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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission file number: 1-13277
CNA SURETY CORPORATION
(Exact name of Registrant as specified in its Charter)
Delaware 36-4144905
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
CNA Plaza, Chicago, Illinois 60685
(Address of principal executive offices) (Zip Code)
(312) 822-5000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
-----
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
42,942,229 shares of Common Stock, $.01 par value as of August 2, 2002.
CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
Page
----
Part I Financial Information:
Item 1. Condensed Consolidated Financial Statements:
Independent Accountants' Report....................... 3
Condensed Consolidated Balance Sheets at
June 30, 2002 (Unaudited) and at December 31, 2001 ... 4
Condensed Consolidated Statements of Income for the
Three- and Six- Months Ended June 30, 2002 and 2001
(Unaudited) .......................................... 5
Condensed Consolidated Statements of Stockholders'
Equity for the Six Months Ended June 30, 2002 and 2001
(Unaudited) .......................................... 6
Condensed Consolidated Statements of Cash Flows for
the Six Months Ended June 30, 2002 and 2001 (Unaudited 7
Notes to Condensed Consolidated Financial Statements
at June 30, 2002 (Unaudited) ......................... 8
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations .................. 13
Part II. Other Information:
Item 1. Legal Proceedings .................................... 22
Item 2. Changes in the Rights of the Company's Security
Holders .............................................. 22
Item 3. Defaults Upon Senior Securities ...................... 22
Item 4. Submission of Matters to a Vote of Security Holders .. 22
Item 5. Other Information .................................... 23
Item 6. Exhibits and Reports on Form 8-K ..................... 23
2
INDEPENDENT ACCOUNTANTS' REPORT
To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois
We have reviewed the accompanying condensed consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of June 30, 2002, and the related
condensed consolidated statements of income for the three-month and six-month
periods ended June 30, 2002 and 2001 and the related condensed consolidated
statements of stockholders' equity and of cash flows for the six-month periods
ended June 30, 2002 and 2001. These financial statements are the responsibility
of the Corporation's management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and of making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance
with auditing standards generally accepted in the United States of America, the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to such condensed consolidated financial statements for them to be in
conformity with accounting principles generally accepted in the United States of
America.
We have previously audited, in accordance with auditing standards generally
accepted in the United States of America, the consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of December 31, 2001, and the related
consolidated statements of income, stockholders' equity, and cash flows for the
year then ended (not presented herein); and in our report dated February 11,
2002, we expressed an unqualified opinion on those consolidated financial
statements. In our opinion, the information set forth in the accompanying
condensed consolidated balance sheet as of December 31, 2001 is fairly stated,
in all material respects, in relation to the consolidated balance sheet from
which it has been derived.
Deloitte & Touche LLP
Chicago, Illinois
August 5, 2002
3
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except per share data)
(Unaudited)
June 30, December 31,
2002 2001
------------- --------------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $467,099 and $464,102) ... $ 487,290 $ 471,841
Equity securities, at fair value (cost: $58,377 and $42,614) ..................... 48,198 35,754
Short-term investments, at cost (approximates fair value) ........................ 54,590 53,600
Other investments, at fair value ................................................. 5,110 5,303
Cash ............................................................................. 13,244 13,159
----------- -----------
Total invested assets and cash ................................................ 608,432 579,657
Deferred policy acquisition costs .................................................. 97,148 89,788
Insurance receivables:
Premiums, including $28,771 and $29,829 from affiliates (net of allowance for
doubtful accounts: $1,955 and $2,614) ........................................... 42,025 39,911
Reinsurance, including $42,770 and $58,027 from affiliates ....................... 153,381 176,235
Intangible assets (net of accumulated amortization: $25,523 and $25,523) ........... 143,785 143,785
Property and equipment, at cost (less accumulated
depreciation: $15,537 and $14,138) ............................................... 17,667 17,645
Prepaid reinsurance premiums ....................................................... 9,424 5,838
Other assets ....................................................................... 9,229 8,739
----------- -----------
Total assets .................................................................. $ 1,081,091 $ 1,061,598
=========== ===========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses ....................................... $ 308,746 $ 315,811
Unearned premiums ................................................................ 211,791 200,379
----------- -----------
Total reserves ................................................................ 520,537 516,190
Debt ............................................................................... 76,195 76,195
Deferred income taxes, net ......................................................... 25,968 19,969
Payable for securities purchased ................................................... 467 11,406
Current income taxes payable ....................................................... 2,395 1,822
Reinsurance and other payables to affiliates ....................................... 9,005 8,923
Other liabilities .................................................................. 40,170 38,665
----------- -----------
Total liabilities ............................................................. $ 674,737 $ 673,170
----------- -----------
Commitments and contingencies (See Note 5)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 44,359 shares
issued and 42,915 shares outstanding at June 30, 2002 and 44,229 shares issued and
42,780 shares outstanding at December 31, 2001.................................... 444 442
Additional paid-in capital ......................................................... 255,526 254,133
Retained earnings .................................................................. 159,718 149,128
Accumulated other comprehensive income ............................................. 6,166 278
Treasury stock, at cost ............................................................ (15,500) (15,553)
----------- -----------
Total stockholders' equity .................................................... 406,354 388,428
----------- -----------
Total liabilities and stockholders' equity .................................... $ 1,081,091 $ 1,061,598
=========== ===========
The accompanying notes are an integral part of these
condensed consolidated financial statements.
4
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Amounts in thousands, except per share data)
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
2002 2001 2002 2001
-------- -------- -------- --------
Revenues:
Net earned premium ................................. $ 75,742 $ 78,850 $142,963 $155,599
Net investment income .............................. 7,121 7,480 14,227 15,215
Net realized investment gains ...................... 1,601 192 1,323 163
-------- -------- -------- --------
Total revenues .................................. 84,464 86,522 158,513 170,977
-------- -------- -------- --------
Expenses:
Net losses and loss adjustment expenses ............ 19,606 16,813 36,253 32,899
Net commissions, brokerage and other underwriting .. 45,594 48,184 87,146 95,021
Interest expense ................................... 445 957 903 2,545
Amortization of intangible assets .................. -- 1,524 -- 3,048
-------- -------- -------- --------
Total expenses .................................. 65,645 67,478 124,302 133,513
-------- -------- -------- --------
Income before income taxes ........................... 18,819 19,044 34,211 37,464
Income taxes ......................................... 5,917 6,701 10,752 13,177
-------- -------- -------- --------
Net income ........................................... $ 12,902 $ 12,343 $ 23,459 $ 24,287
======== ======== ======== ========
Earnings per share ................................... $ 0.30 $ 0.29 $ 0.55 $ 0.57
======== ======== ======== ========
Earnings per share, assuming dilution ................ $ 0.30 $ 0.29 $ 0.55 $ 0.57
======== ======== ======== ========
Weighted average shares outstanding .................. 42,900 42,738 42,868 42,725
======== ======== ======== ========
Weighted average shares outstanding, assuming dilution 43,066 42,931 43,038 42,926
======== ======== ======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Amounts in thousands)
(Unaudited)
Common
Stock Additional
Shares Common Paid-In Comprehensive
Outstanding Stock Capital Income
----------- --------- ---------- -------------
Balance, December 31, 2000 .................................. 42,702 $ 441 $ 253,497
Comprehensive income:
Net income ................................................ -- -- -- $ 24,287
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $152 ...... -- -- -- 156
---------
Total comprehensive income ............................. $ 24,443
=========
Purchase of treasury stock .................................. -- -- --
Stock options exercised and other ........................... 49 1 328
Dividends paid to stockholders .............................. -- -- --
--------- --------- ---------
Balance, June 30, 2001 ...................................... 42,751 $ 442 $ 253,825
========= ========= =========
Balance, December 31, 2001 .................................. 42,780 $ 442 $ 254,133
Comprehensive income:
Net income ................................................ -- -- -- $ 23,459
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $428 ...... -- -- -- 5,888
---------
Total comprehensive income ............................. $ 29,347
=========
Issuance of treasury stock to employee stock purchase program 5 6
Stock options exercised and other ........................... 130 2 1,387
Dividends paid to stockholders .............................. -- -- --
--------- --------- ---------
Balance, June 30, 2002 ...................................... 42,915 $ 444 $ 255,526
========= ========= =========
Accumulated
Other Treasury Total
Retained Comprehensive Stock Stockholders'
Earnings Income (Loss) (at cost) Equity
--------- ------------- ---------- -------------
Balance, December 31, 2000 .................................. $ 135,308 $ 267 $ (15,481) $ 374,032
Comprehensive income:
Net income ................................................ 24,287 -- -- 24,287
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $152 ...... -- 156 -- 156
Total comprehensive income..............................
Purchase of treasury stock .................................. -- -- -- --
Stock options exercised and other ........................... -- -- -- 329
Dividends paid to stockholders .............................. (10,257) -- -- (10,257)
--------- --------- --------- ---------
Balance, June 30, 2001 ...................................... $ 149,338 $ 423 $ (15,481) $ 388,547
========= ========= ========= =========
Balance, December 31, 2001 .................................. $ 149,128 $ 278 $ (15,553) $ 388,428
Comprehensive income:
Net income ................................................ 23,459 -- -- 23,459
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $428....... -- 5,888 -- 5,888
Total comprehensive income..............................
Issuance of treasury stock to employee stock purchase program 53 59
Stock options exercised and other ........................... -- -- -- 1,389
Dividends paid to stockholders .............................. (12,869) -- -- (12,869)
--------- --------- --------- ---------
Balance, June 30, 2002 ...................................... $ 159,718 $ 6,166 $ (15,500) $ 406,354
========= ========= ========= =========
The accompanying notes are an integral part of these
condensed consolidated financial statements.
6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
(Unaudited)
Six Months Ended
June 30,
--------------------------------------
2002 2001
----------------- -----------------
OPERATING ACTIVITIES:
Net income ...................................................................... $ 23,459 $ 24,287
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization ................................................ 1,929 4,761
Accretion of bond discount, net .............................................. 410 394
Net realized investment losses ............................................... (1,323) (163)
Changes in:
Insurance receivables ........................................................ 20,740 (13,679)
Reserve for unearned premiums ................................................ 11,412 232
Reserve for unpaid losses and loss adjustment expenses ....................... (7,065) 2,066
Deferred policy acquisition costs ............................................ (7,360) (3,978)
Deferred income taxes, net ................................................... 2,808 2,065
Reinsurance and other payables to affiliates ................................. 82 (884)
Prepaid reinsurance premiums ................................................. (3,586) (2,381)
Other assets and liabilities, net ............................................ (4,516) (335)
--------- ---------
Net cash provided by operating activities .................................. 36,990 12,385
--------- ---------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases .................................................................... (107,363) (72,060)
Maturities ................................................................... 69,426 43,556
Sales ........................................................................ 36,382 33,287
Purchases of equity securities .................................................. (17,786) (4,446)
Proceeds from the sale of equity securities ..................................... 1,465 505
Changes in short-term investments ............................................... (982) 9,414
Purchases of property and equipment ............................................. (2,120) (1,974)
Changes in receivables/payables for securities sold/purchased, net .............. (10,939) 14,791
Other, net ...................................................................... 118 86
--------- ---------
Net cash provided by (used in) investing activities ........................ (31,799) 23,159
--------- ---------
FINANCING ACTIVITIES:
Principal payments on long-term debt ............................................ -- (25,000)
Dividends to stockholders ....................................................... (6,431) (10,257)
Issuance of treasury stock to employee stock purchase plan ...................... 59 --
Employee stock option exercises ................................................. 1,266 194
--------- ---------
Net cash used in financing activities ...................................... (5,106) (35,063)
--------- ---------
Increase in cash .................................................................. 85 481
Cash at beginning of period ....................................................... 13,159 5,950
--------- ---------
Cash at end of period ............................................................. $ 13,244 $ 6,431
========= =========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest ..................................................................... $ 1,195 $ 2,537
Income taxes ................................................................. $ 7,000 $ 12,650
The accompanying notes are an integral part of these condensed
consolidated financial statements.
7
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2002
(Unaudited)
1. Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of CNA Surety
Corporation and all majority-owned subsidiaries.
Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America ("GAAP") requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
Basis of Presentation
These unaudited Condensed Consolidated Financial Statements should be read
in conjunction with the Consolidated Financial Statements and Notes thereto
included in the Company's 2001 Annual Report to Shareholders. Certain financial
information that is normally included in annual financial statements prepared in
accordance with GAAP, is not required for interim reporting and has been
condensed or omitted. The accompanying unaudited Condensed Consolidated
Financial Statements reflect, in the opinion of management, all adjustments
necessary for a fair presentation of the interim financial statements. All such
adjustments are of a normal and recurring nature. The financial results for
interim periods may not be indicative of financial results for a full year.
Certain reclassifications have been made to the 2001 Financial Statements to
conform with the presentation in the 2002 Condensed Consolidated Financial
Statements.
Accounting Changes
In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 141 and No. 142
entitled "Business Combinations" ("SFAS No. 141") and "Goodwill and Other
Intangible Assets" ("SFAS No. 142"), respectively. SFAS No. 141 requires that
the purchase method of accounting be used for all business combinations
subsequent to June 30, 2001 and specifies criteria for recognizing intangible
assets acquired in a business combination. The Company will adopt this standard
for any future business combinations. SFAS No. 142 requires that goodwill and
intangible assets with indefinite useful lives no longer be amortized, but
instead be tested for impairment at least annually. Any impairment loss for the
excess of the carrying amount of an intangible asset over its fair value would
be recognized as a charge to operations. Intangible assets with definite useful
lives will continue to be amortized over their respective estimated useful
lives. The Company has adopted the provisions of Statement No. 142 effective
January 1, 2002.
Although all of the Company's 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 or operating segments - contract surety and commercial surety,
which also includes fidelity bonds and other insurance products for these
purposes. These two operating segments are comprised of five components: large
commercial, small commercial, large contract, small contract and international
contract and commercial. The small, large and international components of
8
commercial have been aggregated into one operating segment (reporting unit) and
the small, large and international components of contract have been aggregated
into one operating segment (reporting unit) because of their similar economic
characteristics.
The goodwill test for impairment consists of a two-step process that begins
with an estimation of the fair value of the entity's reporting units. The first
step of the test is a screen for potential impairment and the second step
measures the amount of impairment, if any. SFAS No. 142 required an entity to
complete the first step of the transitional goodwill impairment test within six
months of adopting the Statement. In accordance with SFAS No. 142, the Company
identified two reporting units which constitute components of its business that
include goodwill.
The Company completed the first step of the transitional goodwill
impairment test as of June 30, 2002 and has determined that the fair value of
each reporting unit exceeded the reporting unit's carrying amount, and as such
no impairment was taken.
In accordance with the transition guidance provided in SFAS No. 142, the
Company has classified its intangible assets as intangibles with indefinite
lives and has completed its initial impairment test. No asset impairment was
indicated for these indefinite lived intangibles.
In determining whether there is an impairment of goodwill or other
intangible assets, the Company calculated its estimated fair value using the
present value of estimated expected future cash flows. The resulting estimated
fair value was then compared to the net book value, including goodwill. If the
net book value exceeded the estimated fair value, the Company would have
measured the amount of impairment loss by comparing the implied estimated fair
value of goodwill with the carrying amount of that goodwill. To the extent that
the carrying amount of the goodwill exceeds its implied fair value, a goodwill
impairment loss would be recognized. This impairment test will be performed
annually and whenever facts and circumstances indicate that there is a possible
impairment of goodwill. The Company believes the methodology it uses in testing
impairment of goodwill provides a reasonable basis in determining whether an
impairment charge should be taken.
The adoption of this standard eliminated the Company's amortization of
goodwill and intangibles as of December 31, 2001 and therefore, increased the
Company's reported second quarter and six month net income by $1.5 million, or 3
cents per share, and $2.9 million, or 7 cents per share, respectively, as
compared to the prior year. If the provisions of this standard were applied to
prior periods, net income for the first three and six month periods ended June
30, 2001 would have been $13.8 million, or $0.33 per share $27.2 million, or
$0.64 per share.
In October 2001, the FASB issued SFAS No. 144 entitled "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"). SFAS No. 144
addresses accounting and reporting for the impairment or disposal of long-lived
assets. This statement supersedes FASB Statement No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of."
The provisions of this statement were effective for CNA Surety beginning January
1, 2002. The initial adoption of this standard had no impact on the Company's
financial position or results of operations.
9
2. Investments
The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety at June 30, 2002 and December 31, 2001, by
investment category, were as follows (dollars in thousands):
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
June 30, 2002 or Cost Gains Losses Value
- ------------- ----------------- -------------- ------------- --------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury ............................... $ 14,611 $ 690 $ (1) $ 15,300
U.S. Agencies ............................... 22,940 2,702 (3) 25,639
Collateralized mortgage obligations ......... 264 4 -- 268
Mortgage pass-through securities ............ 25,376 562 (1) 25,937
Obligations of states and political subdivisions . 296,082 11,369 (59) 307,392
Corporate bonds .................................. 73,419 3,264 (147) 76,536
Non-agency collateralized mortgage obligations ... 11,506 240 (19) 11,727
Other asset-backed securities:
Second mortgages/home equity loans ............. 5,441 307 -- 5,748
Credit card receivables ........................ 7,000 305 -- 7,305
Manufactured housing ........................... 7,095 395 (8) 7,482
Other .......................................... 1,009 138 -- 1,147
Redeemable preferred stock ....................... 2,356 453 -- 2,809
---------- ---------- ---------- ----------
Total fixed income securities ............... 467,099 20,429 (238) 487,290
Equity securities ................................ 58,377 2,646 (12,825) 48,198
---------- ---------- ---------- ----------
Total ....................................... $ 525,476 $ 23,075 $ (13,063) $ 535,488
========== ========== =========== ==========
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
December 31, 2001 or Cost Gains Losses Value
- ----------------- ----------------- -------------- ------------- --------------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S. Government and agencies:
U.S. Treasury ............................... $ 24,751 $ 561 $ (5) $ 25,307
U.S. Agencies ............................... 67,539 2,119 (706) 68,952
Collateralized mortgage obligations ......... 411 4 (1) 414
Mortgage pass-through securities ............ 22,165 231 -- 22,396
Obligations of states and political subdivisions . 217,757 5,029 (1,987) 220,799
Corporate bonds .................................. 71,029 2,007 (656) 72,380
Non-agency collateralized mortgage obligations ... 12,898 132 (405) 12,625
Other asset-backed securities:
Second mortgages/home equity loans ............. 15,784 537 -- 16,321
Credit card receivables ........................ 10,000 327 -- 10,327
Manufactured housing ........................... 7,314 342 (20) 7,636
Other .......................................... 1,019 108 -- 1,127
Redeemable preferred stock ....................... 13,435 122 -- 13,557
---------- ---------- ---------- ----------
Total fixed income securities ............... 464,102 11,519 (3,780) 471,841
Equity securities ................................ 42,614 2,620 (9,480) 35,754
---------- ---------- ---------- ----------
Total ....................................... $ 506,716 $ 14,139 $ (13,260) $ 507,595
========== ========== =========== ==========
10
3. Reinsurance
The effect of reinsurance on the Company's written and earned premium was
as follows (dollars in thousands):
Three Months Ended June 30,
-------------------------------------------------------
2002 2001
------------------------- --------------------------
Written Earned Written Earned
----------- ----------- ----------- -----------
Direct .......... $ 36,521 $ 32,975 $ 31,499 $ 29,386
Assumed ......... 58,931 51,961 54,283 52,464
Ceded ........... (9,057) (9,194) (4,958) (3,000)
----------- ----------- ----------- -----------
$ 86,395 $ 75,742 $ 80,824 $ 78,850
=========== =========== =========== ===========
Six Months Ended June 30,
-------------------------------------------------------
2002 2001
------------------------- --------------------------
Written Earned Written Earned
----------- ----------- ----------- -----------
Direct .......... $ 73,293 $ 64,688 $ 64,156 $ 57,006
Assumed ......... 104,273 101,502 97,110 104,086
Ceded ........... (26,778) (23,227) (7,815) (5,493)
----------- ----------- ----------- -----------
$ 150,788 $ 142,963 $ 153,451 $ 155,599
=========== =========== =========== ===========
Assumed premiums primarily includes all surety business written or renewed,
net of reinsurance, by CCC and CIC, and their affiliates, after the September
30, 1997 merger ("Merger Date") of CCC Surety Operations and Capsure Holdings
Corp. that is reinsured by Western Surety pursuant to intercompany reinsurance
and related agreements.
The Company's ceded reinsurance program changed significantly in 2002 as
compared to 2001. As a result, ceded written and earned premiums increased in
the three and six month periods of 2002 as compared to the same periods in 2001.
Ceded written premiums increased $4.1 million and $19.0 million to $9.1 million
and $26.8 million, respectively, for the three and six month periods ended June
30, 2002. The increase in ceded written premiums for the second quarter included
$7.5 million for the Company's new $40 million excess of $20 million per
principal excess of loss coverage. The increase in ceded written premiums for
the six months ended June 30, 2002 included $15.0 million for the Company's new
$40 million excess of $20 million per principal excess of loss coverage and $8.5
million for the purchase of extended discovery coverage on the Company's $55
million excess of $5 million per principal excess of loss coverage that was in
place for 2001.
The material differences between the new excess of loss reinsurance program
and the Company's 2001 program are as follows. The annual aggregate coverage
decreased from $115 million in 2001 to $100 million in 2002 with a sub-limit of
$60 million for large commercial accounts. The minimum annual premium for the
2002 excess of loss treaty is $30.0 million compared to $17.2 million of
reinsurance premiums paid in 2001. The 2002 excess of loss treaty provides the
Company with coverage on a per principal basis of 90% of $40 million excess of
$20 million retained by the Company. The higher net retention per principal
together with other changes in reinsurance coverage associated with the 2002
excess of loss reinsurance contract and the extended discovery and related
provisions of the excess of loss reinsurance contract in place for 2001 may
increase the variability of the Company's future results of operations and cash
flows.
11
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):
Three Months Ended June 30,
-------------------------------------------------------
2002 2001
------------------------- --------------------------
$ Ratio $ Ratio
----------- ----------- ----------- ------------
Gross losses and loss adjustment expenses ................... $ 23,092 27.2% $ 25,622 31.3%
Ceded amounts ............................................... (3,486) 37.9 (8,809) 293.5
----------- --------- ----------- ----------
Net losses and loss adjustment expenses ..................... $ 19,606 25.9% $ 16,813 21.3%
=========== ========= =========== ==========
Six Months Ended June 30,
-------------------------------------------------------
2002 2001
------------------------- --------------------------
$ Ratio $ Ratio
----------- ----------- ----------- ------------
Gross losses and loss adjustment expenses ................... $ 41,156 24.8% $ 50,684 31.5%
Ceded amounts ............................................... (4,903) 21.1 (17,785) 323.8
----------- --------- ----------- ----------
Net losses and loss adjustment expenses ..................... $ 36,253 25.4% $ 32,899 21.1%
=========== ========= =========== ==========
4. Reserves for Losses and Loss Adjustment Expenses
Activity in the reserves for unpaid losses and loss adjustment expenses was
as follows (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------- -----------------------------
2002 2001 2002 2001
--------------- ------------- ------------- ---------------
Reserves at beginning of period:
Gross ..................................................... $ 312,225 $ 212,014 $ 315,811 $ 204,457
Ceded reinsurance ......................................... 154,043 76,651 166,318 70,159
---------- ---------- ---------- ----------
Net reserves at beginning of period ..................... 158,182 135,363 149,493 134,298
---------- ---------- ---------- ----------
Net incurred loss and loss adjustment expenses:
Provision for insured events of current period ........... 18,679 16,674 35,344 33,054
Increase (decrease) in provision for insured events of
prior periods ............................................ 927 139 909 (155)
---------- ---------- ---------- ----------
Total net incurred .................................... 19,606 16,813 36,253 32,899
---------- ---------- ---------- ----------
Net payments attributable to:
Current period events .................................... 1,156 7,233 3,073 7,238
Prior period events ...................................... 16,559 13,548 22,600 28,564
---------- ---------- ---------- ----------
Total net payments .................................... 17,715 20,781 25,673 35,802
---------- ---------- ---------- ----------
Net reserves at end of period .............................. 160,073 131,395 160,073 131,395
Ceded reinsurance at end of period ......................... 148,673 75,128 148,673 75,128
---------- ---------- ---------- ----------
Gross reserves at end of period ....................... $ 308,746 $ 206,523 $ 308,746 $ 206,523
========== ========== ========== ==========
5. Legal Proceedings
The Company is party to various lawsuits arising in the normal course of
business, some seeking material damages. The Company believes the resolution of
these lawsuits will not have a material adverse effect on its financial
condition or its results of operations.
12
CNA SURETY CORPORATION AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
General
The following is a discussion and analysis of CNA Surety Corporation ("CNA
Surety" or the "Company") and its 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. Management believes the most significant accounting policies
and related disclosures for purposes of understanding the Company's results of
operations and financial condition pertain to deferred acquisition costs,
reinsurance and reserves for unpaid losses and loss adjustment expenses. The
Company's accounting policies related to reserves for unpaid losses and loss
adjustment expenses and related estimates of reinsurance recoverables, are
particularly critical to an assessment of the Company's financial results. These
areas are highly subjective and require management's most complex judgments
because of the need to make estimates about the effects of matters that are
inherently uncertain. For these reasons, disclosure on these topics is contained
in Item 1. Business of the Company's 2001 Annual Report on Form 10-K as well as
in the Management's Discussion and Analysis of Financial Condition and Results
of Operations and Consolidated Financial Statements and notes thereto within the
2001 Annual Report to Shareholders. Refer to the 2001 Annual Report to
Shareholders Note 1, Significant Accounting Policies, and Notes 7 and 8,
Reinsurance and Reserves for Losses and Loss Adjustment Expenses, respectively,
for further discussion.
Formation of CNA Surety 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 64% of the outstanding
common stock of CNA Surety. Loews Corporation owns approximately 90% of the
outstanding common stock of CNAF. The principal operating subsidiaries of CNAF
that wrote the surety line of business for their own account prior to the Merger
were Continental Casualty Company and its property and casualty affiliates
(collectively, "CCC") and The Continental Insurance Company and its property and
casualty affiliates (collectively, "CIC"). CIC was acquired by CNAF on May 10,
1995. The combined surety operations of CCC and CIC are referred to herein as
CCC Surety Operations.
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"). 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.
13
Business
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 35,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety and
USA. The insurance subsidiaries write, on a direct basis or as business assumed
from CCC and CIC, small fidelity and non-contract surety bonds, referred to as
commercial bonds; small, medium and large contract bonds; and errors and
omissions ("E&O") liability insurance. Western Surety is a licensed insurer in
all 50 states, the District of Columbia and Puerto Rico. USA is licensed in 44
states and the District of Columbia. Western Surety's affiliated company, Surety
Bonding Company of America ("SBCA"), is licensed in 28 states and the District
of Columbia.
"Safe Harbor" Statement under the Private Securities Litigation Reform Act
of 1995
The statements which are not historical facts contained in this Form 10-Q
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.
Results of Operations
CNA Surety Results for Three- and Six- Months Ended June 30, 2002 and 2001
The components of net income for the Company for the three and six months
ended June 30, 2002 and 2001 are summarized as follows (dollars in thousands,
except per share amounts):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------ -------------------------------
2002 2001 2002 2001
--------------- -------------- --------------- ---------------
Total revenues ..................................... $ 84,464 $ 86,522 $ 158,513 $ 170,977
========== ========== ========== ==========
Underwriting income ................................ $ 10,542 $ 13,853 $ 19,564 $ 27,679
Net investment income .............................. 7,121 7,480 14,227 15,215
Net realized investment gains ...................... 1,601 192 1,323 163
Interest expense ................................... 445 957 903 2,545
Amortization of intangible assets .................. -- 1,524 -- 3,048
---------- ---------- ---------- ----------
Income before income taxes ......................... 18,819 19,044 34,211 37,464
Income taxes ....................................... 5,917 6,701 10,752 13,177
---------- ---------- ---------- ----------
Net income ......................................... $ 12,902 $ 12,343 $ 23,459 $ 24,287
========== ========== ========== ==========
Net income per share ............................... $ 0.30 $ 0.29 $ 0.55 $ 0.57
========== ========== ========== ==========
14
Insurance Underwriting
Underwriting results for the Company for the three and six months ended
June 30, 2002 and 2001 are summarized in the following table (dollars in
thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------ -------------------------------
2002 2001 2002 2001
-------------- --------------- --------------- ---------------
Gross written premiums .............................. $ 95,452 $ 85,782 $ 177,566 $ 161,266
========= ========= ========= =========
Net written premiums ................................ $ 86,395 $ 80,824 $ 150,788 $ 153,451
========= ========= ========= =========
Net earned premiums ................................. $ 75,742 $ 78,850 $ 142,963 $ 155,599
Net losses and loss adjustment expenses ............. 19,606 16,813 36,253 32,899
Net commissions, brokerage and other ................ 45,594 48,184 87,146 95,021
--------- --------- --------- ---------
Underwriting income ................................. $ 10,542 $ 13,853 $ 19,564 $ 27,679
========= ========= ========= =========
Loss ratio ............................................ 25.9% 21.3% 25.4% 21.1%
Expense ratio ......................................... 60.2 61.1 60.9 61.1
--------- --------- --------- ---------
Combined ratio ........................................ 86.1% 82.4% 86.3% 82.2%
========= ========= ========= =========
Premiums Written
CNA Surety primarily markets contract and commercial surety bonds. Contract
surety bonds generally secure a contractor's performance and/or payment
obligation with respect to a construction project. Contract surety bonds are
generally required by federal, state and local governments for public works
projects. The most common types include bid, performance and payment bonds.
Commercial surety bonds include all surety bonds other than contract and cover
obligations typically required by law or regulation. The commercial surety
market includes numerous types of bonds categorized as court judicial, court
fiduciary, public official, license and permit and many miscellaneous bonds that
include guarantees of financial performance. The Company also writes fidelity
bonds which cover losses arising from employee dishonesty and other insurance
products.
Gross written premiums are shown in the table below (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------ -------------------------------
2002 2001 2002 2001
--------------- -------------- --------------- ---------------
Contract ........................................... $ 53,890 $ 48,012 $ 93,270 $ 86,344
Commercial ......................................... 34,897 31,432 69,985 60,423
Fidelity and other ................................. 6,665 6,338 14,311 14,499
---------- ---------- ---------- ----------
$ 95,452 $ 85,782 $ 177,566 $ 161,266
========== ========== ========== ==========
Gross written premiums increased 11.3%, or $9.7 million, for the three
months ended June 30, 2002 over the comparable period in 2001. Gross written
premiums for contract surety increased 12.2%, or $5.9 million, reflecting
strength in public construction spending for the first half of 2002. Gross
written premiums for commercial surety increased 11.0%, or $3.5 million, for the
three months ended June 30, 2002 reflecting continued volume growth of small
commercial products and improving rates on large commercial exposures partially
offset by the impacts of the Company's ongoing efforts to reduce aggregate
exposures on large commercial bonds. The estimated impact of the Company's
exposure reduction efforts to date represents approximately $6 million in annual
premium, assuming an average rate per $1,000 of bond exposure of $2.90, or 29
basis points. Fidelity and other products increased 5.2% to
15
$6.7 million for the three months ended June 30, 2002 as compared to the same
period in 2001 due primarily to an increase in fidelity business partially
offset by the discontinuance of the Company's agents' E&O business.
Gross written premiums increased 10.1%, or $16.3 million, for the six
months ended June 30, 2002 over the comparable period in 2001. Gross written
premiums for commercial surety and contract surety increased 15.8%, or $9.6
million, and 8.0%, or $6.9 million, respectively for the six months ended June
30, 2002 reflecting trends comparable to the quarter. Fidelity and other
products decreased 1.3% to $14.3 million for the six months ended June 30, 2002
as compared to the same period in 2001 due primarily to the discontinuance of
the Company's agents' E&O business.
Net written premiums are shown in the table below (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------ -------------------------------
2002 2001 2002 2001
--------------- -------------- --------------- ---------------
Contract .................. $ 49,947 $ 43,512 $ 81,182 $ 79,279
Commercial ................ 30,094 30,974 55,943 59,673
Fidelity and other ........ 6,354 6,338 13,663 14,499
---------- ---------- ---------- ----------
$ 86,395 $ 80,824 $ 150,788 $ 153,451
========== ========== ========== ==========
For the three months ended June 30, 2002, net written premiums increased
6.9% to $86.4 million as compared to the same period in 2001, reflecting the
aforementioned gross production changes partially offset by higher reinsurance
costs. Ceded written premiums increased $4.1 million to $9.1 million for the
three months ended June 30, 2002. Ceded written premiums in the current quarter
include $7.5 million for the Company's new $40 million excess of $20 million per
principal excess of loss coverage. Net written premiums for contract surety
business increased 14.8% to $49.9 million. Net written premiums for commercial
surety decreased 2.8% to $30.1 million for the three months ended June 30, 2002.
The fidelity and other products increased 0.3% to $6.4 million, for the three
months ended June 30, 2002 as compared to the same period in 2001.
For the six months ended June 30, 2002, net written premiums decreased 1.7%
to $150.8 million as compared to the same period in 2001, reflecting the effects
of higher reinsurance costs and the Company's efforts to reduce large commercial
bond exposures. Ceded written premiums increased $19.0 million to $26.8 million
for the six months ended June 30, 2002. Ceded written premiums for the first six
months of 2002 include $15.0 million for the Company's new $40 million excess of
$20 million per principal excess of loss coverage and $8.5 million for the
purchase of extended discovery coverage on our $55 million excess of $5 million
per principal excess of loss coverage that was in place for 2001. Net written
premiums for contract surety business increased 2.4% to $81.2 million. Net
written premiums for commercial surety decreased 6.2% to $55.9 million for the
first six months in 2002. The fidelity and other products decreased 5.8% to
$13.7 million, for the first six months in 2002 as compared to the same period
in 2001.
The material differences between the new excess of loss reinsurance program
and the Company's 2001 program are as follows. The annual aggregate coverage
decreases from $115 million in 2001 to $100 million in 2002 with a sub-limit of
$60 million for large commercial accounts. The minimum annual premium for the
2002 excess of loss treaty is $30.0 million compared to $17.2 million of
reinsurance premiums paid in 2001. The 2002 excess of loss treaty provides the
Company with coverage on a per principal basis of 90% of $40 million excess of
$20 million retained by the Company. The higher net retention per principal
together with other changes in reinsurance coverage associated with the 2002
excess of loss reinsurance contract and the extended discovery and related
provisions of the excess of loss
16
reinsurance contract in place for 2001 may increase the variability of the
Company's future results of operations and cash flows.
Underwriting Income
Underwriting income decreased 23.9% to $10.5 million for the three months
ended June 30, 2002 compared to $13.9 million for the same period in 2001.
Underwriting income decreased 29.3% to $19.6 million for the six months ended
June 30, 2002 compared to the same period in 2001. These decreases are primarily
due to the impact of increased reinsurance costs on net earned premium partially
offset by reduced acquisition and underwriting expenses.
Net Loss Ratio
The net loss ratios for the three months ended June 30, 2002 and 2001 were
25.9% and 21.3%, respectively. The loss ratios included $0.9 million and $0.1
million of net unfavorable loss reserve development for the three months ended
June 30, 2002 and 2001, respectively. Excluding the impact of loss reserve
development, the loss ratios would have been 24.7% and 21.2% for the period
ended June 30, 2002 and June 30, 2001, respectively. For the six months ended
June 30, 2002 and 2001, the loss ratios were 25.4% and 21.1%, respectively. The
loss ratios included $0.9 million of net unfavorable reserve development and
$0.2 million of net favorable reserve development for the six months ended June
30, 2002 and 2001, respectively. Excluding the impact of loss reserve
development, the loss ratios would have been 24.7% and 21.2% for the six month
periods ended June 30, 2002 and June 30, 2001, respectively. The increases in
the adjusted loss ratio for the three and six month periods in 2002 relate
primarily to the estimated impact of the Company's $15 million higher per
principal net retention on the Company's net loss ratio. The Company is using an
initial 2002 accident year net loss ratio of 30.0 percent for the medium to
large commercial and contract branch business compared to 22.5 percent when the
per principal retention was $5 million. This business represents about 61% of
the Company's gross premiums.
Expense Ratio
The expense ratio decreased to 60.2% for the three months ended June 30,
2002 compared to 61.1% for the same period in 2001. For the six months ended
June 30, 2002, the expense ratio decreased to 60.9% from 61.1% for the same
period in 2001. The decrease in the expense ratio for the three- and six- months
ended June 30, 2002 primarily reflects reduced acquisition and underwriting
expenses partially offset by the effect of higher reinsurance costs on net
earned premiums. Net earned premiums declined 3.9% and 8.1% and operating
expenses decreased at a higher rate of 5.4% and 8.3% for the three and six
months ended June 30, 2002, respectively.
Investment Income
For the three months ended June 30, 2002, net investment income was $7.1
million compared to net investment income for the three months ended June 30,
2001 of $7.5 million. The 4.8% decrease in investment income primarily reflects
the impact of lower investment yields. The annualized pretax yields for the
Company's equity and fixed income portfolio were 5.0% and 5.5% for the three
months ended June 30, 2002 and 2001, respectively. The annualized after-tax
yields for the Company's equity and fixed income portfolio were 3.9% and 4.0%
for the three months ended June 30, 2002 and 2001. Net investment income for the
six months ended June 30, 2002 and 2001 was $14.2 million and $15.2 million,
17
respectively. The average pretax yields were 5.0% and 5.6% for the six months
ended June 30, 2002 and 2001. The annualized after-tax yields for the Company's
equity and fixed income portfolio were 3.8% and 4.1% for the six months ended
June 30, 2002 and 2001, respectively.
Net realized investment gains were approximately $1.6 million and $1.3
million for the three and six months ended June 30, 2002 compared to $0.2
million for each of the same periods in 2001.
Analysis of Other Operations
As of January 1, 2002, the Company adopted SFAS No. 142 which requires that
goodwill and intangible assets with indefinite useful lives no longer be
amortized, but instead be tested for impairment at least annually. The periodic
amortization of goodwill and intangibles ceased as of December 31, 2001.
Amortization expense was $1.5 million and $3.0 million for the three and six
months ended June 30, 2001. The Company completed its goodwill-related
impairment tests by June 30, 2002 and no impairment was indicated. Any future
impairment loss for the excess of the carrying amount of an intangible asset
over its fair value would be recognized as a charge to operations. Intangible
assets primarily represent goodwill and identified intangibles arising from the
acquisition of Capsure.
Interest expense decreased 53.5% for the second quarter of 2002 as compared
to the same period in 2001, primarily due to lower interest rates. Average debt
outstanding was $76.2 million for the second quarter in 2002 compared to $78.0
million in the second quarter of 2001. The weighted average interest rate for
the three months ended June 30, 2002 was 2.1% compared to 4.7% for the same
period in 2001. Interest expense decreased 64.5% for the first six months of
2002 as compared to the same period in 2001. Average debt outstanding was $76.2
million for the first six months in 2002 compared to $89.4 million in the first
six months of 2001. The weighted average interest rate for the six months ended
June 30, 2002 was 2.2% compared to 5.4% for the same period in 2001.
Income Taxes
Income tax expense was $5.9 million and $6.7 million and the effective
income tax rates were 31.4% and 35.2% for the three months ended June 30, 2002
and 2001, respectively. For the six months ended June 30, 2002 and 2001, income
tax expense was $10.8 million and $13.2 million and the effective income tax
rates were 31.4% and 35.2%, respectively. The decrease in the estimated
effective tax rate in 2002 primarily relates to the adoption of SFAS No. 142
which ended the periodic amortization the Company's goodwill and intangibles.
18
Liquidity and Capital Resources
It is anticipated that the liquidity requirements of CNA Surety will be met
primarily by funds generated from operations. The principal sources of operating
cash flows are premiums, investment income, and sales and maturities of
investments. CNA Surety also may generate funds from additional borrowings under
the credit facility described below. The primary cash flow uses are payments for
claims, operating expenses, federal income taxes, debt service 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 June 30, 2002, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $481.5 million of fixed income
securities, $47.6 million of equity securities, $33.7 million of short-term
investments, $5.1 million of other investments and $8.2 million of cash. At
December 31, 2001, he carrying value of the Company's insurance subsidiaries'
invested assets was comprised of $466.6 million of fixed income securities,
$35.8 million of equity securities, $38.9 million of short-term investments,
$5.3 million of other investments and $0.8 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, including income taxes, and pay dividends to stockholders. At June 30,
2002, the parent company's invested assets consisted of $5.8 million of fixed
income securities, $0.6 million of equity securities, $20.9 million of
short-term investments and $5.0 million of cash. At December 31, 2001, the
parent company's invested assets consisted of $5.2 million of fixed income
securities, $14.7 million of short-term investments and $2.4 million of cash. As
of June 30, 2002 and December 31, 2001, parent company short-term investments
and cash included $10.7 million and $13.8 million, respectively, of restricted
cash related to premium receipt collections ultimately due to the Company's
insurance subsidiaries.
The Company's consolidated net cash flow provided by operating activities
was $37.0 million for the six months ended June 30, 2002 and $12.4 million for
the comparable period in 2001. The increase in net cash flow provided by
operating activities primarily relates to collections of reinsurance
recoverables and an increase in unearned premium reserves.
CNA Surety's bank borrowings are under a five-year unsecured revolving
credit facility effective September 30, 1997 (the "Credit Facility") that
provides for borrowings of up to $130 million. As of June 30, 2002, the Company
has unused capacity under the revolver of approximately $55 million. The Company
paid down outstanding borrowings under the Credit Facility by $10 million to $65
million on July 29, 2002.
The Credit Facility matures September 30, 2002. The Company is currently in
discussions with members of its bank group and other lenders regarding the
renewal or refinancing of the $65 million in outstanding borrowings under the
Credit Facility. The Company expects to refinance its outstanding borrowings but
anticipates the interest cost will be significantly higher than under the
expiring Credit Facility.
The interest rate on borrowings under the Credit Facility may be fixed, at
CNA Surety's option, for a
19
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, was 0.30% at March 31, 2002 and can vary based on
CNA Surety's leverage ratio (debt to total capitalization) from 0.25% to 0.40%.
As of June 30, 2002, the weighted average interest rate was 2.1% on the $75
million of outstanding borrowings. As of December 31, 2001, the weighted average
interest rate was 2.5% on the $75.0 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 June 30, 2002, 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 by September 30, 2002 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.
In 1999 CNA Surety acquired certain assets of Clark Bonding Company, Inc.,
a Charlotte, North Carolina, insurance agency and brokerage doing business as
The Bond Exchange for $5.9 million. As part of this acquisition, the Company
incurred an additional $1.9 million of debt in the form of a promissory note.
The promissory note matures on July 27, 2004 and has an interest rate of 5.0%.
The balance of this promissory note at June 30, 2002 was $1.2 million.
As an insurance holding company, CNA Surety is dependent upon dividends and
other permitted payments from its insurance subsidiaries to pay operating
expenses, meet debt service requirements, as well as to pay cash dividends. The
payment of dividends by the insurance subsidiaries is subject to varying degrees
of supervision by the insurance regulatory authorities in South Dakota and
Texas. In South Dakota, where Western Surety and SBCA are domiciled, insurance
companies may only pay dividends from earned surplus excluding surplus arising
from unrealized capital gains or revaluation of assets. In Texas, where USA is
domiciled, an insurance company may only declare or pay dividends to
stockholders from the insurer's earned surplus. The insurance subsidiaries may
pay dividends without obtaining prior regulatory approval only if such dividend
or distribution (together with dividends or distributions made within the
preceding 12-month period) is less than, as of the end of the immediately
preceding year, the greater of (i) 10% of the insurer's surplus to policyholders
or (ii) statutory net income. In South Dakota, net income includes net realized
capital gains in an amount not to exceed 20% of net unrealized capital gains.
All dividends must be reported to the appropriate insurance department prior to
payment.
The dividends that may be paid without prior regulatory approval are
determined by formulas established by the applicable insurance regulations, as
described above. The formulas that determine dividend capacity in the current
year are dependent on, among other items, the prior year's ending statutory
surplus and statutory net income. Dividend capacity for 2002 is based on
statutory surplus and income at and for the year ended December 31, 2001.
Without prior regulatory approval in 2002, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $51.5 million in the aggregate. CNA Surety
received $12.0 million and $35.0 million in dividends from its insurance
subsidiaries during the first six months of 2002 and 2001, respectively.
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 $3.5 million for the six months ended June 30,
2002 and $12.2 million for the same period in 2001.
20
Western Surety, SBCA and USA each qualifies as an acceptable surety for
federal and other public works project bonds pursuant to U.S. Department of
Treasury regulations. The underwriting limitations of Western Surety, SBCA and
USA, based on each insurer's statutory surplus, were $16.9 million, $0.4 million
and $1.7 million, respectively, for the twelve month period ended June 30, 2002.
Effective July 1, 2002 through June 30, 2003, the underwriting limitations of
Western Surety, SBCA and USA are $20.7 million, $0.5 million and $1.3 million,
respectively. Through the Quota Share Reinsurance Agreement between CCC and
Western Surety Company, CNA Surety has access to CCC and its affiliates' U.S.
Department of Treasury underwriting limitations. The Quota Share Reinsurance
Agreement expires on September 30, 2002. CCC is under no obligation to renew the
Quota Share Reinsurance Agreement, CNA Surety management believes that the
Agreement will be renewed, although certain terms may change and the cost may
increase. A failure to renew the Quota Share Treaty or a renewal on
substantially different terms may have a material adverse impact on the
Company's future results of operations. The underwriting limitations of CCC and
its affiliates totaled $616.0 million for the twelve months ended June 30, 2002.
Effective July 1, 2002 through June 30, 2003, the underwriting limitations of
CCC and its affiliates total $382.9 million. The decrease in underwriting
limitations for CCC and its affiliates are principally due to decreases in
statutory surplus during 2001 as result of charges associated with changes in
estimates with respect to prior accident year loss reserves and accruals for
retrospective premiums. The CNA Surety management believes that the foregoing US
Treasury underwriting limitations are sufficient for the conduct of its business
and that the reduction in underwriting capacity of CCC and affiliates will not
have a material adverse impact on the Company's results of operations.
CNA Surety management believes that the Company has sufficient available
resources, including capital protection against large losses provided by the
Company's excess of loss reinsurance arrangements, to meet its present capital
needs.
21
CNA SURETY CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings - None.
ITEM 2. Changes in the Rights of the Company's Security Holders - None.
ITEM 3. Defaults Upon Senior Securities - None.
ITEM 4. Submission of Matters to a Vote of Security Holders -
At the Annual Meeting of Shareholders of CNA Surety Corporation
held on May 21, 2002, the Company's shareholders voted on the
following proposals. The numbers of shares issued, outstanding
and eligible to vote as of the record date of March 25, 2002 were
42,873,632. Proxies representing 39,330,870 shares or
approximately 92 percent of the eligible voting shares were
tabulated.
PROPOSAL I
Election of Directors.
Number of Shares/Votes
----------------------
For Authority Withheld
--- ------------------
Giorgio Balzer 39,236,264 94,606
Philip H. Britt 39,262,968 67,902
Robert V. Deutsch 39,170,275 160,595
Edward Dunlop 39,255,575 75,295
Melvin Gray 39,263,068 67,802
Roy E. Posner 39,256,075 74,795
Adrian M. Tocklin 39,204,256 126,614
Mark C. Vonnahme 37,556,119 1,774,751
Peter W. Wilson 39,156,975 173,895
PROPOSAL II
To ratify the Board of Directors' appointment of the Company's
independent auditors, Deloitte & Touche LLP for fiscal year 2002.
For 39,258,220
Against 1,038
Abstain 71,612
22
CNA SURETY CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION (continued)
ITEM 5. Other Information - None.
ITEM 6. Exhibits and Reports on Form 8-K:
(a) Exhibits: - None
(b) Reports on Form 8-K:
May 9, 2002; CNA Surety Corporation Press Release issued
on May 7, 2002.
23
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the Registrant has duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized.
CNA SURETY CORPORATION
(Registrant)
/s/ John S. Heneghan
------------------------
John S. Heneghan
Vice President and Chief
Financial Officer
Date: August 12, 2002