest expense 5,846 7,218 1,831 --
Amortization of intangible assets 5,982 5,900 1,447 --
--------------------------------------------------------------------------------------------------------
Total expenses 223,474 210,082 53,625 48,158
--------------------------------------------------------------------------------------------------------
Income before income taxes (Excess of net earned
premium over direct operating expenses, before
income taxes for Predecessor) 85,931 73,758 17,659 60,406
Income taxes 29,433 28,243 6,663 21,241
--------------------------------------------------------------------------------------------------------
Net income (Excess of net earned premiums over
direct operating expenses, after income taxes
for Predecessor) $ 56,498 $ 45,515 $10,996 $ 39,165
========================================================================================================
Earnings per share $ 1.28 $ 1.04 $ 0.25
===========================================================================================
Earnings per share, assuming dilution $ 1.28 $ 1.04 $ 0.25
===========================================================================================
Weighted average shares outstanding 43,974 43,722 43,302
===========================================================================================
Weighted average shares outstanding, assuming dilution 44,120 43,875 43,552
===========================================================================================
The accompanying notes are an integral part of these financial statements.
17
28
Consolidated Statements of Stockholders' Equity
Accumulated
Common Stock Other Treasury Total
Shares Common Additional Comprehensive Retained Comprehensive Stock Stockholders'
In thousands Outstanding Stock Paid-In Capital Income Earnings Income (Loss) (at cost) Equity
-----------------------------------------------------------------------------------------------------------------------------------
Balance, September 30, 1997
(Date of Inception) -- $ -- $ -- $ -- $ -- $ -- $ -- $ --
Comprehensive income:
Net income -- -- -- 10,996 10,996 -- -- 10,996
Other comprehensive income:
Change in unrealized gains on
securities (after
income taxes), net of
reclassification
adjustment of $0 -- -- -- 474 -- 474 -- 474
------------------------------------ --------
Total comprehensive income $ 11,470
==================================== ========
Increase due to Capsure
Acquisition (See Note 2) 43,294 433 181,629 -- -- -- 182,062
Capital contribution and the
effects of reinsurance
agreements (See Note 2) -- -- 62,859 -- -- -- 62,859
Stock options exercised 26 -- 341 -- -- -- 341
------------------------------------------------------------------ ------------------------------------------------
Balance, December 31, 1997 43,320 $433 $244,829 $ 10,996 $ 474 $ -- $256,732
================================================================== ================================================
Comprehensive income:
Net income -- -- -- 45,515 45,515 -- -- 45,515
Other comprehensive income:
Change in unrealized gains on
securities (after income
taxes), net of
reclassification
adjustment of $208 -- -- -- 2,783 -- 2,783 -- 2,783
------------------------------------ --------
Total comprehensive income $ 48,298
==================================== ========
Issuance of common stock 628 6 7,525 -- -- -- 7,531
Stock options exercised 145 2 861 -- -- -- 863
Dividends paid to stockholders -- -- -- (3,527) -- -- (3,527)
------------------------------------------------------------------ ------------------------------------------------
Balance, December 31, 1998 44,093 $441 $253,215 $ 52,984 $ 3,257 $ -- $309,897
================================================================== ================================================
Comprehensive income:
Net income -- -- -- 56,498 56,498 -- -- 56,498
Other comprehensive income:
Change in unrealized (losses)
on securities (after income
taxes), net of
reclassification adjustment
of $821 -- -- -- (14,407) -- (14,407) -- (14,407)
------------------------------------ --------
Total comprehensive income $ 42,091
==================================== ========
Purchase of treasury stock (1,117) -- -- -- -- (11,772) (11,772)
Stock options exercised and other 30 -- 151 -- -- -- 151
Dividends paid to stockholders -- -- -- (14,063) -- -- (14,063)
------------------------------------------------------------------ ------------------------------------------------
Balance, December 31, 1999 43,006 $441 $253,366 $ 95,419 $(11,150) $(11,772) $326,304
================================================================== ================================================
The accompanying notes are an integral part of these financial statements.
18
CNA Surety Corporation 1999 AR 29
Consolidated Statements of Cash Flows
September 30
(Date of
Inception)
Year Ended Year Ended through
December 31 December 31 December 31
In thousands 1999 1998 1997
------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net income $ 56,498 $ 45,515 $ 10,996
Adjustments to reconcile net income to
net cash provided by
operating activities:
Depreciation and amortization 8,414 7,720 1,915
Accretion of bond discount, net 2,085 2,065 172
Net realized investment gains (15) (844) (85)
Changes in:
Insurance receivables (21,680) 534 (13,282)
Reserve for unearned premiums 15,592 11,921 7,184
Reserve for unpaid losses and loss
adjustment expenses 7,913 19,639 8,100
Deferred policy acquisition costs (10,436) (10,344) 4,950
Deferred income taxes, net 7,506 7,485 4,038
Reinsurance payables 5,458 1,424 --
Other assets and liabilities (3,723) 3,578 5,010
------------------------------------------------------------------------------
Net cash provided by operating activities 67,612 88,693 28,998
------------------------------------------------------------------------------
INVESTING ACTIVITIES
Fixed income securities:
Purchases (172,746) (297,654) (149,580)
Maturities 45,610 56,947 8,654
Sales 107,243 86,170 5,146
Purchases of equity securities (24,444) -- --
Proceeds from the sale of
equity securities 477 -- --
Changes in short-term investments 14,832 89,370 (117,919)
Purchases of property and equipment (5,566) (3,458) (586)
Acquisition of businesses, net of
cash acquired (5,900) -- --
Other, net (789) (1,959) --
------------------------------------------------------------------------------
Net cash used in investing activities (41,283) (70,584) (254,285)
------------------------------------------------------------------------------
FINANCING ACTIVITIES
Proceeds from debt 1,900 -- 118,000
Collection of receivable from
affiliates, net -- -- 116,939
Principal payments on debt (13,000) (5,000) (54,000)
Capital contribution from CCC -- -- 52,250
Closing dividend to Capsure stockholders -- -- (10,591)
Proceeds from issuance of common stock -- 7,531 --
Dividends to stockholders (14,063) (3,527) --
Purchase of treasury stock (11,772) -- --
Other 97 503 126
------------------------------------------------------------------------------
Net cash (used in) provided by
financing activities (36,838) (493) 222,724
------------------------------------------------------------------------------
Increase (decrease) in cash (10,509) 17,616 (2,563)
Cash at beginning of period 17,746 130 2,693
------------------------------------------------------------------------------
Cash at end of period $ 7,237 $ 17,746 $ 130
==============================================================================
Supplemental Disclosure of Cash
Flow Information:
Cash paid during the period for:
Interest $ 5,826 $ 6,721 $ 1,704
Income taxes $ 20,600 $ 17,750 $ --
Non-cash investing activities:
Common stock and options issued in
connection with Capsure
acquisition (See Note 2) $ -- $ -- $ 182,062
==============================================================================
The accompanying notes are an integral part of these financial statements.
19
30
Notes to Consolidated Financial Statements
NOTE 1. SIGNIFICANT ACCOUNTING POLICIES
Formation of CNA Surety Corporation and Merger
In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings Corp.
("Capsure") agreed to merge (the "Merger") the surety business of CNAF with
Capsure's insurance subsidiaries, Western Surety Company ("Western Surety") and
Universal Surety of America ("USA"), into CNA Surety Corporation ("CNA Surety"
or the "Company"). CNAF, through its operating subsidiaries, writes multiple
lines of property and casualty insurance, including surety business that is
reinsured by Western Surety. CNAF owns approximately 63% of the outstanding
common stock of CNA Surety. Loews Corporation owns approximately 86% 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 ("Predecessor").
Pursuant to a reorganization agreement, CCC Surety Operations and Capsure
merged their respective operations at the close of business on September 30,
1997 ("Merger Date"). CNAF, through its property and casualty subsidiaries, CCC
and CIC, contributed $52.25 million of capital to CNA Surety. Through
reinsurance agreements, CCC and CIC ceded to Western Surety all of their net
unearned premiums and loss and loss adjustment expense reserves, as of the
Merger Date, and will cede to Western Surety all surety business written or
renewed by CCC and CIC for a period of five years thereafter. Further, CCC and
CIC have agreed to assume the obligation for any adverse development on recorded
reserves for CCC Surety Operations as of the Merger Date, to limit the loss
ratio on certain defined business written by CNA Surety through December 31,
2000 and to provide certain additional excess of loss reinsurance. CCC also
agreed to provide certain administrative services at specified rates, subject to
inflationary increases, for three years after the Merger, if CNA Surety chooses
to purchase such services.
Principles of Consolidation
The Consolidated Financial Statements include the accounts of CNA Surety
Corporation and all majority-owned subsidiaries. The Consolidated Financial
Statements include the actual combined consolidated operating results of CCC
Surety Operations and Capsure since the Merger Date.
Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles 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.
Predecessor Financial Information
The accompanying Statement of Certain Revenues and Direct Operating Expenses for
the nine months ended September 30, 1997 reflects premiums earned, losses
incurred, loss adjustment expenses (allocated and unallocated) and other direct
operating expenses of CCC Surety Operations, the Predecessor. Such operating
revenues and costs as investment income, realized gains and losses on
investments and certain general and administrative expenses, which are indirect
or overhead in nature, are not reflected in operating results since such items
were not historically allocated to CCC Surety Operations by CNAF or its
subsidiaries.
Since the accompanying Predecessor financial statements exclude certain
revenues and expenses, these financial statements are not intended to be a
complete presentation of CCC Surety Operations. Those revenues and costs that
are reflected in the accompanying financial statements have been determined in
accordance with generally accepted accounting principles.
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.
20
CNA Surety Corporation 1999 AR 31
Notes to Consolidated Financial Statements
As a result, the Company considers all of its fixed income
securities (bonds and redeemable preferred stocks) and equity securities as
available-for-sale. These securities are reported at fair value, with unrealized
gains and losses, net of deferred income taxes, reported as a separate component
of stockholders' equity. Cash flows from purchases, sales and maturities are
reported gross in the investing activities section of the cash flow statement.
The amortized cost of fixed income securities is determined based on cost
and the cumulative effect of amortization of premiums and accretion of discounts
to maturity. Such amortization and accretion are included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective yield method based on estimated cash flows.
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 and other underwriting
expenses which vary with, and are primarily related to, the production of
business, net of reinsurance commission income, are deferred and amortized as a
charge to income as the related premiums are earned.
Intangible Assets
The Merger of CCC Surety Operations and Capsure has been accounted for by CNA
Surety as an acquisition of Capsure, using purchase accounting. Intangible
assets represent goodwill and identified intangibles arising from the
acquisition of Capsure and goodwill arising from the May 1995 acquisition of CIC
by CNAF that was allocated to the surety business of CIC. Intangible assets are
amortized on a straight line basis generally over 30 years.
On July 28, 1999, CNA Surety acquired certain assets of ▇▇▇▇▇ Bonding
Company, Inc., a Charlotte, North Carolina, insurance agency and brokerage doing
business as The Bond Exchange. The Bond Exchange specializes in the distribution
of surety and fidelity bonds with 1999 premium production of approximately $4
million. Goodwill arising from this acquisition was $5.9 million and will be
amortized on a straight line basis over 30 years.
Management assesses the recoverability of intangible assets based upon
estimates of undiscounted future operating cash flows whenever significant
events or changes in circumstances suggest that the carrying amount of an asset
may not be recoverable.
Reserves for Unpaid Losses and Loss Adjustment Expenses
The estimated liability for unpaid losses and loss adjustment expenses includes,
on an undiscounted basis, estimates of (a) the ultimate settlement value of
reported claims, (b) incurred but not reported ("IBNR") claims, (c) future
expenses to be incurred in the settlement of claims and (d) claim recoveries,
before reinsurance recoveries which are reported as an asset. These estimates
are determined based on the Company's loss experience, as well as consideration
of industry experience, current trends and conditions. The estimated liability
for unpaid losses and loss adjustment expenses is an estimate and there is the
potential that actual future loss payments will differ significantly from
initial estimates. The methods of determining such estimates and the resulting
estimated liability are regularly reviewed and updated. Changes in the estimated
liability are reflected in operating income in the year in which such changes
are determined to be needed.
Insurance Premiums
Insurance premiums are recognized as revenue ratably over the terms of the
related policies. Premium revenues are net of amounts ceded to reinsurers.
Unearned premiums represent the portion of premiums written, before ceded
reinsurance which is shown as an asset, applicable to the unexpired terms of
policies in force calculated on a daily pro rata basis.
Reinsurance
The Company assumes and cedes insurance with other insurers and reinsurers to
limit maximum loss, provide greater diversification of risk and minimize
exposure on larger risks. Premiums and loss and loss adjustment expenses that
are ceded under reinsurance arrangements reduce the respective revenues and
expenses.
21
32
Notes to Consolidated Financial Statements
Amounts recoverable from reinsurers are estimated in a manner
consistent with the claim liability associated with the reinsured policy and are
reported as reinsurance receivable rather than netted against the estimated
liability for unpaid losses and loss adjustment expenses.
Stock-Based Compensation
As allowed under Statement of Financial Accounting Standards ("SFAS") No. 123,
"Accounting for Stock-Based Compensation," the Company accounts for its stock
option plans in accordance with Accounting Principles Board ("APB") Opinion No.
25, "Accounting for Stock Issued to Employees." The Company has not issued stock
options where the exercise price is less than the fair market value of the
Company's common stock on the date of grant and, accordingly, no compensation
expense has been recognized.
Income Taxes
Deferred income taxes are established for the future tax effects of temporary
differences between the tax and financial reporting bases of assets and
liabilities using currently enacted tax rates. Such temporary differences
primarily relate to insurance reserves, deferred policy acquisition costs and
intangible assets. The effect on deferred taxes of a change in tax rates is
recognized in income in the period of enactment.
Property and Equipment
Property and equipment are carried at cost less accumulated depreciation.
Depreciation is based on the estimated useful lives of the various classes of
property and equipment and determined principally on a straight-line basis. The
cost of maintenance and repairs is charged to income as incurred, major
improvements are capitalized.
Earnings Per Share
Basic earnings per common share is computed by dividing income available to
common stockholders by the weighted average number of common shares outstanding
for the period. Diluted earnings per common share is computed based on the
weighted average number of shares outstanding plus the dilutive effect of common
stock equivalents which is computed using the treasury stock method.
Accounting Changes
In March 1998, ▇▇▇▇▇ issued SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use," which provides guidance on
accounting for costs of computer software developed or obtained for internal use
and for determining whether computer software is for internal use. For the
purposes of the SOP, internal-use software is software acquired, internally
developed or modified solely to meet the entity's internal needs for which no
substantive plan exists or is being developed to market the software externally
during the software's development or modification. Accounting treatment for
costs associated with software developed or obtained for internal use, as
defined by this SOP, is based upon a number of factors, including the point in
time during the project that costs are incurred, as well as the types of costs
incurred. The Company has adopted SOP 98-1 in the accompanying Consolidated
Financial Statements. The adoption of which did not have a material effect on
the Company's financial position and results of operations.
In April 1998, ▇▇▇▇▇ issued SOP 98-5, "Reporting on the Costs of Start-Up
Activities," which provides guidance on the financial reporting of start-up
costs and organization costs. It requires costs of start-up activities and
organization costs, as defined, to be expensed as incurred. The Company has
adopted SOP 98-5 in the accompanying Consolidated Financial Statements. The
adoption of which did not have a material effect on the Company's financial
position and results of operations.
In October 1998, ▇▇▇▇▇ issued SOP 98-7, "Deposit Accounting: Accounting
for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk,"
which provides accounting guidance for insurance and reinsurance contracts that
do not transfer insurance risk, excluding long-duration life and health
insurance contracts. The Company has adopted SOP 98-7 in the accompanying
Consolidated Financial Statements. The adoption of which did not have a material
effect on the Company's financial position and results of operations.
Reclassifications
Certain reclassifications have been made to the 1998 and 1997 financial
statements to conform with the presentation in the 1999 Consolidated Financial
Statements.
22
CNA Surety Corporation 1999 AR 33
NOTE 2. CAPSURE ACQUISITION
The purchase price for Capsure has been allocated to Capsure's assets that
were acquired and to Capsure's liabilities that were assumed based on the
estimated fair value of such assets and liabilities at the Merger Date.
The purchase price for the outstanding shares of Capsure common stock was
determined as follows:
In thousands
------------------------------------------------------------------------------
Traded value of Capsure shares to be exchanged at
$11.00 per share $178,177
Value of Capsure options 2,527
CCC Surety Operations merger-related costs 1,358
------------------------------------------------------------------------------
Total purchase price $182,062
==============================================================================
The purchase price was allocated as follows:
In thousands
------------------------------------------------------------------------------
Capsure net assets at historical cost $100,875
Fair value adjustments:
Purchased intangibles (73,844)
Intangibles arising from Merger 155,031
------------------------------------------------------------------------------
Total purchase price $182,062
==============================================================================
Intangible assets arising from the Merger were allocated as follows:
In thousands Amortization
Intangible Asset Component Amount Period
------------------------------------------------------------------------------
Agency Force $ 20,500 20 years
Goodwill 134,531 30 years
-----------------------------------------------------------
Total intangibles $155,031
===========================================================
CNA Surety's beginning stockholders' equity was comprised of the following:
In thousands
------------------------------------------------------------------------------
Purchase price $182,062
Capital contribution of $52,250 from CCC
and the effects of reinsurance agreements 62,859
------------------------------------------------------------------------------
Stockholders' equity $244,921
==============================================================================
Unaudited Pro Forma Results
The following table of unaudited pro forma information has been prepared as if
the acquisition of Capsure had been consummated at the beginning of 1997. This
unaudited pro forma financial information gives effect to the following: (i)
consummation of the Merger and the related transactions and the contribution of
capital to and the incurrence of additional debt by CNA Surety; (ii) purchase
accounting adjustments to reflect Capsure's assets and liabilities at fair
value; (iii) estimated indirect and overhead expenses for the CCC Surety
Operations; and (iv) estimated interest expense related to the additional debt:
Year Ended
(ProForma)
Unaudited
In thousands, except per share amounts 1997
------------------------------------------------------------------------------
Revenues $258,682
Net income $ 34,375
Earnings per share $ 0.79
==============================================================================
23
34
Notes to Consolidated Financial Statements
The foregoing unaudited pro forma operating results include non-recurring
charges, primarily merger-related costs of Capsure, of $22.0 million, net of tax
(or $0.51 per share) for the year ended December 31, 1997.
This unaudited pro forma financial information is intended for information
purposes only and is not necessarily indicative of the results of operations
which would have been achieved and reported had the Merger and related
transactions been consummated on the date assumed, nor is it necessarily
indicative of the future consolidated operating results of CNA Surety.
NOTE 3. INVESTMENTS
The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety by investment category, were as follows:
Gross Gross
Amortized Cost Unrealized Unrealized Estimated
In thousands December 31, 1999 or Cost Gains Losses Fair Value
-------------------------------------------------------------------------------------------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury $ 17,575 $ 6 $ (129) $ 17,452
U.S. Agencies 49,786 58 (1,764) 48,080
Collateralized mortgage obligations 2,123 3 (10) 2,116
Mortgage pass-through securities 46,701 -- (1,610) 45,091
Obligations of states and political subdivisions 229,499 56 (11,402) 218,153
Corporate bonds 43,395 3 (2,934) 40,464
Non-agency collateralized mortgage obligations 12,845 -- (278) 12,567
Other asset-backed securities:
Second mortgages/home equity loans 19,041 16 (237) 18,820
Credit card receivables 8,101 1 (323) 7,779
Other 7,624 2 (192) 7,434
-------------------------------------------------------------------------------------------------
Total fixed income securities 436,690 145 (18,879) 417,956
Equity securities 23,968 3,274 (1,345) 25,897
-------------------------------------------------------------------------------------------------
Total $460,658 $3,419 $(20,224) $443,853
=================================================================================================
Gross Gross
Amortized Cost Unrealized Unrealized Estimated
In thousands December 31, 1999 or Cost Gains Losses Fair Value
-------------------------------------------------------------------------------------------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury $ 19,009 $ 412 $ -- $ 19,421
U.S. Agencies 68,922 2,189 -- 71,111
Collateralized mortgage obligations 17,741 78 (76) 17,743
Mortgage pass-through securities 24,834 172 (1) 25,005
Obligations of states and political subdivisions 206,264 2,329 (355) 208,238
Corporate bonds 36,538 686 (465) 36,759
Non-agency collateralized mortgage obligations 18,811 32 (149) 18,694
Other asset-backed securities:
Second mortgages/home equity loans 12,169 219 (1) 12,387
Credit card receivables 4,896 5 (3) 4,898
Other 9,682 24 (48) 9,658
-------------------------------------------------------------------------------------------------
Total fixed income securities 418,866 6,146 (1,098) 423,914
Equity securities -- -- -- --
-------------------------------------------------------------------------------------------------
Total $418,866 $6,146 $ (1,098) $423,914
=================================================================================================
24
CNA Surety Corporation 1999 AR 35
Notes to Consolidated Financial Statements
The Company's insurance subsidiaries, as required by state law, deposit certain
securities with state insurance regulatory authorities. At December 31, 1999,
securities on deposit had an aggregate carrying value of $3.3 million.
Short-term investments are generally comprised of U.S. Treasury bills,
corporate notes, money market funds and investment-grade commercial paper
equivalents.
The amortized cost and estimated fair value of fixed income securities,
by contractual maturity, at December 31, 1999 and 1998 are shown below. Actual
maturities will differ from contractual maturities as borrowers may have the
right to call or prepay obligations with or without call or prepayment
penalties:
In thousands 1999 1998
----------------------------------------------------------------------------------------------
Amortized Estimated Amortized Estimated
Fixed Income Securities: Cost Fair Value Cost Fair Value
----------------------------------------------------------------------------------------------
Due within one year $ -- $ -- $ 3,354 $ 3,364
Due after one year but within five years 47,697 47,022 67,091 68,817
Due after five years but within ten years 117,047 112,286 160,158 163,152
Due after ten years 175,511 164,841 100,130 100,196
----------------------------------------------------------------------------------------------
340,255 324,149 330,733 335,529
Mortgage pass-through securities,
collateralized mortgage obligations and
asset-backed securities 96,435 93,807 88,133 88,385
----------------------------------------------------------------------------------------------
$436,690 $417,956 $418,866 $423,914
==============================================================================================
Major categories of net investment income and net realized investment gains
(losses) were as follows:
September 30
(Date of
Inception)
Year Ended Year Ended through
December 31 December 31 December 31
In thousands 1999 1998 1997
----------------------------------------------------------------------------------------------
Investment income:
Fixed income securities $ 22,593 $ 22,111 $ 3,061
Equity securities 92 -- --
Short-term investments 2,917 2,233 2,707
Other 866 523 112
----------------------------------------------------------------------------------------------
Total investment income 26,468 24,867 5,880
Investment expenses (618) (608) (114)
----------------------------------------------------------------------------------------------
Net investment income $ 25,850 $ 24,259 $ 5,766
----------------------------------------------------------------------------------------------
Gross realized investment gains:
Fixed income securities $ 690 $ 867 $ 90
Equity securities 2 -- --
Other -- 2 11
Gross realized investment losses:
Fixed income securities (674) (19) --
Equity securities (1) -- --
Other (2) (6) (16)
----------------------------------------------------------------------------------------------
Net realized investment gain $ 15 $ 844 $ 85
==============================================================================================
25
36
Notes to Consolidated Financial Statements
Net unrealized gain and loss on securities included in stockholders' equity at
December 31, 1999 and 1998 was comprised of the following:
In thousands 1999 1998
-----------------------------------------------------------------------------
Gains Losses Net Gains Losses Net
Fixed income securities $ 145 $(18,879) $(18,734) $6,146 $(1,098) $ 5,048
Equity securities 3,274 (1,345) 1,929 -- -- --
Other -- (349) (349) -- (37) (37)
-----------------------------------------------------------------------------
$3,419 $(20,573) (17,154) $6,146 $(1,135) 5,011
-----------------------------------------------------------------------------
Deferred income taxes 6,004 (1,754)
-----------------------------------------------------------------------------
Net unrealized (loss)
gain on securities $(11,150) $ 3,257
=============================================================================
NOTE 4. DEBT
CNA Surety has a five-year unsecured revolving credit facility that provides for
borrowings of up to $130.0 million. The interest rate on borrowings under the
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 applicable margin. The margin, including the
facility fee, varies based on CNA Surety's leverage ratio (debt to total
capitalization) and ranges from 0.25% to 0.40%. The credit facility provides for
the payment of all outstanding principal balances after five years with no
required principal payments prior to such time.
The credit facility contains among other conditions, limitations on CNA
Surety with respect to the incurrence of additional indebtedness and requires
the maintenance of certain financial ratios. As of December 31, 1999, management
believes that the Company was in compliance with all restrictions or covenants
contained in the credit facility agreement.
On July 28, 1999, CNA Surety acquired certain assets of ▇▇▇▇▇ 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 Consolidated Balance Sheet at December 31, 1999 reflects total debt
of $101.9 million and $113.0 million at December 31, 1998. The weighted average
interest rate on outstanding borrowings was 6.33% and 5.53% at December 31,
1999 and 1998, respectively.
NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table summarizes fair value information about financial
instruments, whether or not recognized in the balance sheet, for which it is
practicable to estimate that value. In cases where quoted market prices are not
available, fair values may be based on estimates using present value or other
valuation techniques. These techniques are significantly affected by the
assumptions used, including the discount rates and estimates of future cash
flows. Potential taxes and other transaction costs have not been considered in
estimating fair value. Accordingly, the estimates presented herein are
subjective in nature and are not necessarily indicative of the amounts that the
Company could realize in a current market exchange. This information excludes
certain financial instruments and all non-financial instruments such as
insurance contracts from fair value disclosure. Therefore, these fair value
amounts cannot be aggregated to determine the underlying economic value of the
Company.
26
CNA Surety Corporation 1999 AR 37
Notes to Consolidated Financial Statements
The carrying amounts and estimated fair values of financial instruments at
December 31, 1999 and 1998 were as follows:
1999 1998
-------------------------------------------------------------------------------
Carrying Estimated Carrying Estimated
In thousands Amount Fair Value Amount Fair Value
-------------------------------------------------------------------------------
Fixed income securities $417,956 $417,956 $423,914 $423,914
Equity securities 25,897 25,897 -- --
Short-term investments 43,033 43,033 57,865 57,865
Other investments 5,277 5,277 5,830 5,830
Cash 7,237 7,237 17,746 17,746
Debt 101,900 101,900 113,000 113,000
===============================================================================
The following methods and assumptions were used by the Company in estimating
fair values of financial instruments: Investments-The estimated fair values for
the fixed income securities and equity securities are based upon quoted market
prices, where available. For fixed income securities not actively traded, the
estimated fair values are determined using values obtained from independent
pricing services or, in the case of private placements, by discounting expected
future cash flows using a current market rate applicable to the yield, credit
quality and maturity of the investments.
Cash, Short-Term Investments and Other Investments-The carrying value for these
instruments approximates their estimated fair values. Debt-The estimated fair
value of the Company's debt is based on the quoted market prices for the same or
similar issues or on the current rates offered to the Company for debt of the
same remaining maturity.
NOTE 6. DEFERRED POLICY ACQUISITION COSTS
Policy acquisition costs deferred and the related amortization of deferred
policy acquisition costs were as follows:
September 30
(Date of Predecessor
Inception Nine(1) Months
Year Ended Year Ended through Ended
December 31 December 31 December 31 September 30
In thousands 1999 1998 1997 1997
----------------------------------------------------------------------------------
Balance at beginning of period $ 74,488 $ 64,144 $ 69,094 $ 37,689
Costs deferred 130,182 115,764 20,931 48,126
Amortization (119,746) (105,420) (25,881) (48,075)
Deferred policy acquisition
costs of Capsure at
September 30, 1997, date
of Merger -- -- -- 31,354
----------------------------------------------------------------------------------
Balance at end of period $ 84,924 $ 74,488 $ 64,144 $ 69,094
==================================================================================
(1)Amounts are for Predecessor except for the deferred policy acquisition costs
of Capsure acquired and the balance at the end of the period which is for CNA
Surety.
NOTE 7. REINSURANCE
The Company's insurance subsidiaries, in the ordinary course of business, cede
reinsurance to other insurance companies to limit their exposure to loss.
Reinsurance arrangements are used to limit maximum loss, provide greater
diversification of risk and minimize exposure on larger risks. Reinsurance
contracts do not ordinarily relieve the Company of its primary obligations to
claimants. Therefore, a contingent liability exists with respect to reinsurance
ceded to the extent that any reinsurer is unable to meet the obligations assumed
under the reinsurance agreements. The Company evaluates the financial condition
of its reinsurers, establishes allowances for uncollectible amounts and monitors
concentrations of credit risk. At December 31, 1999, CNA Surety's largest
reinsurance receivable, including prepaid reinsurance premiums of $0.8 million,
was approximately $8.5 million with a company rated A++ (Superior) by A.M. Best
Company, Inc.
27
38
Notes to Consolidated Financial Statement
The effect of reinsurance on premiums written and earned was as
follows:
September 30 Predecessor
Year Ended Year Ended (Date of Inception) Nine Months
December 31 December 31 through December 31 Ended September 30
In thousands 1999 1998 1997 1997
----------------------------------------------------------------------------------------------------------------------------
Written Earned Written Earned Written Earned Written Earned
----------------------------------------------------------------------------------------------------------------------------
Direct $108,968 $103,993 $105,288 $103,298 $24,561 $27,159 $114,969 $112,751
Assumed from affiliates 197,891 186,939 172,935 163,003 50,691 40,653 -- --
Assumed from
non-affiliates -- -- -- -- -- -- 1,106 2,034
Ceded (7,872) (7,392) (7,621) (7,564) (1,263) (2,379) (7,445) (6,221)
----------------------------------------------------------------------------------------------------------------------------
Net premiums $298,987 $283,540 $270,602 $258,737 $73,989 $65,433 $108,630 $108,564
============================================================================================================================
Assumed premiums from affiliates are comprised of all surety business written or
renewed, net of reinsurance, by CCC and CIC after the Merger Date that is
reinsured by Western Surety pursuant to intercompany reinsurance and related
agreements.
The effect of reinsurance on losses and loss adjustment expenses incurred
was as follows:
September 30
(Date of Predecessor
Inception) Nine Months
Year Ended Year Ended through Ended
December 31 December 31 December 31 September 30
In thousands 1999 1998 1997 1997
-----------------------------------------------------------------------------------------------
Gross losses and loss adjustment expenses $ 63,933 $ 53,828 $ 12,613 $ (7,265)
Reinsurance recoveries (19,261) (8,830) (479) (4,251)
-----------------------------------------------------------------------------------------------
Net losses and loss adjustment expenses $ 44,672 $ 44,998 $ 12,134 $ (11,516)
===============================================================================================
NOTE 8. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the reserves for unpaid losses and loss adjustment expenses was as
follows:
September 30
(Date of Predecessor
Inception) Nine(1)Months
Year Ended Year Ended through Ended
December 31 December 31 December 31 September 30
In thousands 1999 1998 1997 1997
-----------------------------------------------------------------------------------------------
Reserves at beginning of period:
Gross $150,020 $130,381 $122,281 $ 119,151
Ceded reinsurance 7,986 7,656 7,273 15,467
-----------------------------------------------------------------------------------------------
Net reserves at beginning of period 142,034 122,725 115,008 103,684
-----------------------------------------------------------------------------------------------
Net incurred loss and loss
adjustment expenses:
Provision for insured events of
current period 57,757 49,350 12,781 23,484
Decrease in provision for insured events
of prior periods (13,085) (4,352) (647) (35,000)
-----------------------------------------------------------------------------------------------
Total net incurred 44,672 44,998 12,134 (11,516)
-----------------------------------------------------------------------------------------------
Net payments attributable to:
Current period events 16,809 6,094 4,256 4,307
Prior period events 32,428 19,595 161 3,780
-----------------------------------------------------------------------------------------------
Total net payments 49,237 25,689 4,417 8,087
-----------------------------------------------------------------------------------------------
Net reserves of Capsure at September 30,
1997, date of Merger -- -- -- 30,927
Net reserves at end of period 137,469 142,034 122,725 115,008
Ceded reinsurance at end of period 20,464 7,986 7,656 7,273
-----------------------------------------------------------------------------------------------
Gross reserves at end of period $157,933 $150,020 $130,381 $ 122,281
===============================================================================================
(1)Amounts are for Predecessor except for the net reserves of Capsure and both
ceded reinsurance and gross reserves at the end of the period which are for CNA
Surety.
28
CNA Surety Corporation 1999 AR 39
Notes to Consolidated Financial Statements
The Company recorded net favorable reserve development which resulted in
reductions in the estimated liability of $13.1 million for the year ended
December 31, 1999, $4.4 million for the year ended December 31, 1998 and $0.6
million for the period from inception through December 31, 1997. Net favorable
reserve development of $13.1 million in 1999 primarily reflects increased
salvage and subrogation recoveries received with respect to accident years prior
to 1997.
On a pro forma basis, favorable development was $40.9 million ($35.0
million related to the Predecessor) for the year ended December 31, 1997. Based
on the CCC Surety Operations' 1997 study of reserves, management determined that
it had been overly cautious in interpreting claim data and had discounted
favorable trends. Consistent with the CCC Surety Operations' regular study of
reserve levels, the CCC Surety Operations released $35.0 million of prior year
reserves in 1997. Approximately $33 million of this reserve development related
to CIC and principally to accident years prior to 1996.
NOTE 9. COMMITMENTS AND CONTINGENCIES
At December 31, 1999, the future minimum commitment under operating leases was
as follows: 2000-$3.5 million; 2001-$2.4 million; 2002-$1.0 million, 2003-$0.6
million and 2004 and thereafter-$0.8 million. Total rental expense for the years
ended December 31, 1999 and 1998 was $3.4 million and $3.3 million,
respectively, and $0.8 million for the period from September 30, 1997 (date of
inception) through December 31, 1997.
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.
NOTE 10. INCOME TAXES
The components of deferred income taxes as of December 31, 1999 and 1998 were
as follows:
In thousands 1999 1998
------------------------------------------------------------------------------
Deferred tax assets related to:
Net operating losses $ -- $ 3,767
Unearned premium reserve 13,790 12,709
Unrealized loss on securities 6,004 --
Accrued expenses 1,288 3,768
Loss and loss adjustment expense reserve 2,785 3,059
Other 4,200 2,644
------------------------------------------------------------------------------
Total deferred tax assets 28,067 25,947
------------------------------------------------------------------------------
Deferred tax liabilities related to:
Deferred policy acquisition costs 29,963 26,071
Intangible assets 6,368 6,727
Unrealized gain on securities -- 1,754
Other 2,183 2,044
------------------------------------------------------------------------------
Total deferred tax liabilities 38,514 36,596
------------------------------------------------------------------------------
Net deferred tax liability $10,447 $10,649
==============================================================================
CNA Surety and its subsidiaries file a consolidated federal income tax return.
As of December 31, 1999, the Company utilized net operating loss carryforwards
of approximately $10.8 million of the remaining consolidated net operating
losses which were available as of December 31, 1998.
29
40
Notes to Consolidated Financial Statements
The income tax provisions consisted of the following:
September 30
(Date of Predecessor
Inception) Nine Months
Year Ended Year Ended through Ended
December 31 December 31 December 31 September 30
In thousands 1999 1998 1997 1997
------------------------------------------------------------------------------
Federal current $21,074 $20,087 $2,558 $21,466
Federal deferred 7,506 7,485 4,038 (225)
State 853 671 67 --
------------------------------------------------------------------------------
Total income tax expense $29,433 $28,243 $6,663 $21,241
==============================================================================
A reconciliation from the federal statutory tax rate to the effective tax rate
is as follows:
September 30
(Date of Predecessor
Inception) Nine Months
Year Ended Year Ended through Ended
December 31 December 31 December 31 September 30
1999 1998 1997 1997
------------------------------------------------------------------------------
Federal statutory rate 35.0% 35.0% 35.0% 35.0%
Tax exempt income deduction (3.4) (1.7) -- --
Non-deductible expenses,
principally amortization
of goodwill 2.2 2.6 2.4 0.2
State income tax, net of
federal income tax benefit 0.6 1.0 0.2 --
Other (0.1) 1.4 0.1 --
------------------------------------------------------------------------------
Total income tax expense 34.3% 38.3% 37.7% 35.2%
==============================================================================
NOTE 11. EMPLOYEE BENEFITS
CNA Surety sponsors a tax deferred savings plan ("401(k) plan") covering
substantially all of its employees. Under the 401(k) plan, the Company matches
70% of the participating employee's contribution up to 6% of eligible
compensation (4.2% maximum matching). Effective January 1, 2000, the Company
match was increased 100% of the participating employee's contribution up to 3%
of eligible compensation and 50% of the participating employee's contribution
between 3% and 6% of eligible compensation (4.5% maximum matching). In addition,
the Company may also make an annual discretionary profit sharing contribution to
the 401(k) plan, subject to the approval of the Company's Board of Directors.
The profit sharing contribution may be restricted by plan and regulatory
limitations. The Company contribution, including profit sharing, to the 401(k)
plan was $3.3 million and $3.2 million for the years ended December 31, 1999 and
1998 and $0.6 million for the period from September 30, 1997 through December
31, 1997.
Western Surety sponsors two post-retirement benefit plans covering certain
employees. One plan provides medical benefits, and the other plan provides sick
leave termination payments. The post-retirement health care plan is contributory
and the sick leave plan is non-contributory. The actuarially determined net
periodic post-retirement costs for these plans were $0.6 million and $0.4
million, respectively, for the years ended December 31, 1999 and 1998 and $0.1
million for the period from September 30, 1997 (date of inception) through
December 31, 1997. The unfunded accumulated post-retirement benefit obligation
(for retirees and fully vested active plan participants) was $5.4 million and
$4.9 million as of December 31, 1999 and 1998, respectively, and is included in
other liabilities in the consolidated balance sheet. The following table
summarizes the actuarial accounting assumptions for post-retirement benefit
plans:
1999 1998 1997
------------------------------------------------------------------------------
Discount Rate 6.5% 7.0% 7.0%
Initial healthcare cost trend 8.0% 9.0% 9.0%
Ultimate healthcare cost trend 5.0% 5.0% 5.0%
Ultimate medical trend reached in fiscal year 2002 2002 2002
==============================================================================
30
CNA Surety Corporation 1999 AR 41
Notes to Consolidated Financial Statements
NOTE 12. STOCKHOLDERS' EQUITY
The Company has reserved shares of its common stock for issuance to directors,
officers, employees and certain advisors of the Company through incentive stock
options, non-qualified stock options and stock appreciation rights ("SARs") to
be granted under the CNA Surety 1997 Long-Term Equity Compensation Plan ("CNA
Surety Plan"). The Company has also reserved shares of its common stock for
issuance to Capsure option holders under the CNA Surety Corporation Replacement
Stock Option Plan ("Replacement Plan"). The CNA Surety Plan and Replacement Plan
are collectively referred to as the "Plan." The aggregate number of shares
available for which options may be granted under the Plan is 3,000,000.
Options issued under the Replacement Plan have the same exercise price,
rights, benefits, terms and conditions as the Capsure options replaced. The
number of unexercised and outstanding Capsure options issued to the holders
under the Replacement Plan on September 30, 1997 was 335,235. The exercise
prices of the replacement options ranged between $0.05 and $8.00 per share on
September 30, 1997.
The Compensation Committee (the "Committee") of the Board of Directors,
consisting of independent members of the Board of Directors, administers the
Plan. The Committee determines the option prices. Prices may not be less than
the fair market value of the Company's common stock on the date of grant for
incentive stock options and may not be less than the par value of the Company's
common stock for non-qualified stock options.
The Plan provides for the granting of incentive stock options as defined
under the Code. All non-qualified stock options and incentive stock options
granted under the Plan expire ten years after the date of grant and in the case
of the Replacement Plan the options expire ten years from the original Capsure
grant date.
Weighted
Shares Subject Average Option
to Option Price Per Share
------------------------------------------------------------------------------
Balance at September 30, 1997 335,235 $ 3.46
Options granted 463,500 $15.82
Options cancelled (23,363) $15.58
Options exercised (26,000) $ 4.86
-------------------------------------------------------------
Balance at December 31, 1997 749,372 $10.68
=============================================================
Options granted 153,200 $15.50
Options cancelled (15,475) $15.87
Options exercised (145,031) $ 3.47
-------------------------------------------------------------
Balance at December 31, 1998 742,066 $13.34
=============================================================
Options granted 570,200 $11.06
Options cancelled (61,300) $13.83
Options exercised (29,437) $ 2.97
-------------------------------------------------------------
Balance at December 31, 1999 1,221,529 $12.50
=============================================================
As of December 31, 1999, the number of shares available for granting of
options under the Plan were 1,578,003. The following table summarizes
information about stock options outstanding at December 31, 1999:
Options Outstanding Options Exercisable
----------------------------------------------------------------------------------------------------
Weighted Average Weighted Weighted
Range of Number Remaining Average Number Average
Exercise Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price
----------------------------------------------------------------------------------------------------
$2.25 to $15.875 1,221,529 8.3 years $12.50 204,465 $8.77
====================================================================================================
The weighted average fair market value (at grant date) per option granted was
$4.29, $5.04 and $6.62, respectively, for options granted during 1999, 1998 and
the period from September 30, 1997 (date of inception) through December 31,
1997. The fair value of these options was estimated at grant date using a
Black-Scholes option pricing model with the following weighted average
assumptions for the year ended December 31, 1999: risk free interest rate of
5.25%; dividend yield of 2.0%; expected option life of six years; and volatility
of 40.3%. Similar assumptions for the year ended December 31, 1998 and the
period from September 30, 1997 (date of inception)
31
42
Notes to Consolidated Financial Statements
through December 31, 1997 were: risk free interest rate of 4.45% and 5.76%;
dividend yield of 2.0% and 0%; expected option life of 6 years and volatility of
33.4% and 30.6%, respectively.
The Company adopted the financial disclosure provisions of SFAS No. 123,
"Accounting for Stock-Based Compensation" with respect to its stock-based
incentive plans. The Company applies APB Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations, in accounting for its plans
as allowed for under the provisions of SFAS No. 123. Accordingly, no
compensation cost has been recognized for its stock-based incentive plans as
the exercise price of the granted options equals the market price at the grant
date. Had compensation cost for these plans been determined on the fair value at
the grant date for options granted, the Company's pro forma net income for the
year ended December 31, 1999 and 1998 would have been $55.2 million and $44.8
million, respectively; and $10.9 million for the period from September 30, 1997
to December 31, 1997. Diluted net income per share would have been $1.25 and
$1.02 for the 1999 and 1998 and $0.25 for the period from September 30, 1997
through December 31, 1997.
Effective January 1, 1998, the Company established the CNA Surety
Corporation Non-Employee Directors Deferred Compensation Plan. Under this plan,
each director who is not a full-time employee of the Company or any of its
affiliates may defer all or a portion of the annual retainer fee that would
otherwise be paid to such director. The deferral amount, which must be in
multiples of 10% of the retainer fee, will be credited to a deferred
compensation account and will be deemed invested in Common Stock Units equal to
the deferred fees divided by the fair market value of CNA Surety common stock as
of each quarterly meeting date. Each director will be fully vested in his or her
deferred compensation amount. Aggregate common stock units outstanding as of
December 31, 1999 were 17,291. Common Stock Units are convertible into CNA
Surety common stock at the election of the director.
NOTE 13. SEGMENT INFORMATION
The Company is a leading provider of surety and fidelity bonds in the United
States. According to A.M. Best, the surety and fidelity segment of the domestic
property and casualty insurance industry aggregates approximately $3.8 billion
in direct written premiums, comprised of approximately $3.0 billion in surety
premiums and $0.8 billion in fidelity premiums.
Surety bonds are three-party agreements in which the issuer of the bond
(the surety) joins with a second party (the principal) in guaranteeing to a
third party (the owner/obligee) the fulfillment of some obligation on the part
of the principal. The surety is the party who guarantees fulfillment of the
principal's obligation to the obligee. There are two broad types of surety
products--contract surety and commercial surety bonds.
Contract surety bonds secure a contractor's performance and/or payment
obligation generally with respect to a construction project. Contract surety
bonds are generally required by federal, state and local governments for public
works projects. Commercial surety bonds include all surety bonds other than
contract and cover obligations typically required by law or regulation. Fidelity
bonds cover losses arising from employee dishonesty.
Although all of its products are sold through the same independent
insurance agent and broker distribution network, the Company's underwriting and
management reporting are organized by the two broad types of surety
products--contract surety and commercial surety, which also includes fidelity
bonds and other insurance products for these purposes. These two operating
segments have been aggregated into one reportable business segment for financial
reporting purposes because of their similar economic and operating
characteristics.
32
CNA Surety Corporation 1999 AR 43
Notes to Consolidated Financial Statements
The following tables set forth gross and net written premiums, in thousands of
dollars, by product and between domestic and international risks and the
respective percentage of the total for the past three years.
Gross Written Premium
Pro Forma
For the years ended December 31 1999 1998 1997
----------------------------------------------------------------------------------------------------------
Dollars Percent Dollars Percent Dollars Percent
----------------------------------------------------------------------------------------------------------
Contract $150,022 48.9% $132,242 47.5% $123,014 46.2%
Commercial 130,502 42.5 121,046 43.5 119,662 44.9
Fidelity and other 26,335 8.6 24,936 9.0 23,742 8.9
----------------------------------------------------------------------------------------------------------
Total $306,859 100.0% $278,224 100.0% $266,418 100.0%
==========================================================================================================
Domestic $286,253 93.3% $266,998 96.0% $255,635 96.0%
International 20,606 6.7 11,226 4.0 10,783 4.0
----------------------------------------------------------------------------------------------------------
Total $306,859 100.0% $278,224 100.0% $266,418 100.0%
==========================================================================================================
Net Written Premium
Pro Forma
For the years ended December 31 1999 1998 1997
----------------------------------------------------------------------------------------------------------
Dollars Percent Dollars Percent Dollars Percent
----------------------------------------------------------------------------------------------------------
Contract $145,616 48.7% $127,114 47.0% $118,138 46.0%
Commercial 128,834 43.1 120,638 44.6 117,162 45.6
Fidelity and other 24,537 8.2 22,850 8.4 21,767 8.4
----------------------------------------------------------------------------------------------------------
Total $298,987 100.0% $270,602 100.0% $257,067 100.0%
==========================================================================================================
Domestic $280,463 93.8% $260,506 96.3% $246,923 96.1%
International 18,524 6.2 10,096 3.7 10,144 3.9
----------------------------------------------------------------------------------------------------------
Total $298,987 100.0% $270,602 100.0% $257,067 100.0%
==========================================================================================================
Approximately $57.9 million, or 18.9%, of gross written premiums were generated
from national insurance brokers in 1999 with the single largest national broker
production comprising $21.7 million, or 7.1%, of gross written premiums.
NOTE 14. STATUTORY FINANCIAL DATA
CNA Surety's insurance subsidiaries file financial statements prepared in
accordance with statutory accounting practices prescribed or permitted by
applicable insurance regulatory authorities. Prescribed statutory accounting
practices include state laws, regulations and general administrative rules, as
well as guidance provided in a variety of publications of the National
Association of Insurance Commissioners ("NAIC"). Permitted statutory accounting
practices encompass all accounting practices that are not prescribed. The
permitted statutory accounting practices of CNA Surety's insurance subsidiaries
did not have a material effect on reported statutory surplus or income. The
principal differences between statutory financial statements and financial
statements prepared in accordance with generally accepted accounting principles
are that statutory financial statements do not reflect deferred policy
acquisition costs and deferred income taxes and fixed income securities are
generally carried at amortized cost in statutory financial statements.
In 1998, the NAIC adopted the Codification of Statutory Accounting
Principles ("Codification"). The states of South Dakota and Texas have not yet
adopted the Codification. The Company has not yet quantified the effects of
Codification on its statutory financial statements. The Codification, which is
intended to standardize regulatory accounting and reporting for the insurance
industry, is proposed to be effective January 1, 2001 if adopted by the
domiciliary state.
The NAIC has promulgated Risk Based Capital ("RBC") requirements for
property and casualty insurance companies to evaluate the adequacy of statutory
capital and surplus in relation to investment and insurance risks such as asset
quality, loss reserve adequacy and other business factors. The RBC information
is used by state insurance regulators as an early warning mechanism to identify
insurance companies that potentially are inadequately capitalized. In addition,
the formula defines new minimum capital standards that supplement the current
system of fixed minimum capital and surplus requirements on a state-by-state
basis. Regulatory compliance is
33
44
Notes to Consolidated Financial Statements
determined by a ratio (the "Ratio") of the enterprise's regulatory total
adjusted capital, as defined by the NAIC, to its authorized control level RBC,
as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized
control level RBC requires no corrective actions by the company or regulators.
As of December 31, 1999, each of CNA Surety's insurance subsidiaries had a Ratio
that was in compliance with the minimum RBC requirements.
CNA Surety's insurance subsidiaries are subject to regulation and
supervision by the various state insurance regulatory authorities in which they
conduct business. Such regulation is generally designed to protect policyholders
and includes such matters as maintenance of minimum statutory surplus and
restrictions on the payment of dividends. Generally, statutory surplus of each
insurance subsidiary in excess of a statutorily prescribed minimum is available
for payment of dividends to the parent company. However, such distributions as
dividends may be subject to prior regulatory approval. Without prior regulatory
approval in 2000, CNA Surety's insurance subsidiaries may pay stockholder
dividends of $60.5 million in the aggregate. Combined statutory surplus for the
insurance subsidiaries at December 31, 1999 was $193.5 million.
NOTE 15. RELATED PARTY TRANSACTIONS
CCC and the insurance subsidiaries of the Company have entered into various
reinsurance agreements designed to protect against adverse loss reserve
development related to the CCC Surety Operations reserves at the Merger Date,
and help preserve, through the year 2000, the profitability of CCC Surety
Operations and certain additional accounts. The reinsurance agreements together
with the Services and Indemnity Agreement, that is described below, provided
for the initial transfer of the CCC Surety Operations to CNA Surety's insurance
subsidiaries. The reinsurance agreements entered into at the Merger Date are:
(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").
The Services and Indemnity Agreement provides the insurance subsidiaries
with the authority to perform various administrative, management, underwriting
and claim functions in order to conduct the business of the CCC Surety
Operations and to be reimbursed by CCC for services rendered. In consideration
for providing the foregoing services, CCC has agreed to pay the insurance
subsidiaries a quarterly fee of $50,000. There was no amount due to the CNA
Surety insurance subsidiaries as of December 31, 1999.
Through the Quota Share Treaty, CCC and CIC ceded, as of the Merger Date,
and subsequently paid on October 1, 1997, to Western Surety all of its net
unearned premiums and loss and loss adjustment expense reserves, net of $29.0
million of ceded commissions. The payment totaled $116.9 million.
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. CCC
and CIC paid Western Surety, net of commissions and reinsured loss payments,
$103.8 million for the year ended December 31, 1999, $100.8 million for the year
ended December 31, 1998 and $21.2 million during the period from September 30,
1997 (date of inception) through December 31, 1997. As of December 31, 1999 and
1998, CNA Surety had a reinsurance receivable balance from CCC and CIC of $57.1
million and $47.2 million, respectively. This balance is primarily comprised of
direct premium receivables of CCC and CIC with respect to the surety business
ceded to Western Surety. CNA Surety had reinsurance payables to CCC and CIC of
$6.9 million and $1.4 million as of December 31, 1999 and 1998, respectively,
primarily related to reinsured losses.
Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and
loss adjustment expenses transferred to Western Surety by agreeing to pay
Western Surety, within 30 days following the end of each calendar quarter, the
amount of any adverse development on such reserves, as reestimated as of the end
of such calendar quarter. There was not any adverse reserve development for the
period from September 30, 1997 (date of inception) through December 31, 1999.
The Quota Share Treaty has a term of five years from the Merger Date.
The Stop Loss Contract protects 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 limits the insurance
subsidiaries' prospective net loss ratios with respect to certain accounts and
lines of insured business for at least three fiscal 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
34
CNA Surety Corporation 1999 AR 45
Notes to Consolidated Financial Statements
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 will pay
to CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have
paid CCC all required annual premiums. There was no amount due to the CNA Surety
insurance subsidiaries from CCC under the Stop Loss Contract as of December 31,
1999.
The Excess of Loss Contract provides 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 in excess of the $55 million of coverage provided to the insurance
subsidiaries by third party reinsurers, which is in turn in excess of the $5
million of coverage per principal to be retained by the CNA Surety insurance
subsidiaries. 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. The two Excess of Loss Contracts collectively provide 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. CCC is also obligated to act as a joint insurer, or "co-surety,"
for business covered by the Excess of Loss Contract when requested by the CNA
Surety insurance subsidiaries. In consideration for the reinsurance coverage
provided by the Excess of Loss Contracts, the insurance subsidiaries pay 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. There were no amounts due to CCC under
the Excess of Loss Contract and Second Excess of Loss Contract as of December
31, 1999. Both Excess of Loss Contracts commenced immediately following the
Merger Date and continue for a period of five years from the Merger Date.
CNA Surety also entered into an Administrative Services Agreement with CCC
as of the Merger Date. The agreement allows the Company continued use of certain
real and personal property owned or leased by CCC. The Company may cancel,
without penalty, any lease under the agreement by giving CCC sixty days notice.
The Company can also purchase many of the administrative services provided to
the CCC Surety Operations by CCC. CNA Surety, however, is under no obligation to
purchase any services under the Administrative Services Agreement. The aggregate
maximum annual cost for the use of real and personal property and for services
available under the agreement is approximately $7.9 million. Administrative
services are provided at specified rates, subject to inflationary increases. The
Company was charged $5.5 million, $7.5 million and $2.5 million for the year
ended December 31, 1999, 1998 and the period from September 30, 1997 (date of
inception) through December 31, 1997, respectively, for rents and services
provided under the agreement. In addition, the Company was charged $3.0 million
and $2.2 million for direct costs incurred by CCC on the Company's behalf during
1999 and 1998, respectively. The Company paid CCC $8.7 million and owed $0.6
million which was reflected in other liabilities in the Company's Consolidated
Balance Sheet at December 31, 1999.
Western Surety has entered into a series of business transactions with
entities in which either or both CCC or affiliates of CCC have an interest. This
series of transactions involves two separate refundment guarantees for the
benefit of Hellespont Shipping Corporation ("Hellespont"). Hellespont is 49
percent owned by Majestic Shipping Corporation, which is a wholly owned
subsidiary of Loews Corporation ("Loews"). Loews owns approximately 86 percent
of the outstanding stock of CNA Financial Corporation ("CNAF"), CNAF owns
approximately 63 percent of CNA Surety, and CCC is a principal operating
subsidiary of CNAF. As one of several sureties participating in the surety
program for Samsung Heavy Industries Co., Ltd., Seoul, Korea ("Samsung"), CCC
has provided refundment guarantees for repayment of advance payments made by
Hellespont on two shipbuilding contracts between Samsung and Hellespont's
subsidiaries, should Samsung not perform the contracts. Loews is also a
subordinated beneficiary of the guarantees. These refundment guarantees were
transferred to Western Surety through the Quota Share Treaty and are covered by
the Excess of Loss Contracts
35
46
Notes to Consolidated Financial Statements
provided by CCC. Each guarantee is in the amount of $55.4 million, plus
interest, and will terminate on acceptance of the ships by their buyers. These
acceptances are currently anticipated to be made upon delivery of the ships now
scheduled for December 2001 and March 2002, respectively. Premiums written on
these guarantees in 1999 totaled $1.3 million to Western Surety of which 28
percent was paid to CCC as a ceding commission.
NOTE 16. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the results of operations of CNA Surety for the
year ended December 31, 1999, 1998 and for the period from September 30, 1997
(date of inception) through December 31, 1997 and a summary of unaudited
quarterly results of the Predecessor for the nine months ended September 30,
1997:
CNA Surety
In thousands, except per share amounts First Quarter Second Quarter Third Quarter Fourth Quarter
-------------------------------------------------------------------------------------------------------------
1999
Revenues $74,607 $75,884 $78,402 $80,512
=============================================================================================================
Income before income taxes $19,751 $19,482 $23,322 $23,376
Income taxes 6,708 6,644 8,118 7,963
-------------------------------------------------------------------------------------------------------------
Net income $13,043 $12,838 $15,204 $15,413
=============================================================================================================
Basic and diluted earnings per common share $ 0.30 $ 0.29 $ 0.34 $ 0.35
=============================================================================================================
1998
Revenues $65,534 $69,399 $75,325 $73,582
=============================================================================================================
Income before income taxes $15,981 $17,800 $18,507 $21,470
Income taxes 6,166 6,643 7,025 8,409
-------------------------------------------------------------------------------------------------------------
Net income $ 9,815 $11,157 $11,482 $13,061
=============================================================================================================
Basic and diluted earnings per common share $ 0.23 $ 0.25 $ 0.26 $ 0.30
=============================================================================================================
Inception to
December 31
------------------------------------------------------------------------------
1997
Revenues $71,284
==============================================================================
Income before income taxes $17,659
Income taxes 6,663
------------------------------------------------------------------------------
Net income $10,996
==============================================================================
Basic and diluted earnings per common share $ 0.25
==============================================================================
Predecessor
First Quarter Second Quarter Third Quarter Fourth Quarter
-------------------------------------------------------------------------------------------------------------
1997
Net earned premiums $33,829 $36,155 $38,580 $ --
=============================================================================================================
Excess of net earned premiums over direct
operating costs $41,878 $ 8,174 $10,354 $ --
Income taxes 14,690 2,894 3,657 --
-------------------------------------------------------------------------------------------------------------
Excess of net earned premiums over direct
operating costs, net of income taxes $27,188 $ 5,280 $ 6,697 $ --
=============================================================================================================
36
CNA Surety Corporation 1999 AR 47
Independent Auditors' Report
THE BOARD OF DIRECTORS AND STOCKHOLDERS
CNA SURETY CORPORATION
We have audited the consolidated balance sheets of CNA Surety Corporation and
subsidiaries as of December 31, 1999 and 1998, and the related consolidated
statements of income, stockholders' equity and cash flows for the years ended
December 31, 1999 and 1998 and for the period from September 30, 1997 (date of
inception) through December 31, 1997. We have also audited the accompanying
special-purpose financial statement of certain revenues and direct operating
expenses of CCC Surety Operations, a business unit of CNA Financial Corporation,
for the nine-month period ended September 30, 1997. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
The accompanying special-purpose financial statement was prepared to
present certain revenues and direct operating expenses of CCC Surety Operations
and is not intended to be a complete presentation of CCC Surety Operations. Note
1 to the consolidated financial statements describes the basis of presentation
of this special-purpose financial statement.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of CNA Surety Corporation and
subsidiaries as of December 31, 1999 and 1998, and the results of their
operations and their cash flows for the years ended December 31, 1999 and 1998,
and for the period from September 30, 1997 (date of inception) through December
31, 1997, in conformity with generally accepted accounting principles.
Furthermore, in our opinion, such special-purpose financial statement presents
fairly in all material respects, certain revenues and direct operating expenses
of CCC Surety Operations for the nine-month period ended September 30, 1997, in
conformity with generally accepted accounting principles.
/s/ Deloitte & Touche LLP
-------------------------
Chicago, Illinois
February 22, 2000
37
48
DIRECTORS
▇▇▇▇▇▇▇ ▇▇▇▇▇▇
Business Men's Assurance
Company of America
▇▇▇▇▇▇ ▇. ▇▇▇▇▇
Bank One N.A.
▇▇▇ ▇. ▇▇▇▇▇▇▇▇
Equity Group
Investments, Inc.
▇▇▇▇▇▇ ▇▇▇▇▇▇
The ▇▇▇▇▇ Corp.
Retired
▇▇▇▇▇▇ ▇▇▇▇
Graycor, Inc.
▇▇▇ ▇. ▇▇▇▇▇
Western Surety Company
Retired
▇▇▇▇▇▇▇ ▇. ▇▇▇▇
Equity Group
Investments, Inc.
▇▇▇ ▇. ▇▇▇▇▇▇
Loews Corporation
Retired
▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇
CNA
▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇
CNA
Retired
▇▇▇▇ ▇. ▇▇▇▇▇▇▇▇
CNA Surety Corporation
OFFICERS
▇▇▇▇▇▇ ▇. ▇▇▇
Senior Vice President and
Chief Underwriting Officer,
Contract Surety
▇▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇▇▇
Vice President and
Chief Marketing Officer
▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇▇▇
Vice President
and Chief Human
Resources Officer
▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇
Vice President and
Chief Claims Officer
▇▇▇▇ ▇. ▇▇▇▇▇▇▇▇
Vice President,
Chief Financial Officer
and Treasurer
▇▇▇ ▇. ▇▇▇▇▇
Vice President,
Legislative Affairs
▇▇▇▇ ▇. ▇▇▇▇▇▇
Vice President,
General Counsel
and Secretary
▇▇▇▇▇▇▇ ▇. ▇▇▇▇
Senior Vice President
and Chief Operating Officer,
Western Surety
▇▇▇▇▇ ▇. ▇▇▇▇
Vice President,
International Surety
▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇
Senior Vice President
and Chief Operations Officer
▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇
Senior Vice President and
Chief Underwriting Officer,
Commercial Surety
▇▇▇▇ ▇. ▇▇▇▇▇▇▇▇
President and
Chief Executive Officer
Design ▇▇▇▇▇▇▇ Design Printing Active Graphics Photography ▇▇▇▇ ▇▇▇▇▇
Photography
