CNA SURETY CORP - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER: 1-13277
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CNA SURETY CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 36-4144905
(STATE OR OTHER JURISDICTION OF INCORPORATION OR (I.R.S. EMPLOYER IDENTIFICATION NO.)
ORGANIZATION)

CNA PLAZA, CHICAGO, ILLINOIS 60685
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

(312) 822-5000
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

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Securities registered pursuant to Section 12(b) of the Act: NONE

Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $0.01 PAR VALUE
(Title of Class)
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [ ]

The aggregate market value of voting stock held by nonaffiliates was $172.9
million based upon the closing price of $11.11 per share on March 5, 2004, using
beneficial ownership of stock rules adopted pursuant to Section 13 of the
Securities Exchange Act of 1934 to exclude voting stock owned by Directors,
Officers and Major Stockholders, some of whom may not be held to be affiliates
upon judicial determination.

At March 5, 2004, 42,991,871 shares of the Registrant's Common Stock were
outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the CNA Surety Corporation Proxy Statement prepared for the
2004 annual meeting of shareholders, pursuant to Regulation 14A, are
incorporated by reference into Part III of this report.

CNA SURETY CORPORATION AND SUBSIDIARIES

TABLE OF CONTENTS

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CNA SURETY CORPORATION AND SUBSIDIARIES

PART I.

ITEM 1. BUSINESS

GENERAL

CNA Surety Corporation ("CNA Surety" or "Company") is an insurance holding
company in the United States formed through the September 30, 1997 combination
of the surety business of CNA Financial Corporation with Capsure Holdings
Corp.'s ("Capsure") insurance subsidiaries. CNA Surety is currently one of the
largest surety providers in the United States with approximately a 9.6% market
share (based upon 2002 A.M. Best written premium data). Its wide selection of
surety products range from very small commercial bonds to large contract bonds.

FORMATION OF CNA SURETY AND MERGER

In December 1996, CNA Financial Corporation ("CNAF") and Capsure agreed to
merge (the "Merger") the surety business of CNAF with Capsure's insurance
subsidiaries, Western Surety Company ("Western Surety") and Universal Surety of
America ("USA"), into CNA Surety. CNAF, through its operating subsidiaries,
writes multiple lines of property and casualty insurance, including surety
business that is reinsured by Western Surety. CNAF owns approximately 64% of the
outstanding common stock of CNA Surety. Loews Corporation ("Loews") owns
approximately 90% of the outstanding common stock of CNAF. The principal
operating subsidiaries of CNAF that wrote the surety line of business for their
own account prior to the Merger were Continental Casualty Company and its
property and casualty affiliates (collectively, "CCC") and The Continental
Insurance Company and its property and casualty affiliates (collectively,
"CIC"). CIC was acquired by CNAF on May 10, 1995. The combined surety operations
of CCC and CIC are referred to herein as CCC Surety Operations.

DESCRIPTION OF BUSINESS

CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 34,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety and
USA. The insurance subsidiaries write, on a direct basis or as business assumed
from CCC and CIC, small fidelity and non-contract surety bonds, referred to as
commercial bonds; small, medium and large contract bonds; and errors and
omissions ("E&O") liability insurance. Western Surety is a licensed insurer in
all 50 states, the District of Columbia and Puerto Rico. USA is licensed in 44
states and the District of Columbia. Western Surety's affiliated company, Surety
Bonding Company of America ("SBCA"), is licensed in 28 states and the District
of Columbia.

FINANCIAL STRENGTH RATINGS

A.M. BEST COMPANY, INC. ("A.M. BEST")

Western Surety is currently rated A (Excellent) with a negative rating
outlook, by A.M. Best. An A (Excellent) rating is assigned to those companies
which A.M. Best believes have an excellent ability to meet their ongoing
obligations to policyholders. A (Excellent) rated insurers have been shown to be
among the strongest in ability to meet policyholder and other contractual
obligations. The rating outlook indicates the potential direction of a company's
rating for an intermediate period, generally defined as the next 12 to 36
months. Through intercompany reinsurance and related agreements, CNA Surety's
customers have access to CCC's broader underwriting capacity. CCC is currently
rated A (Excellent) with a negative outlook by A.M. Best. A.M. Best's letter
ratings range from A++ (Superior) to F (In Liquidation) with A++ being highest.

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STANDARD AND POOR'S ("S&P")

CCC and Western Surety are both currently rated A- (Strong), by S&P. On
August 7, 2003, S&P placed CCC and Western Surety on credit watch with negative
implications. S&P's letter ratings range from AAA+ (Extremely Strong) to CC
(Extremely Weak) with AAA+ being highest. Ratings from "AA" to "CCC" may be
modified by the addition of a plus or minus sign to show relative standing
within the major rating categories. An insurer rated 'A' has strong financial
security characteristics, but is somewhat more likely to be affected by adverse
business conditions than are insurers with higher ratings.

PRODUCT INFORMATION

According to the Surety Association of America ("SAA"), industry estimates
for 2000, approximately 75% of the United States surety market is represented by
bonds required by federal statutes, state laws, and local ordinances. These
bonding requirements range from federal construction projects, where the
contractor is required to post performance and payment bonds which guarantee
performance of contracts to the government as well as payment of bills to
subcontractors and suppliers, to license and permit bonds which guarantee
compliance with legal requirements for business operations.

PRODUCTS AND POLICIES

Unlike a standard, two-party insurance policy, 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.
In addition, sureties are generally entitled to recover from the principal any
losses and expenses paid to third parties. The surety's responsibility is to
evaluate the risk and determine if the principal meets the underwriting
requirements for the bond. Accordingly, surety bond premiums primarily reflect
the type and class of risk and related costs associated with both processing the
bond transaction and investigating the applicant including, if necessary, an
analysis of the applicant's creditworthiness and ability to perform.

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.

Contract bond guarantee obligations include the following:

Bid bonds: used by contractors submitting proposals on potential
contracts.

Performance bonds: guarantee to the owner the performance of the
contractor's obligations according to the terms and conditions of the
contract.

Payment bonds: guarantee payment of the contractor's obligations under
the contract for labor, subcontractors, and materials supplied to the
project. Payment bonds are utilized in public projects where liens are not
permitted.

Other examples of contract bonds are completion, maintenance and supply
bonds.

Commercial surety business is comprised of bonds covering obligations
typically required by law or regulation, such as the following:

License and Permit bonds: required by statutes or ordinances for a
number of purposes including guaranteeing the payment of certain taxes and
fees and providing consumer protection as a condition to granting licenses
related to selling real estate or motor vehicles and contracting services.

Judicial and Fiduciary bonds: required by statutes, courts or legal
documents for the protection of those on whose behalf a fiduciary acts.
Examples of such fiduciaries include executors and administrators of
estates, and guardians of minors and incompetents.
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Public Official bonds: required by statutes and ordinances to
guarantee the lawful and faithful performance of the duties of office by
public officials.

CNA Surety also writes direct contract and commercial surety bonds for
international risks. Such bonds are written to satisfy the international bond
requirements of domestic customers and for select foreign clients.

In 2000, CNA Surety purchased an equity interest in De Montfort Insurance
Company PLC, a United Kingdom-based insurance company, which specializes in
providing surety bonds and credit insurance. The investment in De Montfort
supports CNA Surety's international growth strategy by enhancing the company's
international distribution capabilities in the European surety marketplace.

In addition, the Company markets surety related products such as fidelity
bonds and errors and omissions ("E&O") insurance. Fidelity bonds cover losses
arising from employee dishonesty. Examples of purchasers of fidelity bonds are
law firms, insurance agencies and janitorial service companies. CNA Surety
writes E&O policies for two classes of insureds: notaries public and tax
preparers. The notary public E&O policy is marketed as a companion product to
the notary public bond and the tax preparer E&O policy is marketed to small tax
return preparation firms.

Although all of its products are sold through the same independent
insurance agent and broker distribution network, the Company's underwriting is
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.

The following tables set forth, for each principal class of bonds, gross
written premiums, net written premiums and number of domestic bonds and policies
in force and the respective percentages of the total for the past three years
(amounts in thousands, except average bond amounts):

- -------------------------

(1) The average bond penalty is a measure of the average limit of liability
associated with bonds in force at each reporting period.

In 2003, no individual agency generated more than 3.1% of aggregate gross
written premiums. Approximately $61.2 million, or 16.5%, of gross written
premiums were generated from national insurance brokers in 2003 with the single
largest national broker production comprising $19.2 million, or 5.2%, of gross
written premiums.

MARKETING

The Company principally markets its products in all 50 states, as well as
the District of Columbia and Puerto Rico. Its products are marketed primarily
through independent producers, including multi-line agents and brokers such as
surety specialists, many of whom are members of the National Association of
Surety Bond Producers. CNA Surety enjoys broad national distribution of its
products, which are marketed through approximately 34,000 of the approximately
44,000 independent property and casualty insurance agencies in the United
States. In addition, the Company employs 41 full-time salaried marketing
representatives and 5 telemarketing representatives to continually service its
vast producer network. Relationships with these independent producers are
maintained through the Company's 42 local branch offices.

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The following table sets forth the distribution of the domestic business of
CNA Surety, by state based upon gross written premiums in each of the last three
years:

Contract Surety

With respect to standard contract surety, the core focus for the Company is
contractors with less than $50 million in contracted work in progress. This
segment is comprised of small contractors (less than $5 million in work in
progress), medium contractors ($5-$30 million) and the lower end of the large
contractors (greater than $30 million). These small and medium contractors, as a
group, represent a significant portion of the United States construction market.
While the Company's emphasis continues to be on small and medium contractors,
the Company's aggregate exposures to very large accounts has increased in recent
years. The Company has approximately 39 very large accounts with contracted work
programs of at least $150 million, the majority of which have been clients of
the Company for more than ten years. The Company is actively reducing both the
number of these large accounts and the exposure on each account through a
variety of underwriting methods. Some of these accounts are maintained on a
"co-surety" or joint insurer basis with other sureties in order to manage
aggregate exposure.

The Company also fulfills the bond requirements of select small and
emerging specialty contractors. For example, CNA Surety participates in the
non-standard contract surety market through the federal government's Small
Business Administration ("SBA") surety bond guarantee programs. These programs
provide that the SBA assumes 70% - 90% of the coverage in exchange for 10% - 30%
of the premium.

Commercial Surety

A large portion of the commercial surety market is comprised of small
obligations that are routine in nature and require minimal underwriting.
Customers are focused principally on prompt and efficient service. These small
transactional bonds represent approximately 73% of the Company's commercial
gross written premiums and 31% of the Company's total gross written premium.

The Company continues to focus its marketing efforts on this small
commercial bond market through its Sioux Falls, South Dakota service center. In
this market segment, CNA Surety emphasizes one-day response service, easy-to-use
forms and an extensive array of commercial bond products. In addition,
independent agents are provided pre-executed bond forms, powers of attorney, and
facsimile authorizations that allow them to issue many standard bonds in their
offices.

CNA Surety also maintains a specific underwriting staff in Chicago
dedicated to middle market and "Fortune 1000" accounts. CNA Surety's insurance
subsidiaries may also direct their marketing to particular industries or classes
of bonds on a broad basis. For instance, the Company maintains programs directed
at

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notary bonds, mortgage broker compliance bonds and grain warehouse dealer bonds
(protecting funds associated with grain storage). The Company's large commercial
account business is estimated to represent approximately 27% of the Company's
commercial gross written premiums and 12% of the Company's total gross written
premium.

UNDERWRITING

CNA Surety is focused on consistent underwriting profitability. The extent
and sophistication of underwriting activity varies by type of risk. Contractor
accounts and large commercial surety customers undergo credit, financial and
managerial review and analysis on a regular basis. Certain classifications of
bonds, such as fiduciary and court appeal bonds, also require more extensive
underwriting.

CNA Surety also targets various products in the surety and fidelity bond
market which are characterized by relatively low-risk exposure and small bond
amounts. The underwriting criteria, including the extent of bonding authority
granted to independent agents, varies depending on the class of business and the
type of bond. For example, relatively little underwriting information is
typically required of certain low-exposure risks such as notary bonds.

COMPETITION

The surety and fidelity market is highly competitive. According to 2002
data from A.M. Best, the U.S. market aggregates approximately $4.8 billion in
direct written premiums, comprised of approximately $3.8 billion in surety
premiums and approximately $1.0 billion in fidelity premiums. The large
diversified insurance companies hold the largest market shares. For example, the
20 largest surety companies account for approximately 81% of the domestic surety
market and 94.6% of the domestic fidelity market. In 2002, CNA Surety was the
third largest surety provider with a 9.6% market share.

Primary competitors of CNA Surety are approximately 20 national, multi-line
companies participating in the surety market throughout the country. Management
believes that its principal strengths are diverse product offerings, service and
accessibility and long-term relationships with agents and accounts. Competition
has increased as a result of ten years of profitable underwriting experience
through 1999. This competition has typically manifested itself through reduced
premium rates and greater tolerance for relaxation of underwriting standards.
Beginning in 2000 and through the end of 2003, the surety industry's
underwriting performance began to be impacted by the significant increases in
corporate defaults. Although premium rates began firming in 2001, particularly
on large accounts due to deteriorating underwriting performance throughout the
surety industry, management believes such competition will continue and impact
the Company's ability to raise rates further.

REINSURANCE

The Company's insurance subsidiaries, in the ordinary course of business,
cede reinsurance to other insurance companies and affiliates. 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
reinsurance contracts. The Company evaluates the financial condition of its
reinsurers, establishes allowances for uncollectible amounts and monitors
concentrations of credit risk.

The Company's reinsurance program is predominantly comprised of excess of
loss reinsurance contracts that limit the Company's retention on a per principal
basis. The Company's reinsurance coverage is provided by third party reinsurers
and related parties. Refer to Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations and Note 6 to the Consolidated
Financial Statements, Reinsurance, for further discussion.

At December 31, 2003, CNA Surety's largest reinsurance receivable from an
affiliate, CCC, an A rated company by A.M. Best, was approximately $18.4
million. At December 31, 2002, CNA Surety's largest

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reinsurance receivable from an affiliate, CCC, an A rated company by A.M. Best,
was approximately $17.6 million.

In addition, due to the nature of the reinsurance products available to the
Company and other sureties, reinsurers may cover principals for whom the Company
writes surety bonds in one year, but then exclude or provide only limited
reinsurance for these same principals in subsequent years. As a result the
Company may continue to have exposure to these principals with limited or no
reinsurance for bonds written during years that the Company had reinsurance
covering these principals.

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 losses and loss
adjustment expenses that give consideration to the inherent difficulty and
variability in the estimation process. In addition, CNA Surety utilizes an
independent actuarial firm of national standing to conduct periodic reviews of
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
period in which such changes are determined to be needed.

A table is included in Note 7 to the Consolidated Financial Statements,
Reserves for Loss and Loss Adjustment Expenses that presents the activity in the
reserves for unpaid losses and loss adjustment expenses for the Company and is
incorporated herein by reference. This table highlights the impact of revisions
to the estimated liability established in prior years.

The following table sets forth a reconciliation of the consolidated loss
reserves reported in accordance with generally accepted accounting principles
("GAAP"), and the reserves reported to state insurance regulatory authorities in
accordance with statutory accounting principles ("SAP") for the year ended
December 31, 2003 (dollars in thousands):

Net reserves at end of year, GAAP basis..................... $ 255,182
Ceded reinsurance, net of salvage and subrogation........... 158,357
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Gross reserves at end of year, GAAP basis................... 413,539
Estimated reinsurance recoverable netted against gross
reserves for SAP.......................................... (158,357)
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Net reserves at end of year, SAP basis...................... $ 255,182
=========

The loss reserve development table below illustrates the change over time
of reserves established for the Company's estimated losses and loss adjustment
expenses at the end of various calendar years. The first section shows the
reserves as originally reported at the end of the stated year. The second
section shows the cumulative amounts paid as of the end of successive years with
respect to that reserve liability. The third section shows re-estimates of the
original recorded reserve as of the end of each successive year which is the
result of management's expanded awareness of additional facts and circumstances
that pertain to the unsettled claims. The last section compares the latest
re-estimated reserve to the reserve originally established, and indicates
whether or not the original reserve was adequate or inadequate to cover the
estimated costs of unsettled claims.

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The loss reserve development table is cumulative as of each December 31,
and, therefore, ending balances should not be added since the amount at the end
of each calendar year includes activity for both the current and prior years.
The loss reserve development table reflects, on a pro forma basis, the reserves
of the CCC Surety Operations and Capsure since 1993 and CIC since its
acquisition in May of 1995. Such historical development is not necessarily
indicative of the financial results that would have occurred under the ownership
and management of CNA Surety or of future operating results.

CLAIMS

Proactive claims management is an important factor for the profitable
underwriting of surety and fidelity products. The Company maintains an
experienced and dedicated staff of in-house claim specialists. Claim handling is
performed in Chicago. The disposition of claims and other claim-related activity
is done in accordance with established policies, procedures and expense controls
designed to minimize loss costs and maximize salvage and subrogation recoveries.
Indemnity and subrogation rights exist on a significant portion of the business
written, enabling the Company to pursue loss recovery from the principal.

ENVIRONMENTAL CLAIMS

The Company does not typically bond contractors that specialize in
hazardous environmental remediation work. The Company does however bond several
accounts that have incidental environmental exposure with

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respect to which the Company provides bonding programs. In the commercial surety
market, the Company provides bonds to large corporations that are in the
business of mining various minerals and are obligated to post reclamation bonds
that guarantee that property which was disturbed during mining is returned to an
acceptable condition when the mining is completed. The Company also provides
court and other surety bonds for large corporations wherein the underlying
action involves environmental related issues. While no environmental
responsibility is overtly provided by commercial or contract bonds, some risk of
environmental exposure may exist if the surety were to assume certain rights in
the completion of a defaulted project or through salvage recovery. The Company
estimates its net case incurred losses on known claims of this nature to be
$11.8 million as of December 31, 2003.

REGULATION

The Company's insurance subsidiaries are subject to varying degrees of
regulation and supervision in the jurisdictions in which they transact business
under statutes that delegate regulatory, supervisory and administrative powers
to state insurance regulators. In general, an insurer's state of domicile has
principal responsibility for such regulation which is designed generally to
protect policyholders rather than investors and relates to matters such as the
standards of solvency which must be maintained; the licensing of insurers and
their agents; the examination of the affairs of insurance companies, including
periodic financial and market conduct examinations; the filing of annual and
other reports, prepared on a statutory basis, on the financial condition of
insurers or for other purposes; establishment and maintenance of reserves for
unearned premiums and losses; and requirements regarding numerous other matters.
Licensed or admitted insurers generally must file with the insurance regulators
of such states, or have filed on its behalf, the premium rates and bond and
policy forms used within each state. In some states, approval of such rates and
forms must be received from the insurance regulators in advance of their use.

Western Surety is domiciled in South Dakota and licensed in all 50 states
and the District of Columbia and Puerto Rico. SBCA is domiciled in South Dakota
and licensed in 28 states and the District of Columbia. USA is domiciled in
Texas and licensed in 44 states and the District of Columbia.

Insurance regulations generally also require registration and periodic
disclosure of certain information concerning ownership, financial condition,
capital structure, general business operations and any material transactions or
agreements by or among affiliates. Such regulation also typically restricts the
ability of any one person to acquire 10% or more, either directly or indirectly,
of a company's stock without prior approval of the applicable insurance
regulatory authority. In addition, dividends and other distributions to
stockholders generally may be paid only out of unreserved and unrestricted
statutory earned surplus. Such distributions may be subject to prior regulatory
approval, including a review of the implications on Risk-Based Capital
requirements. A discussion of Risk-Based Capital requirements for property and
casualty insurance companies is included in both Management's Discussion and
Analysis of Financial Condition and Results of Operations and Note 13 to the
Consolidated Financial Statements, Statutory Financial Data. Without prior
regulatory approval in 2004, CNA Surety's insurance subsidiaries may pay
stockholder dividends of $19.0 million in the aggregate. For the year ended
December 31, 2003, CNA Surety received $28.5 million in dividends from its
insurance subsidiaries.

CNA Surety's insurance subsidiaries are subject to periodic financial and
market conduct examinations. These examinations are generally performed by the
domiciliary state insurance regulatory authorities. The South Dakota Department
of Commerce and Regulation -- Division of Insurance (the "South Dakota
Department") conducted its financial and market conduct examination of Western
Surety for the five-year period ended December 31, 1996. The South Dakota
Department made a finding of non-compliance with respect to the Company's
practices regarding return of premiums and recommended that Western Surety
change its current procedures regarding the return of premiums. The regulation
in question was subsequently amended to exclude surety products that eliminated
any non-compliance by the Company. The Texas Department of Insurance (the "Texas
Department") conducted an examination of USA's financial matters as of December
31, 1996. There were no significant issues noted which required corrective
action by USA. Both the South Dakota Department of Commerce and
Regulation-Insurance Division and the Texas Department of Insurance have
completed their respective reviews of the five-year period ended December 31,
2001. The
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points noted in their reviews were largely administrative in nature and have
been addressed by management. They do not have a material impact policyholders'
surplus, nor have they resulted in any fines or penalties to CNA Surety or any
of its subsidiaries.

Certain states in which CNA Surety's insurance subsidiaries conduct their
business require insurers to join a guaranty association. Guaranty associations
provide protection to policyholders of insurers licensed in such states against
the insolvency of those insurers. In order to provide the associations with
funds to pay certain claims under policies issued by insolvent insurers, the
guaranty associations charge members assessments based on the amount of direct
premiums written in that state. Such assessments were not material to CNA
Surety's results of operations in 2003.

Western Surety and SBCA each qualifies as an acceptable surety for federal
and other public works project bonds pursuant to U.S. Department of Treasury
regulations. U.S. Treasury underwriting limitations are based on an insurer's
statutory surplus. The underwriting limitations of Western Surety, SBCA and USA,
based on each insurer's statutory surplus, were $20.7 million, $0.5 million and
$1.3 million, respectively, for the twelve-month period ended June 30, 2003.
Effective July 1, 2003 through June 30, 2004, the underwriting limitations of
Western Surety and SBCA are $21.9 million and $0.5 million, respectively.
Through the Surety Quota Share Treaty between CCC and Western Surety Company,
CNA Surety has access to CCC and its affiliates' U.S. Department of Treasury
underwriting limitations. The Surety Quota Share Treaty had an original term of
five years from the Merger Date and was renewed on October 1, 2002 and on
January 1, 2004 on substantially the same terms. Effective July 1, 2003 through
June 30, 2004, the underwriting limitations of CCC and its affiliates total
$569.6 million. CNA Surety management believes that the foregoing U.S. Treasury
underwriting limitations are sufficient for the conduct of its business.

INVESTMENTS

CNA Surety insurance subsidiaries' investment practices must comply with
insurance laws and regulations and must also comply with certain covenants under
CNA Surety's credit facility. Generally, insurance laws and regulations
prescribe the nature and quality of, and set limits on, the various types of
investments that may be made by CNA Surety's insurance subsidiaries.

The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs.

An investment committee of CNA Surety's Board of Directors establishes
investment policy and oversees the management of each portfolio. A professional
independent investment adviser has been engaged to assist in the management of
each insurance subsidiary investment portfolio pursuant to established
investment committee guidelines. The insurance subsidiaries pay an advisory fee
based on the market value of the assets under management.

EMPLOYEES

As of December 31, 2003, the Company employed 785 persons. CNA Surety has
not experienced any work stoppages. Management of CNA Surety believes its
relations with its employees are good.

AVAILABILITY OF SEC REPORTS

A copy of this Annual Report on Form 10-K, as well as CNA Surety's
subsequent Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any
amendments to such reports are available, free of charge, on the Internet at CNA
Surety's website (www.cnasurety.com) as soon as reasonably practicable after
being filed with or submitted to the Securities and Exchange Commission (the
"SEC"). Prior to the filing of this Form 10-K, CNA Surety provided links to the
SEC's website (www.sec.gov) which contained the equivalent

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of the reports described above. Any materials the Company files with the SEC may
be read and obtained at the SEC's Public Reference Room at 450 Fifth Street, NW,
Washington, DC 20549. Information regarding the operation of the Public
Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. This
reference to the CNA Surety's website or the SEC's address does not constitute
incorporation by reference of the information contained on the website and
should not be considered part of this document.

ITEM 2. PROPERTIES

CNA Surety leases its executive offices and its shared branch locations
with Continental Casualty Company ("CCC") under the Administrative Services
Agreement. CNA Surety currently uses approximately 94,760 square feet and
related personal property at 35 branch locations and its home and executive
offices (27,648 square feet), in Chicago, Illinois. CNA Surety's annual rent for
this space is approximately $2.8 million. CNA Surety may terminate its use of
these locations as set forth in the Administrative Services Agreement, without
material penalty, by providing CCC with 30 days written notice. In 2004, CNA
Surety intends to enter into separate lease or sub-lease agreements with CCC for
these shared locations.

CNA Surety leases approximately 81,100 square feet of office space for its
primary processing and service center at 101 South Phillips Avenue, Sioux Falls,
South Dakota, under a lease expiring in 2012. The annual rent, which is subject
to annual adjustments, was $0.9 million as of December 31, 2003. CNA Surety also
leases space for contract and commercial branch offices in Tallahassee, FL,
Dallas, Texas; New York, New York; Troy, Michigan; Roseville, California;
Houston, Texas; and San Juan, Puerto Rico. Annual rent for these offices was
$0.6 million with leases terminating in 2004, 2004, 2007, 2005, 2005, 2006, and
2006, respectively.

ITEM 3. LEGAL PROCEEDINGS

The Company and its subsidiaries are parties 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.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

12

PART II.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The Company's common stock ("Common Stock") trades on the New York Stock
Exchange under the symbol SUR. On March 5, 2004, the last reported sale price
for the Common Stock was $11.11 per share. The following table shows the range
of high and low sales prices for shares of the Common Stock as reported on the
New York Stock Exchange during 2003 and 2002.

The number of stockholders of record of Common Stock on March 5, 2004, was
approximately 414.

DIVIDENDS

Effective November 21, 2002, the Company announced that its Board of
Directors suspended its quarterly cash dividend. The Board reassessed the level
of dividends which would be appropriate based upon a number of factors,
including CNA Surety's financial condition, operating characteristics, projected
earnings and growth, capital requirements of its insurance subsidiaries and debt
service obligations. The reintroduction of a quarterly or annual dividend and
the amount of any such dividend will be reassessed at future Board meetings.

13

ITEM 6. SELECTED FINANCIAL DATA

The following financial information has been derived from the Consolidated
Financial Statements and Notes thereto.

The following information presented for CNA Surety is as of and for the
years ended December 31, 2003, 2002, 2001, 2000 and 1999.

- -------------------------

(1) Includes the effect of recording revisions of prior year reserves. The
dollar amount and the percentage point effect on the loss ratio of these
reserve revisions were an addition of $39,290, or 12.9% for the year ended
December 31, 2003, an addition of $6,180, or 2.1%, for the year ended
December 31, 2002, an addition of $4,812, or 1.5%, for the year ended
December 31, 2001, a reduction of $7,093, or 2.4%, for the year ended
December 31, 2000, and a reduction of $13,085, or 4.6%, for the year ended
December 31, 1999.

(2) As of January 1, 2002, the Company adopted the Financial Accounting
Standards Board's Statement of Financial Accounting Standards No. 142
concerning the accounting for goodwill and other intangible assets. 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 2002 net income by $5.7 million, or 13 cents per share,
respectively, as compared to the same period in 2001. If the provisions of
this standard were applied to prior periods, net income for the years ended
December 31, 2001, 2000, and 1999 would have been $42.6 million, or $0.99
per share; $59.3 million, or $1.38 per share; $62.1 million, or $1.41 per
share respectively.

14

ITEM 7. 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 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.

INTRODUCTION

Management believes that the following areas represent the most significant
risks and uncertainties impacting the operating performance and financial
condition of the Company. The financial impacts of these issues would affect
gross and net written premium, incurred losses and reserves for unpaid losses.
Each of these issues is discussed in greater detail later in this section.

Availability and cost of reinsurance

Reinsurance coverage is an important component of the Company's capital
structure. Reinsurance allows the Company to meet certain regulatory
restrictions that would otherwise limit the size of bonds that the Company
writes and limit the market segments in which the Company could compete. In
addition, reinsurance reduces the potential volatility of earnings and protects
the Company's capital by limiting the amount of loss associated with any one
bond principal. Due to increased loss frequency and severity for both the
Company and within the surety industry in general that began emerging in 1999,
the Company, beginning in 2002, paid substantially higher reinsurance premiums
and was required to retain higher amounts of its per principal exposure. Through
aggressive exposure reduction efforts and continued underwriting discipline, the
Company has been able to purchase additional limits and more expansive
reinsurance protection for 2003 and 2004 as compared to 2002.

Exposure to loss on principals excluded from reinsurance programs

Beginning in 2002, the Company's reinsurers excluded certain accounts (for
which the Company had continuing exposure from bonds written in prior years)
from the reinsurance programs. For these accounts, the company would retain up
to $60 million of loss. Due to the improved financial condition of some of these
accounts and the Company's efforts to have these accounts covered, two of these
accounts are again covered under the Company's 2004 reinsurance program.
However, the Company's reinsurance program for 2004 does exclude three
principals. Of these excluded principals, one is a foreign industrial
enterprise, one is a domestic electric utility and the other is a large national
contractor. As of December 31, 2003, Management estimates that the Company's net
exposure to these accounts would be $31 million, $49 million and $60 million,
respectively. The foreign industrial enterprise and the electric utility are
discussed on page 22, and the large national contractor is discussed in detail
on page 25. As of December 31, 2003, no material loss event has occurred with
respect to these three principals.

Financial strength ratings

Surety bond principals and obligees often refer to the financial strength
ratings assigned by A.M. Best Co. ("A.M. Best"), Standard and Poor's ("S&P") and
other similar companies when they are choosing a surety company. Because the
Company uses the underwriting capacity of Continental Casualty Company ("CCC")
and its subsidiaries to serve larger accounts, the insurer financial strength
rating of both the Company and CCC factor into customers' decisions. After
reporting a significant operating loss in the third quarter of 2003, the
Company's A.M. Best rating was lowered from A+ to A with a negative outlook. CCC
also reported a significant operating loss in the third quarter of 2003, but
A.M. Best affirmed CCC's rating of A with a negative outlook. Management
believes that the current ratings are sufficient for the Company to conduct all
aspects of its business. Management also believes that a one level reduction in
ratings would have only a minimal impact on operations. A further decrease
beyond one level would likely have a material adverse impact on the Company's
ability to write business. Management believes that the likelihood of further
ratings

15

downgrades has been reduced by ongoing efforts to reduce large exposures and the
lower per principal retentions under the 2004 reinsurance program.

Economic Conditions

The Company's results are impacted by general corporate credit conditions,
as well as by the condition of the public construction segment of the economy.
While corporate credit default rates appear to be improving from recent
historically high levels, the amount of new public construction spending appears
to be slowing. An improvement in overall corporate default rates could be
expected to have a favorable impact on the Company's loss costs. A slow down in
public construction spending could be expected to put pressure on the Company's
written premium production and also adversely impact loss costs. Management
believes that the diversification of the Company's book of business, with
approximately 39% of premium from products that are less sensitive to economic
conditions, mitigates the impact of these economic factors.

Bond Premium Rates

The premium rates that the Company charges for its bonds have a direct
impact on the amount of revenue generated and on the ratio of incurred losses to
earned premium. Over the last several years, the company has charged higher
rates for its bonds, particularly in the large commercial and contract segments.
These two segments demonstrated the greater rate need due to the emergence of
increased loss frequency and severity as noted above. While the Company will
continue to aggressively pursue rate increases where indicated, competitive
factors appear to be pointing to a decreased ability to achieve the level of
rate increases that have been obtained over the past several years, particularly
in the small and middle market contract segments.

CRITICAL ACCOUNTING POLICIES

Management believes the most significant accounting policies and related
disclosures for purposes of understanding the Company's results of operations
and financial condition pertain to reserves for unpaid losses and loss
adjustment expenses and reinsurance, investments, goodwill and other intangible
assets, and deferred policy acquisition costs. 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.

Reserves for Unpaid Losses and Loss Adjustment Expenses and Reinsurance

CNA Surety accrues liabilities for unpaid losses and loss adjustment
expenses under its surety and property and casualty insurance contracts based
upon estimates of the ultimate amounts payable under the contracts related to
losses occurring on or before the balance sheet date. As of any balance sheet
date, all claims have not yet been reported and some claims may not be reported
for many years. As a result, the liability for unpaid losses includes
significant estimates for incurred-but-not-reported claims. Additionally,
reported claims are in various stages of the settlement process. Each claim is
settled individually based upon its merits, and certain claim liabilities may
take years to settle, especially if legal action is involved.

The Company uses a variety of techniques to establish the liabilities for
unpaid claims recorded at the balance sheet date. While techniques may vary,
each employs significant judgments and assumptions. Techniques may involve
detailed statistical analysis of past claim reporting, settlement activity,
salvage and subrogation activity, claim frequency and severity data when
sufficient information exists to lend statistical credibility to the analysis.
The analysis may be based upon internal loss experience or industry experience.
Techniques may vary depending on the type of claim being estimated. Liabilities
may also reflect implicit or explicit assumptions regarding the potential
effects of future economic and social inflation, judicial decisions, law
changes, and recent trends in such factors.

16

Receivables recorded with respect to insurance losses ceded to reinsurers
under reinsurance contracts are estimated in a manner similar to liabilities for
insurance losses and, therefore, are also subject to uncertainty. In addition to
the factors cited above, estimates of reinsurance recoveries may prove
uncollectible if the reinsurer is unable to perform under the contract.
Reinsurance contracts do not relieve the ceding company of its obligations to
indemnify its own policyholders.

CNA Surety's Consolidated Balance Sheet includes estimated liabilities for
unpaid losses and loss adjustment expenses of $413.5 million and reinsurance
receivables related to losses of $158.4 million at December 31, 2003 compared to
estimates of $303.4 million and $137.3 million, respectively, at December 31,
2002. While many factors impact these estimates, Management believes that past
changes in the Company's business mix and reinsurance program along with
increased corporate default rates were the primary drivers of the need to
substantially increase reserve levels in 2003. Beginning in the late 1990's, the
Company began writing more bonds for large corporate clients. Shortly
thereafter, corporate default rates increased dramatically. These exposures
proved to be more volatile than the Company's more traditional contract and
small commercial surety products, and began resulting in a higher frequency of
severe losses. As a result, the Company's reinsurers significantly increased
rates, reduced the amount of coverage available to the Company and excluded
certain accounts from the reinsurance program. For 2002, the Company's per
principal retention increased from $5 million to $20 million. Although the
Company reduced its per principal retention to $15 million for 2003, these
higher retentions, at a time of continuing higher frequency of severe losses,
further increased the volatility of results.

Since 2001, the Company has been aggressively reducing its exposures to
large corporate clients. Management believes that these efforts, along with
continued underwriting discipline in its traditional contract and small
commercial products, have been key to further reducing the Company's per
principal retention for most accounts to $10 million for the 2004 reinsurance
program. Management anticipates that these steps will reduce the volatility of
the Company's results.

Due to the inherent uncertainties in the process of establishing the
liabilities for unpaid losses and loss adjustment expenses, the actual ultimate
claims amounts will differ from the currently recorded amounts. This difference
could have a material effect on reported earnings. For example, a 10% increase
in the December 31, 2003 net estimate for unpaid losses and loss adjustment
expenses would produce a charge to pre-tax earnings of approximately $25.5
million. Future effects from changes in these estimates will be recorded as a
component of losses incurred in the period such changes are determined to be
needed.

Investments

Management believes the Company has the ability to hold all fixed income
securities to maturity. However, the Company may dispose of securities prior to
their scheduled maturity due to changes in interest rates, prepayments, tax and
credit considerations, liquidity or regulatory capital requirements, or other
similar factors. As a result, the Company considers all of its fixed income
securities (bonds and redeemable preferred stocks) and equity securities as
available-for-sale. These securities are reported at fair value, with unrealized
gains and losses, net of deferred income taxes, reported as a separate component
of stockholders' equity. Cash flows from purchases, sales and maturities are
reported gross in the investing activities section of the cash flow statement.

The amortized cost of fixed income securities is determined based on cost
and the cumulative effect of amortization of premiums and accretion of discounts
to maturity. Such amortization and accretion are included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective-yield method based on estimated cash flows. All
securities transactions are recorded on the trade date. Investment gains or
losses realized on the sale of securities are determined using the specific
identification method. Investments with an other-than-temporary decline in value
are written down to fair value, resulting in losses that are included in
realized investment gains and losses.

Short-term investments that 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.
Invested assets are exposed to various risks, such as interest rate risk, market
risk and credit risk. Due to
17

the level of risk associated with invested assets and the level of uncertainty
related to changes in the value of these assets, it is possible that changes in
risks in the near term may significantly affect the amounts reported in the
Consolidated Balance Sheets and Consolidated Statements of Income.

Goodwill and Other Intangible Assets

CNA Surety's Consolidated Balance Sheet as of December 31, 2003 includes
goodwill and identified intangibles of approximately $138.8 million. These
amounts represent goodwill and identified intangibles arising from the
acquisition of Capsure Holdings Corp. ("Capsure"). Prior to 2002, goodwill from
this and other acquisitions were generally amortized as a charge to earnings
over periods not exceeding 30 years. Under Statement of Financial Accounting
Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets"
("SFAS No. 142"), which was adopted by CNA Surety as of January 1, 2002,
periodic amortization ceased, in accordance with an impairment-only accounting
model.

A significant amount of judgment is required in performing goodwill
impairment tests. Such tests include periodically determining or reviewing the
estimated fair value of CNA Surety's reporting units. Under SFAS No. 142, fair
value refers to the amount for which the entire reporting unit may be bought or
sold. There are several methods of estimating fair value, including market
quotations, asset and liability fair values and other valuation techniques, such
as discounted cash flows and multiples of earnings or revenues. If the carrying
amount of a reporting unit, including goodwill, exceeds the estimated fair
value, then individual assets, including identifiable intangible assets, and
liabilities of the reporting unit are estimated at fair value. The excess of the
estimated fair value of the reporting unit over the estimated fair value of net
assets would establish the implied value of goodwill. The excess of the recorded
amount of goodwill over the implied value of goodwill is recorded as an
impairment loss.

Deferred Policy Acquisition Costs

Policy acquisition costs, consisting of commissions, premium taxes and
other underwriting expenses which vary with, and are primarily related to, the
production of business, net of reinsurance commissions, are deferred and
amortized as a charge to income as the related premiums are earned. Anticipated
investment income is considered in the determination of the recoverability of
deferred acquisition costs.

FORMATION OF CNA SURETY CORPORATION AND MERGER

In December 1996, CNA Financial Corporation ("CNAF") and Capsure agreed to
merge (the "Merger") the surety business of CNAF with Capsure Holdings Corp.'s
("Capsure") insurance subsidiaries, Western Surety Company ("Western Surety")
and Universal Surety of America ("USA"), into CNA Surety. CNAF, through its
operating subsidiaries, writes multiple lines of property and casualty
insurance, including surety business that is reinsured by Western Surety. CNAF
owns approximately 64% of the outstanding common stock of CNA Surety. Loews
Corporation ("Loews") owns approximately 90% of the outstanding common stock of
CNAF.

BUSINESS

CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 34,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety and
USA. The insurance subsidiaries write, on a direct basis or as business assumed
from CCC and Continental Insurance Company ("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.

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.
18

Western Surety is currently rated A (Excellent) with a negative rating
outlook, by A.M. Best. An A (Excellent) rating is assigned to those companies
which A.M. Best believes have an excellent ability to meet their ongoing
obligations to policyholders. A (Excellent) rated insurers have been shown to be
among the strongest in ability to meet policyholder and other contractual
obligations. The rating outlook indicates the potential direction of a company's
rating for an intermediate period, generally defined as the next 12 to 36
months. Through inter-company reinsurance and related agreements, CNA Surety's
customers have access to CCC's broader underwriting capacity. CCC is currently
rated A (Excellent) with a negative outlook by A.M. Best. A.M. Best's letter
ratings range from A++ (Superior) to F (In Liquidation) with A++ being highest.

CCC and Western Surety are both currently rated A- (Strong), by S&P. On
August 7, 2003, S&P placed CCC and Western Surety on credit watch with negative
implications. S&P's letter ratings range from AAA+ (Extremely Strong) to CC
(Extremely Weak) with AAA+ being highest. Ratings from "AA" to "CCC" may be
modified by the addition of a plus or minus sign to show relative standing
within the major rating categories. An insurer rated "A" has strong financial
security characteristics, but is somewhat more likely to be affected by adverse
business conditions than are insurers with higher ratings.

RESULTS OF OPERATIONS

Financial Measures

The Management's Discussion and Analysis of Financial Condition and Results
of Operations ("MD&A") discusses certain generally accepted accounting
principles ("GAAP") and non-GAAP financial measures in order to provide
information used by management to monitor the Company's operating performance.
Management utilizes various financial measures to monitor the Company's
insurance operations and investment portfolio. Underwriting results, which are
derived from certain income statement amounts, are considered a non-GAAP
financial measure and are used by management to monitor performance of the
Company's insurance operations. The Company's investment portfolio is monitored
through analysis of various quantitative and qualitative factors and certain
decisions related to the sale or impairment of investments produce realized
gains and losses, which is also a component used in the calculation of net
income and is a non-GAAP financial measure.

Underwriting results are computed as net earned premiums less net loss and
loss adjustment expenses and net commissions, brokerage and other underwriting
expenses. Management uses underwriting results to monitor its insurance
operations' results without the impact of certain factors, including net
investment income, net realized investment gains (losses) and interest expense.
Management excludes these factors in order to analyze the direct relationship
between net earned premiums and the related net loss and loss adjustment
expenses along with net commissions, brokerage and other underwriting expenses.

Operating ratios are calculated using insurance results and are widely used
by the insurance industry and regulators such as state departments of insurance
and the National Association of Insurance Commissioners for financial regulation
and as a basis of comparison among companies. The ratios discussed in the
Company's MD&A are calculated using GAAP financial results and include the net
loss and loss adjustment expense ratio ("loss ratio") as well as the net
commissions, brokerage and other underwriting expense ratio ("expense ratio")
and combined ratio. The loss ratio is the percentage of net incurred claim and
claim adjustment expenses to net earned premiums. The expense ratio is the
percentage of net commissions, brokerage and other underwriting expenses,
including the amortization of deferred acquisition costs, to net earned
premiums. The combined ratio is the sum of the loss and expense ratios.

The Company's investment portfolio is monitored by management through
analyses of various factors including unrealized gains and losses on securities,
portfolio duration, and exposure to interest rate, market and credit risk. Based
on such analyses, the Company may impair an investment security in accordance
with its policy, or sell a security. Such activities will produce net realized
investment gains and losses.

While management uses various GAAP and non-GAAP financial measures to
monitor various aspects of the Company's performance, net income is the most
directly comparable GAAP measure and represents a

19

more comprehensive measure of operating performance. Management believes that
its process of evaluating performance through the use of these non-GAAP
financial measures provides a basis for enhanced understanding of its operating
performance and the impact to net income as a whole. Management also believes
that investors may find these widely used financial measures described above
useful in interpreting the underlying trends and performance, as well as to
provide visibility into the significant components of net income.

COMPARISON OF CNA SURETY ACTUAL RESULTS FOR THE YEARS ENDED DECEMBER 31, 2003,
2002 AND 2001

Analysis of Net Income(Loss)

The Company had a net loss of $14.1 million for the year ended December 31,
2003 compared to net income of $30.1 million and $36.9 million for the
comparable periods in 2002 and 2001, respectively. The decrease in 2003 compared
to 2002 was driven by higher incurred losses and lower investment income.

The decrease in net income for 2002 compared to 2001 was driven by higher
incurred losses, realized investment losses and lower investment income. These
adverse changes were partially offset by lower interest expense and the
cessation of amortization expense related to goodwill and other intangible
assets.

Analysis of the components of net income are discussed in the following
sections.

Results of Insurance Operations

Underwriting components for the Company for the years ended December 31,
2003, 2002 and 2001 are summarized in the following table (dollars in
thousands):

Premiums Written

CNA Surety primarily markets contract and commercial surety bonds. Contract
surety bonds generally secure a contractor's performance and/or payment
obligation with respect to a construction project. Contract surety bonds are
generally required by federal, state and local governments for public works
projects. The most common types include bid, performance and payment bonds.
Commercial surety bonds include all surety bonds other than contract and cover
obligations typically required by law or regulation. The commercial surety
market includes numerous types of bonds categorized as court judicial, court
fiduciary, public official, license and permit and many miscellaneous bonds that
include guarantees of financial performance. The Company also writes fidelity
bonds that cover losses arising from employee dishonesty and other insurance
products.

20

Gross written premiums for the years ended December 31, 2003, 2002 and 2001
are shown in the table below (dollars in thousands):

Gross written premiums for the year ended December 31, 2003 increased 3.2%,
or $11.5 million, over the comparable period in 2002. Gross written premiums for
contract surety increased 5.4%, or $10.6 million, reflecting improving rates.
Gross written premiums for commercial surety decreased 0.2%, or $0.3 million,
for the year ended December 31, 2003 reflecting the Company's ongoing effort to
reduce aggregate exposures to large commercial accounts that was offset by
continued volume growth of small commercial products and improving rates on
large commercial bonds. The estimated impact of the Company's exposure reduction
efforts to date represents approximately $23 million in annual premium, assuming
an average rate per $1,000 of bond exposure of $3.46, or 35 basis points, and
approximately $6.7 billion of bond exposure. Fidelity and other products
increased 4.3% or $1.2 million for the year ended December 31, 2003 as compared
to the same period in 2002 due primarily to volume growth in fidelity and E&O
products.

Gross written premiums for the year ended December 31, 2002 increased 8.1%,
or $26.9 million, over the comparable period in 2001. Gross written premiums for
contract surety increased 9.6%, or $17.3 million, reflecting modest growth in
public construction spending and improving rates. Gross written premiums for
commercial surety increased 7.2%, or $9.0 million, for the year ended December
31, 2002 reflecting continued volume growth of small commercial products and
improving rates on large commercial bonds partially offset by the impacts of the
Company's ongoing efforts to reduce aggregate exposures on large commercial
accounts. Fidelity and other products increased 2.2% to $28.0 million for the
year ended December 31, 2002 as compared to the same period in 2001 due
primarily to an increase in fidelity business partially offset by the Company's
decision to cease writing agents' E&O business.

Net written premiums for the years ended December 31, 2003, 2002 and 2001
are shown in the table below (dollars in thousands):

For the year ended December 31, 2003 net written premiums increased 4.1% to
$319.2 million as compared to the same period in 2002, reflecting the
aforementioned gross production partially offset by higher reinsurance costs.
Ceded written premiums decreased $1.0 million to $52.2 million for the year
ended December 31, 2003. Ceded written premiums for 2003 include $38.0 million
for the Company's $45 million excess of $15 million per principal excess of loss
coverage and $3.8 million (net of expected return premium) for the Company's $40
million excess of $60 million per principal excess of loss coverage purchased
from CCC. Net written premiums for contract surety business increased 6.8% to
$184.4 million. Net written premiums for commercial surety decreased 0.4% to
$106.9 million for the year ended December 31, 2003. Fidelity and other products
increased 4.2% to $27.9 million for the year 2003 as compared to 2002.

Net written premiums for the year ended December 31, 2002 decreased 2.9% to
$306.7 million as compared to the same period in 2001, reflecting the
aforementioned gross production variances, the effects of higher reinsurance
costs and the Company's efforts to reduce large commercial bond exposures. Ceded
written

21

premiums increased $36.0 million to $53.2 million for the year ended December
31, 2002. Ceded written premiums for 2002 include $30.0 million for the
Company's $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. Net written premiums for contract surety business increased 4.2% to
$172.6 million. Net written premiums for commercial surety decreased 12.6% to
$107.3 million for the year ended December 31, 2002. Fidelity and other products
decreased 2.4% to $26.7 million for the year 2002 as compared to 2001 due to a
new quota share reinsurance arrangement effective January 1, 2002.

Excess of Loss Reinsurance

2003 Third Party Reinsurance Compared to 2002 Third Party Reinsurance

Effective January 1, 2003, CNA Surety entered into a new excess of loss
treaty ("2003 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal to $15 million with a 5%
co-participation in the $45 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaced the $40
million excess of $20 million per principal coverage ("2002 Excess of Loss
Treaty"). The material differences between the new excess of loss reinsurance
program and the Company's 2002 Excess of Loss Treaty were as follows. The annual
aggregate coverage increased from $100 million in 2002 to $110 million in 2003.
The minimum annual premium for the 2003 Excess of Loss Treaty was $38.0 million
compared to $30.0 million of reinsurance premiums paid in 2002. The 2003 Excess
of Loss Treaty provided the Company with coverage on a per principal basis of
95% of $45 million excess of $15 million retained by the Company.

The contract also included similar special acceptance provisions for larger
contract accounts contained in the 2002 Excess of Loss Treaty. In addition to
the one large national contract principal and the two commercial principals
excluded (based upon class of business in 2002), the Company's reinsurers also
excluded three other contract principals from the 2003 Excess of Loss Treaty for
a total of six excluded principals. Of the two commercial principals, one is a
domestic electric utility with an estimated bonded exposure of $49 million and
is currently rated B by Standard and Poor's ("S&P"). The bonded exposure will
decline over the term of the bond which extends until 2007. The other is a
foreign industrial enterprise with an estimated bonded exposure of $31 million.
The remaining $31 million of the bonded exposure is expected to be discharged by
June 30, 2004. Each of the four contract principals continues to perform their
contractual obligations underlying the Company's surety bonds. With respect to
the three contract principals other than the large national contractor
(described later), two principals have substantially completed asset sales, debt
reductions and other reorganization efforts.

The third contract principal went into claim during 2003. Although in claim
and experiencing financial difficulties, the contractor continued to perform
substantially all of its contractual obligations underlying the Company's surety
bonds. This contractor filed for bankruptcy in late September of 2003. Based
upon currently available information, management believes its net exposure to
loss on this contractor could be up to $15 million. This claim exposure was
considered in the Company's net reserve addition in the third quarter of 2003
for the 2003 accident year.

2004 Third Party Reinsurance Compared to 2003 Third Party Reinsurance

Effective January 1, 2004, CNA Surety entered into a new excess of loss
treaty ("2004 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal to $10 million with a 5%
co-participation in the $90 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $45
million excess of $15 million per principal coverage, as well as the $40 million
excess of $60 per principal and the $3 million excess of $12 million coverage
that had been provided by CCC. The material differences between the new excess
of loss reinsurance program and the Company's 2003 Excess of Loss Treaty are as
follows. The annual aggregate coverage increases from $110 million in 2003 to
$157 million in 2004. The minimum annual premium for the 2004 excess of loss
treaty is $49.2 million (net of expected return premium) compared to a total of
$42.0 million of reinsurance

22

premiums paid in 2003 (net of expected return premium) for the $45 million
excess of $15 million, the $40 million excess of $60 million and the $3 million
excess of $12 million treaties. The contract also includes an optional twelve
month extended discovery period, for an additional premium, which will provide
coverage for losses discovered in 2005 on bonds that were in force during 2004,
and somewhat less restrictive special acceptance provisions for larger contract
accounts than those contained in the 2003 Excess of Loss Treaty. In addition to
the one large contract principal (described later) and the two commercial
principals excluded (based upon class of business), the Company's reinsurers had
excluded three other contract principals from the 2003 Excess of Loss Treaty.
The one large contract principal and the two commercial principals remain
excluded from the 2004 Excess of Loss Treaty. The other two contract principals
that have completed asset sales and other reorganization efforts have been
accepted into the 2004 Excess of Loss Treaty.

Related Party Reinsurance

Intercompany reinsurance agreements together with the Services and
Indemnity Agreement that are described below provide for the transfer of the
surety business written by CCC and CIC to Western Surety. All of these
agreements originally were entered into on September 30, 1997 (the "Merger
Date"): (i) the Surety Quota Share Treaty (the "Quota Share Treaty"); (ii) the
Aggregate Stop Loss Reinsurance Contract (the "Stop Loss Contract"); and (iii)
the Surety Excess of Loss Reinsurance Contract (the "Excess of Loss Contract").
All of these contracts have expired. Some have been renewed on different terms
as described below.

The Services and Indemnity Agreement provides the Company's insurance
subsidiaries with the authority to perform various administrative, management,
underwriting and claim functions in order to conduct the business of CCC and CIC
and to be reimbursed by CCC for services rendered. In consideration for
providing the foregoing services, CCC has agreed to pay Western Surety a
quarterly fee of $50,000. This agreement was renewed on January 1, 2004 and
expires on December 31, 2004; and is annually renewable thereafter. There was no
amount due to the CNA Surety insurance subsidiaries as of December 31, 2003.

Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all
surety business written or renewed by CCC and CIC after the Merger Date. CCC and
CIC transfer the related liabilities of such business and pay to Western Surety
an amount in cash equal to CCC's and CIC's net written premiums written on all
such business, minus a quarterly ceding commission to be retained by CCC and CIC
equal to $50,000 plus 28% of net written premiums written on such business.

Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and
loss adjustment expense reserves transferred to Western Surety as of September
30, 1997 by agreeing to pay Western Surety, within 30 days following the end of
each calendar quarter, the amount of any adverse development on such reserves,
as re-estimated as of the end of such calendar quarter. There was not any
adverse reserve development for the period from September 30, 1997 (date of
inception) through December 31, 2003.

The Quota Share Treaty had an original term of five years from the Merger
Date and was renewed on October 1, 2002 on substantially the same terms with an
expiration date of December 31, 2003. The Quota Share Treaty was again renewed
on January 1, 2004 on substantially the same terms with an expiration date of
December 31, 2004; and is annually renewable thereafter. The ceding commission
paid to CCC and CIC by Western Surety remained at 28% of net written premiums
and contemplates an approximate 4% override commission for fronting fees to CCC
and CIC on their actual direct acquisition costs.

The Stop Loss Contract terminated on December 31, 2000 and was not renewed.
The Stop Loss Contract protected the insurance subsidiaries from adverse loss
experience on certain business underwritten after the Merger Date. The Stop Loss
Contract between the insurance subsidiaries and CCC limited the insurance
subsidiaries' prospective net loss ratios with respect to certain accounts and
lines of insured business for three full accident years following the Merger
Date. In the event the insurance subsidiaries' accident year net loss ratio
exceeds 24% in any of the accident years 1997 through 2000 on certain insured
accounts (the "Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end
of each calendar quarter following the Merger Date, to pay to the insurance
subsidiaries a dollar amount equal to (i) the amount, if any, by which their
actual accident year net loss ratio exceeds the applicable Loss Ratio Cap,
multiplied by (ii) the applicable net
23

earned premiums. In consideration for the coverage provided by the Stop Loss
Contract, the insurance subsidiaries paid to CCC an annual premium of $20,000.
The CNA Surety insurance subsidiaries have paid CCC all required annual
premiums. As of December 31, 2003, the Company had billed $54.9 million under
the Stop Loss Contract and had received $24.9 million.

The Excess of Loss Contract provided the insurance subsidiaries of CNA
Surety with the capacity to underwrite large surety bond exposures by providing
reinsurance support from CCC. The Excess of Loss Contract provided $75 million
of coverage for losses in excess of the $60 million per principal. Subsequent to
the Merger Date, the Company entered into a second excess of loss contract with
CCC ("Second Excess of Loss Contract"). The Second Excess of Loss Contract
provided additional coverage for principal losses that exceed the foregoing
coverage of $75 million per principal provided by the Excess of Loss Contract,
or aggregate losses per principal in excess of $135 million. In consideration
for the reinsurance coverage provided by the Excess of Loss Contracts, the
insurance subsidiaries paid to CCC, on a quarterly basis, a premium equal to 1%
of the net written premiums applicable to the Excess of Loss Contract, subject
to a minimum premium of $20,000 and $5,000 per quarter under the Excess of Loss
Contract and Second Excess of Loss Contract, respectively. The two Excess of
Loss Contracts collectively provided coverage for losses discovered on surety
bonds in force as of the Merger Date and for losses discovered on new and
renewal business written during the term of the Excess of Loss Contracts. Both
Excess of Loss Contracts commenced following the Merger Date and continued until
September 30, 2002. The discovery period for losses covered by the Excess of
Loss Contracts extends until September 30, 2005.

Effective October 1, 2002, the Company secured replacement excess of loss
protection from CCC for per principal losses that exceed $60 million in two
parts -- a) $40 million excess of $60 million and b) $50 million excess of $100
million. This excess of loss protection is primarily necessary to support
contract surety accounts with bonded backlogs or work-in-process in excess of
$60 million. The Company generally limits support for new large commercial
surety accounts to $25 million. In addition to the foregoing structural changes
in its high layer excess of loss reinsurance programs, the cost for these
protections increased significantly as compared to the cost of the previous two
Excess of Loss Contracts. The $40 million excess of $60 million contract is for
a three year term beginning October 1, 2002 and provides annual aggregate
coverage of $80 million and $120 million aggregate coverage for the entire three
year term. The Company paid annual reinsurance premiums of $3.8 million (net of
expected return premium) in year one to CCC.

Effective January 1, 2004, the Company obtained replacement coverage from
third party reinsurers as part of the 2004 Excess of Loss Treaty. Accordingly,
the $40 million excess of $60 million contract with CCC was commuted effective
January 1, 2004. As part of this commutation, the Company is entitled to receive
a commutation payment of $10.9 million from CCC that is expected to be received
in the first quarter of 2004. As of December 31, 2003 the full amount of the
commutation payment had been recognized as a receivable. The Company and CCC
entered into a new $40 million excess of $60 million reinsurance contract
providing coverage exclusively for the one large national contractor that is
excluded from the Company's third party reinsurance. This contract is effective
from January 1, 2004 to December 31, 2004. The premium for this contract is $3.0
million plus an additional premium if a loss is ceded to this contract.

The reinsurance premium for the coverage provided by the $50 million excess
of $100 million contract was $6.0 million. This contract expired on December 31,
2003. The Company and CCC entered into a new $50 million excess of $100 million
contract for the period of January 1, 2004 to December 31, 2004. The premium for
this contract is $6.0 million plus an additional premium if a loss is ceded to
this contract.

Effective October 1, 2003, the Company entered into a $3 million excess of
$12 million excess of loss contract with CCC. The reinsurance premium for the
coverage provided by the $3 million excess of $12 million contract was $0.3
million plus, if applicable, additional premiums based on paid losses. The
contract provided for aggregate coverage of $12 million. This contract
effectively lowered the Company's net retention per principal for the remainder
of 2003 to $12 million plus a 5% co-participation in the $45 million layer of
excess reinsurance with third party reinsurers. This contract was to expire on
December 31, 2004. Effective January 1, 2004, the Company obtained replacement
coverage from third party reinsurers as part of the 2004 Excess of Loss Treaty.
As of December 31, 2003 and December 31, 2002, CNA Surety had an

24

insurance receivable balance from CCC and CIC of $71.1 million and $51.7
million, respectively. CNA Surety had no reinsurance payables to CCC and CIC as
of December 31, 2003 and had reinsurance payables of $21.3 million to CCC and
CIC as of December 31, 2002.

Large National Contractor

The Company has provided significant surety bond protection guaranteeing
projects undertaken by the large national contract principal that is excluded
from the Company's third party insurance. The related party reinsurance
available to the Company for this principal and the credit extended to the
principal by affiliates of the Company are described below.

Reinsurance

If the Company should suffer any losses that are discovered prior to
September 30, 2005 arising from bonds issued to the contractor with effective
dates of September 30, 2002 and prior, the Company would retain the first $60
million of losses on bonds written, and CCC would incur 100% of losses above $60
million pursuant to the extended discovery provisions of the two Excess of Loss
treaties that expired on September 30, 2002. Any losses discovered after
September 30, 2005 on bonds with effective dates prior to September 30, 2002
would be covered up to $150 million pursuant to the $50 million excess of $100
million contract with CCC described above and a twelve month contract with CCC
effective January 1, 2004 that provides $40 million excess of $60 million
reinsurance coverage exclusively for the national contractor.

For bonds that the Company has written after September 30, 2003, in
addition to the coverage provided by excess of loss reinsurance treaties
described above ($40 million excess of $60 million and $50 million excess of
$100 million) the Company and CCC have entered into facultative reinsurance in
connection with larger bonds. The Company's exposure on bonds written from
October 1, 2002 through October 31, 2003 was limited to $20 million per bond.
For bonds written subsequent to November 1, 2003, and for bonds the company may
write in 2004, the Company's exposure will be limited to $14.5 million per bond.

The Company believes the run-off protection provided by the extended
discovery provisions of the expired agreements, the current protection provided
by the $40 million excess of $60 million and the $50 million excess of $100
million treaties, and the facultative reinsurance provided for larger bonds
written after September 30, 2002, should limit the Company's exposure for bonds
written on behalf of the national contractor to $60 million.

CNAF Credit Facility

In December 2002 and January 2003, CNAF, parent of CCC, provided loans in
an aggregate amount of approximately $45 million to the national contractor. The
loans were provided by CNAF to help the contractor meet its liquidity needs. The
loans are evidenced by demand notes and until replaced by the credit facility
described below, accrue interest at 10%. In March 2003, CNAF entered into a
credit facility with the contractor under which CNAF has agreed to provide up to
$86 million of loans to the contractor and certain of its subsidiaries,
including the refinancing of the already advanced $45 million of credit
described above. The credit facility matures in March of 2006. CNAF has been
granted a security interest in substantially all of the assets of the contractor
to secure borrowings under the new credit facility. Loews, parent of CNAF, and
CNAF have entered into a participation agreement, pursuant to which Loews has
purchased a one-third participation share in CNAF's position in the credit
facility, on a dollar-for-dollar basis, up to a maximum of $25 million. Although
Loews does not have rights against the contractor directly under the
participation agreement, it shares recoveries and fees under the facility on a
proportional basis with CNAF. In March 2003, CNAF also purchased approximately
$28 million of the contractor's outstanding bank debt for $16.4 million. Under
the new credit facility CNAF agreed to sell the bank debt to the contractor for
$16.4 million, with $11.4 million funded under the new credit facility and $5
million from money loaned to the contractor by its owners. Under its purchase
agreement with the banks CNAF is also required to reimburse the banks for any
draws upon approximately $6.5 million in outstanding letters of credit issued by
the banks for the contractor's benefit that expire between May and August 2003.
Any CNAF reimbursements for draws upon the banks'

25

letters of credit will become obligations of the contractor to CNAF as draws
upon the credit facility. As of December 31, 2003, CNAF has credit exposure of
$55 million under the credit facility, net of participation by Loews, in the
amount of $25 million, for total outstanding of $80 million. As of February 27,
2004, $83 million was the total outstanding under the credit facility.

The contractor has initiated a restructuring plan that is intended to
reduce costs and improve cash flow, and a chief restructuring officer has been
appointed to manage execution of the plan. CNA Surety intends to continue to
provide surety bonds on behalf of the contractor during this restructuring
period, subject to the contractor's initial and ongoing compliance with CNA
Surety's underwriting standards. Indemnification and subrogation rights,
including rights to contract proceeds on construction projects in the event of
default, exist that reduce CNA Surety's exposure to loss. While the Company
believes that the contractor's restructuring efforts will be successful and
provide sufficient cash flow for its operations and for repayment of its
borrowings, the contractor's failure to achieve its restructuring plan could
have a material adverse effect on CNA Surety's future results of operations,
cash flow and capital. If such failures occur, the Company estimates that
possible losses, net of indemnification and subrogation recoveries, but before
recoveries under reinsurance contracts, could be up to $200 million. However,
the related party reinsurance treaties discussed above should limit the
Company's per principal exposure to approximately $60 million.

Net Loss Ratio

The loss ratios for the years ended December 31, 2003, 2002 and 2001 were
56.7%, 31.6% and 25.2%, respectively. The loss ratios included $39.3 million,
$6.2 million, and $4.8 million in net unfavorable loss reserve development for
the years ended December 31, 2003, 2002 and 2001, respectively. The net adverse
development on prior accident years of $39.3 million in 2003 primarily relates
to accident years 2001 and 2002 due to changes in estimates of large losses
resulting from the material adverse claim activity in the third quarter of 2003.
This change in estimated net losses reflects the receipt of a payment demand
with respect to a portion of an aggregate $45 million insurance program bond.
This net adverse development also includes approximately $8 million of claims
pertaining to self-insured workers' compensation bonds issued in the 1980's on
behalf of companies now in bankruptcy.

In addition to the net unfavorable loss reserve development, the higher net
loss ratio in 2003 primarily relates to net reserve additions of approximately
$49.0 million for the current accident year due to material adverse loss
severity on the Company's branch commercial and contract business. The net
additions to reserves for the current accident year primarily relate to two
large claims totaling $23 million incurred in the quarter and changes in
estimates of large losses resulting from this significant adverse claim
activity. Approximately $15 million of net additions relate to a net loss with
respect to an insurance program bond for a now bankrupt large commercial
account. The other $8 million relates to a contract claim. A portion of the
remaining change in estimated net losses for the current accident year relates
to a contractor that went into claim during the year.

The net adverse loss reserve development in 2002 includes $2.4 million
associated with the assumed international credit and surety business from CNA Re
that the Company ceased writing in 2000. The remainder is primarily related to
increased claim frequency in the Company's small and specialty contract
business. The occurrence of the $12.0 million bankruptcy loss in the third
quarter of 2002 raised the estimated branch contract and commercial net accident
year loss ratio to approximately 40 percent for the nine months ended September
30, 2002. Due to the occurrence of this loss and other adverse loss trends,
together with the uncertain outlook for the economy and credit markets, the
Company raised its expected baseline accident year net loss ratio on the branch
contract and commercial business to 36.0 percent for the fourth quarter from the
initial 2002 accident year net loss ratio of 30.0 percent.

The $4.8 million of adverse reserve development in 2001 includes
approximately $1 million of adverse development for the insurance agent E&O
product that the Company ceased writing in 2001. The remainder is primarily
related to increased claim frequency in the Company's small and specialty
contract business. In addition to the $4.8 million of net unfavorable loss
reserve development during 2001, the 2001 loss ratio includes approximately $7.8
million pertaining to the Company's exposure to Enron Corporation. Gross

26

incurred loss and loss adjustment expenses for the year ended December 31, 2001
reflect $78 million for this exposure.

On January 2, 2003, CNA Surety settled litigation brought by J.P. Morgan
Chase & Co. ("Chase") in connection with three surety bonds issued on behalf of
Enron Corporation subsidiaries. The penal sums of the three bonds totaled
approximately $78 million. The Company paid Chase approximately $40.7 million
and assigned its recovery rights in the Enron bankruptcy to Chase in exchange
for a full release of its obligations under the bonds. The Company has no other
exposure related to the Enron Corporation. CNA Surety's net loss related to the
settlement, after anticipated recoveries under excess of loss reinsurance
treaties, was previously fully reserved. Immediately upon execution of the
settlement documents, the Company sent written notice for reimbursement to its
reinsurers. As of December 31, 2003, the Company has billed a total of $37.1
million to its reinsurers. Four reinsurers responsible for payment of 46% of the
treaty proceeds have paid their portions of the claim. Pursuant to the treaty,
the Company demanded and began arbitration proceedings against all the
reinsurers that have not paid. Management believes none of the reinsurers have
valid defenses under the reinsurance treaties to avoid payment, and that the
Company will fully recover all reinsurance recoverables recorded related to this
settlement. As such, the Company has not recorded a reduction with respect to
these reinsurance recoverables as of December 31, 2003.

The surety business assumed from CCC and CIC is subject to an aggregate
stop loss reinsurance contract between CCC and the Company that limits the
Company's accident year net loss ratio on this business to 24% for accident
years 1997 (October 1, 1997 to December 31, 1997), 1998, 1999 and 2000. The
Company recorded estimated reinsurance recoveries from CCC of $29.9 in 2003,
$2.5 million in 2002, $16.6 million in 2001 and $5.8 million in 2000 under this
contract. As of December 31, 2003, the Company had an estimated unpaid loss
recoverable balance of approximately $29.9 million under the Stop Loss Contract.

Within the commercial surety segments, the Company has exposures related to
a small number of accounts, which are now in various stages of bankruptcy
proceedings. In addition, certain other accounts have experienced deterioration
in creditworthiness since the Company issued bonds to them. Given the current
economic climate and its impact on these companies, the Company may experience
an increase in claims and, possibly, incur high severity losses. Such losses
would be recognized in the period in which the claims are filed and determined
to be a valid loss under the provisions of the surety bond issued.

Expense Ratio

The expense ratio increased to 62.6% for the year ended December 31, 2003
as compared to 60.3% for 2002. The increase in the expense ratio for the year
ended December 31, 2003 primarily reflects the impact of higher reinsurance
costs on net earned premiums and higher operating expenses. Operating expenses
increased 6.1% for the year ended December 31, 2003 primarily due to increased
salary and related expenses, including an accrual for post-employment benefits
for three former senior executives and other transition related costs, increased
policyholder dividend expense and higher costs for insurance and professional
services. The Company continues to work to offset higher reinsurance and loss
costs with premium rate actions, acquisition cost reductions and continued
productivity improvements and operating efficiencies.

The expense ratio decreased to 60.3% for the year ended December 31, 2002
as compared to 63.2% for 2001. The decrease in the expense ratio for the year
ended December 31, 2002 primarily reflects reduced acquisition and underwriting
expenses which were partially offset by the effect of higher reinsurance costs
on net earned premiums. Net earned premiums declined 7.0% and operating expenses
decreased at a higher rate of 11.4% for the year ended December 31, 2002.

Exposure Management

As the foregoing results indicate, the Company's business is subject to
certain risks and uncertainties associated with the current economic environment
and corporate credit conditions. In response to these risks and uncertainties,
the Company has enacted various exposure management initiatives, particularly to
reduce its risks on large commercial accounts. As the following table depicts,
the Company has reduced its exposure,

27

before the effects of reinsurance, by 48% in 2003 on large commercial accounts,
which are defined as accounts with exposures in excess of $10 million:

With respect to contract surety, the Company's portfolio is predominantly
comprised of contractors with work programs of less than $50 million. "Work
program" is the estimated contract value of uncompleted bonded and unbonded
work. Bonded backlog is a measure of the Company's exposure in the event of
default before indemnification, salvage and subrogation recoveries. The
following table summarized the composition of the Company's contractor portfolio
by size of estimated work program at December 31, 2003:

The Company will manage its exposure to any one contract credit and
aggressively looks for co-surety, shared accounts and other means to support or
reduce larger exposures. Reinsurance, indemnification and subrogation rights,
including rights to contract proceeds on construction projects in the event of
default, exist that substantially reduce CNA Surety's exposure to loss.

Investment Income

For the year ended December 31, 2003, net investment income was $26.3
million compared to net investment income for the years ended December 31, 2002
and 2001 of $27.8 million and $29.5 million, respectively. The annualized pretax
yield was 4.4%, 4.8% and 5.3% for the years ended December 31, 2003, 2002 and
2001, respectively. The annualized after-tax yield was 3.6%, 3.8% and 4.0% for
the years ended December 31, 2003, 2002 and 2001, respectively. The decrease in
investment income for the year ended December 31, 2003 is attributable to the
impact of lower investment yields and greater investment in tax-exempt
securities. The decrease in investment income for the year ended December 31,
2002 is attributable to the impact of lower investment yields and reduced
invested assets primarily associated with increased policyholder dividend
payments to shareholders and the retirement of debt.

Net realized investment gains/losses were approximately $1.8 million in
gains, $7.6 million in losses and $46,000 in gains for the years ended December
31, 2003, 2002 and 2001, respectively. The net realized investment losses in
2002 reflect the Company's insurance subsidiaries decision to liquidate their
common
28

equity portfolios during 2002. The volatility of the equity markets was
adversely impacting the Company's reported regulatory capital requirements.

The following summarizes net realized investment gains (losses) for the
three years ended December 31, 2003:

The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality fixed income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.

Invested assets are exposed to various risks, such as interest rate, market
and credit. Due to the level of risk associated with certain of these invested
assets and the level of uncertainty related to changes in the value of these
assets, it is possible that changes in risks in the near term may significantly
affect the amounts reported in the Consolidated Balance Sheets and Consolidated
Statements of Income. The Company's Quantitative and Qualitative Discussion
about Market Risk is contained in Item 7A of this Form 10-K.

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 $6.1 million for the year ended December 31, 2001.
Intangible assets primarily represent goodwill and identified intangibles
arising from the acquisition of Capsure.

The Company completed its annual goodwill impairment testing as of October
1, 2003 whereby no impairment was indicated.

Interest expense decreased $0.2 million, or 10.8%, for the year ended
December 31, 2003 compared to the same period in 2002, primarily due to lower
outstanding debt levels. The weighted average interest rate for the year ended
December 31, 2003 was 2.4% compared to 2.2% and 4.4% for the periods ended
December 31, 2002 and 2001, respectively. Interest expense decreased $2.2
million, or 56.5%, for the year ended December 31, 2002 compared to the same
period in 2001, primarily due to lower outstanding debt levels and lower
interest rates. Average debt outstanding was $55.6 million in 2003 compared to
$73.4 million and $82.8 million in 2002 and 2001, respectively.

Income Taxes

The Company's income tax benefit was $18.0 million for the year ended
December 31, 2003 compared to income tax expense of $12.6 million and $19.8
million, respectively for the same periods in 2002 and 2001. The effective
income tax rates were 56.0%, 29.6% and 35.0% for the years ended December 31,
2003, 2002 and 2001, respectively. The change in the estimated effective tax
rate in 2003 primarily relates to taxable losses from insurance underwriting and
greater investments in tax-exempt securities in 2003. The decrease in the
estimated effective tax rate in 2002 primarily relates to increased tax-exempt
income and the adoption of SFAS No. 142, which ended the periodic amortization
of the Company's goodwill and intangible assets.

29

LIQUIDITY AND CAPITAL RESOURCES

It is anticipated that the liquidity requirements of CNA Surety will be met
primarily by funds generated from operations. The principal sources of operating
cash flows are premiums, investment income, and sales and maturities of
investments. CNA Surety also may generate funds from additional borrowings under
the credit facility described below. The primary cash flow uses are payments for
claims, operating expenses, federal income taxes, debt service, as well as
dividends to CNA Surety stockholders. In general, surety operations generate
premium collections from customers in advance of cash outlays for claims.
Premiums are invested until such time as funds are required to pay claims and
claims adjusting expenses.

The Company believes that total invested assets, including cash and
short-term investments, are sufficient in the aggregate and have suitably
scheduled maturities to satisfy all policy claims and other operating
liabilities, including dividend and income tax sharing payments of its insurance
subsidiaries. At December 31, 2003, the carrying value of the Company's
insurance subsidiaries' invested assets was comprised of $573.7 million of fixed
income securities, $49.8 million of short-term investments, $1.1 million of
other investments and $2.0 million of cash. At December 31, 2002, the carrying
value of the Company's insurance subsidiaries' invested assets was comprised of
$564.8 million of fixed income securities, $41.9 million of short-term
investments, $1.3 million of other investments and $10.7 million of cash.

Cash flow at the parent company level is derived principally from dividend
and tax sharing payments from its insurance subsidiaries. The principal
obligations at the parent company level are to service debt, pay operating
expenses, including income taxes, and pay dividends to stockholders. At December
31, 2003, the parent company's invested assets consisted of $6.3 million of
fixed income securities, $1.1 million of equity securities, $14.1 million of
short-term investments and $6.0 million of cash. At December 31, 2002, the
parent company's invested assets consisted of $5.7 million of fixed income
securities, $0.8 million of equity securities, $8.8 million of short-term
investments and $4.3 million of cash. As of December 31, 2003 and December 31,
2002, parent company short-term investments and cash included $6.6 million and
$4.8 million, respectively, of restricted cash related to premium receipt
collections ultimately due to the Company's insurance subsidiaries.

The Company's consolidated net cash flow provided by operating activities
was $25.2 million, $85.5 million and $57.0 million for the years ended December
31, 2003, 2002 and 2001, respectively. The decrease in cash flow provided in
2003 is primarily due to increased loss payments. The increase in net cash flow
provided by operating activities in 2002 primarily relates to decreases in
insurance receivables, primarily reinsurance recoverables from affiliates.

On September 30, 2002, the Company refinanced $65 million in outstanding
borrowings under its previous credit facility with a new credit facility (the
"2002 Credit Facility"). The 2002 Credit Facility, as amended September 30,
2003, provides an aggregate of up to $50 million in borrowings divided between a
revolving credit facility (the "Revolving Credit Facility") of $30 million and a
term loan facility (the "Term Loan") of $20 million. The Revolving Credit
Facility matures on September 30, 2005. The Revolving Credit Facility may be
increased from time to time by the amount of amortization under the Term Loan
facility up to an additional $10 million. Such increase is subject to consent by
each Revolving Credit Bank, and will take place upon receipt by the Banks of the
respective installment payments under the Term Loan facility.

Effective January 30, 2003, the Company entered into an interest rate swap
on the Term Loan. As a result, the current effective interest rate on the term
loan as of December 31, 2003 was 2.76%.

The Term Loan balance was reduced by $10 million through December 31, 2003
according to the scheduled amortization. Further amortization of the Term Loan
will take place at $10 million per year, in equal semi-annual installments of $5
million on the following dates:

30

The interest rate on borrowings under the 2002 Credit Facility may be
fixed, at CNA Surety's option, for a period of one, two, three, or six months
and is based on, among other rates, the London Interbank Offered Rate ("LIBOR"),
plus the applicable margin. The margin, including a facility fee and utilization
fee on the Revolving Credit Facility, was 1.30% at December 31, 2003 and can
vary based on CNA Surety's leverage ratio (debt to total capitalization) from
1.15% to 1.45%. The margin on the Term Loan, was 0.625% at December 31, 2003 and
can vary based on CNA Surety's leverage ratio (debt to total capitalization)
from 0.48% to 0.80%. As of December 31, 2003, the weighted average interest rate
was 2.4% on the $50 million of outstanding borrowings. As of December 31, 2002,
the weighted average interest rate on the 2002 Credit Facility was 1.9% on the
$60 million of outstanding borrowings.

The 2002 Credit Facility contains, among other conditions, limitations on
CNA Surety with respect to the incurrence of additional indebtedness and
maintenance of a rating of at least "A" by A.M. Best for each of the Company's
insurance subsidiaries. The 2002 Credit Facility also requires the maintenance
of certain financial ratios as follows: a) maximum funded debt to total
capitalization ratio of 25%, b) minimum net worth of $350.0 million and c)
minimum fixed charge coverage ratio of 2.5 times. Due to the net loss reported
for the third quarter of 2003, the Company was in violation of the minimum fixed
charge coverage test. The lenders granted the Company a waiver for this
violation and amended the 2002 Credit Facility to replace the fixed charge
coverage ratio requirement for the next three quarters with a minimum earnings
requirement. At December 31, 2003 and 2002, CNA Surety was in compliance with
all restrictive debt covenants in effect at those times.

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 December 31, 2003 was $0.4 million.

A summary of the Company's commitments as of December 31, 2003 is presented
in the following table:

COMMITMENTS

- ---------------

(a) reflects post-employment obligations to former executives and unfunded
post-retirement benefit plans

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

31

the current year are dependent on, among other items, the prior year's ending
statutory surplus and statutory net income. Dividend capacity for 2004 is based
on statutory surplus and income at and for the year ended December 31, 2003.
Without prior regulatory approval in 2004, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $19.0 million in the aggregate. CNA Surety
received $28.5 million in dividends from its insurance subsidiaries in 2003 and
$31.2 million in 2002.

Combined statutory surplus totaled $190.4 million at year-end, resulting in
a net written premium to statutory surplus ratio of 1.7 to 1. On December 31,
2003 the Company changed its legal entity structure so that USA and SBCA became
subsidiaries of Western Surety. Insurance regulations restrict Western Surety's
maximum net retention on a single surety bond to 10 percent of statutory
surplus. Under the 2004 Excess of Loss Treaty, the Company's net retention on
new bonds would generally be $10 million plus a 5% co-participation in the $90
million layer of excess reinsurance above the Company's retention and this
regulation would require minimum statutory surplus of $145.0 million at Western
Surety. This surplus constraint may limit the amount of future dividends Western
Surety could otherwise pay to CNA Surety Corporation.

In accordance with the provisions of inter-company 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 when estimated tax payments would be
required by the Internal Revenue Service ("IRS"). CNA Surety received
tax-sharing payments from its subsidiaries of $7.4 million for the year ended
December 31, 2003 and $9.9 million for the year ended December 31, 2002.

Western Surety and SBCA each qualify as an acceptable surety for federal
and other public works project bonds pursuant to U.S. Department of Treasury
regulations. U.S. Treasury underwriting limitations are based on an insurer's
statutory surplus. Effective July 1, 2003 through June 30, 2004, the
underwriting limitations of Western Surety and SBCA are $21.9 million and $0.5
million, respectively. Through the Surety Quota Share Treaty between CCC and
Western Surety Company, CNA Surety has access to CCC and its affiliates' U.S.
Department of Treasury underwriting limitations. The Surety Quota Share Treaty
had an original term of five years from the Merger Date and was renewed on
October 1, 2002 on substantially the same terms. Effective July 1, 2003 through
June 30, 2004, the underwriting limitations of CCC and its affiliates total
$569.6 million. CNA Surety management believes that the foregoing U.S. Treasury
underwriting limitations are sufficient for the conduct of its business.

Subject to the aforementioned uncertainties concerning the Company's per
principal net retentions, CNA Surety management believes that the Company has
sufficient available resources, including capital protection against large
losses provided by the Company's excess of loss reinsurance arrangements, to
meet its present capital needs.

32

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, 2003
and 2002 (dollars in thousands):

Invested assets are exposed to various risks, such as interest rate, market
and credit. Due to the level of risk associated with certain of these invested
assets and the level of uncertainty related to changes in the value of these
assets, it is possible that changes in risks in the near term may significantly
affect the amounts reported in the Consolidated Balance Sheets and Consolidated
Statements of Income. The Company's Quantitative and Qualitative Discussion
about Market Risk is contained in Item 7A of this Form 10-K.

The following table sets forth the ratings assigned by S&P or Moody's
Investor Services, Inc. ("Moody's") of the fixed income securities portfolio of
the Company as of December 31, 2003 and 2002 (dollars in thousands):

As of December 31, 2003 and 2002, 99% of the Company's fixed income
securities were considered investment grade by S&P or Moody's and 79% and 82%
were rated at least AA by those agencies for 2003 and 2002, respectively. The
Company's investments in fixed income securities do not contain any industry
concentration of credit risk.

As of December 31, 2003, municipal securities of the State of Texas, the
State of Michigan, the State of Florida, and the State of Illinois and each
state's related political subdivisions each represent 5.6%, 5.5%, 5.4%

34

and 4.5%, respectively, of the estimated fair value of the Company's fixed
income portfolio. Municipal securities of each other state individually
represent less than 4% of the Company's fixed income portfolio.

The following table provides the composition of fixed maturity securities
with an unrealized loss at December 31, 2003 in relation to the total of all
fixed maturity securities by contractual maturities:

The following table summarizes for fixed maturities in an unrealized loss
position at December 31, 2003, the aggregate fair value and gross unrealized
loss by length of time those securities have been continuously in an unrealized
loss position (dollars in thousands):

A significant judgment in the valuation of investments is the determination
of when an other-than-temporary decline in value has occurred. The Company
follows a consistent and systematic process for impairing securities that
sustain other-than-temporary declines in value. The Company has established a
watch list that is reviewed by the Chief Financial Officer and two other
executive officers on at least a quarterly basis. The watch list includes
individual securities that fall below certain thresholds or that exhibit
evidence of impairment indicators including, but not limited to, a significant
adverse change in the financial condition and near term prospects of the
investment or a significant adverse change in legal factors, the business
climate or credit ratings.

When a security is placed on the watch list, it is monitored for further
market value changes and additional news related to the issuer's financial
condition. The focus is on objective evidence that may influence the evaluation
of impairment factors.

The decision to record an impairment loss incorporates both quantitative
criteria and qualitative information. The Company considers a number of factors
including, but not limited to: (a) the length of time and the extent to which
the market value has been less than book value, (b) the financial condition and
near term prospects of the issuer, (c) the intent and ability of the Company to
retain its investment for a period of time sufficient to allow for any
anticipated recovery in value, (d) whether the debtor is current on interest and
principal payments and (e) general market conditions and industry or sector
specific factors.

For securities for which an impairment loss has been recorded, the security
is written down to fair value and the resulting losses are recognized in
realized gains/losses in the Consolidated Statements of Operations.

For the years ended December 31, 2003 and 2002, the Company had no impaired
securities.

35

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 losses and loss
adjustment expenses that give consideration to the inherent difficulty and
variability in the estimation process. 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 period in which such changes are determined to be
needed.

The Company's estimated liability for unpaid loss and loss adjustment
expenses is recorded at management's best estimate that is based on various
statistical reviews and analyses performed by the Company and management's
judgment as to the responsiveness of these reviews and analyses to the factors
affecting the Company's loss and loss adjustment expense reserves. Management
considers factors such as changes in inflation, changes in claim handling and
case reserving, changes in underwriting and pricing, changes in reinsurance
programs, the Company's net retained liability and changes in the legal
environment.

CNA Surety utilizes an independent actuarial firm 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. In connection with this actuarial
certification, the Company's independent actuarial firm provides management with
additional reports and analysis and its independent judgments regarding loss and
loss adjustment expense reserve estimates for management's review.

The Company recorded net unfavorable loss reserve development which
resulted in increases in the estimated liability of $39.3 million, $6.2 million
and $4.8 million for the years ended December 31, 2003, 2002 and 2001,
respectively. Note 7 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. 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 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 a company or
regulators. As of December 31, 2003, 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 generally should
not exceed 3 to 1. On December 31, 2003, Western Surety and its insurance
subsidiaries had a combined statutory surplus of $190.4 million and its net
written premiums to surplus ratio was 1.7 to 1. On December 31, 2002, CNA Surety
had a combined statutory surplus of $231.4 million. The combined statutory
surplus of Western Surety and SBCA was $223.7 million and its net written
premiums to surplus ratio was 1.3 to 1. USA's statutory surplus was $7.6 million
and the net written premiums to surplus ratio was 0.8 to 1. The
36

Company believes that each insurance company's statutory surplus is sufficient
to support its current and anticipated premium levels.

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 twelve financial
ratios that address various aspects of each insurer's financial condition and
stability. In 2003 and 2002, most of the ratios for Western Surety, USA and SBCA
were within the "usual" ranges as defined by the NAIC, except as noted. In 2003,
Western Surety's Investment Yield was outside the usual range due to greater
investment in tax-exempt securities. Also, the One-Year Reserve Development to
Policyholder's Surplus was outside the usual range due to prior year adverse
claim development. In 2002, Western Surety's IRIS Ratios were all within the
usual ranges as defined by the NAIC. In 2003, USA's Change in Net Writings was
outside the usual range due to decreased writings of contract surety bonds. In
2003 and 2002, USA's Two-Year Overall Operating ratio was outside of the usual
range, primarily due to increases in the loss and expense ratios. In 2002, USA's
Change in Policyholders' Surplus ratio was outside of the usual range primarily
due to USA's declaration and payment of an extraordinary dividend to CNA Surety
Corporation. SBCA's Investment Yield for 2003 and 2002 was outside of the usual
range primarily due to generally lower investment rates along with a
concentration of short-term investments. In 2002, SBCA's Change in Net Writings
ratio was outside of the usual range due to increased notary bond volume.

IMPACT OF ADOPTING ACCOUNTING PRONOUNCEMENTS

In August 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 143 entitled
"Accounting for Asset Retirement Obligations" ("SFAS No 143"). SFAS No. 143
addresses accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. The Company adopted the provisions of SFAS No.143 effective January 1,
2003. The adoption of SFAS No. 143 did not have an impact on the Company's
financial position or results of operations.

In November of 2002, the FASB issued FASB Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (an interpretation of FASB SFAS
No. 5, 57, and 107 and rescission of FASB Interpretation No. 34)" ("FIN No.
45"). FIN No. 45 clarifies the requirements of FASB SFAS No. 5, "Accounting for
Contingencies" ("SFAS No. 5") relating to a guarantor's accounting for, and
disclosure of, the issuance of certain types of guarantees. FIN 45 provided for
additional disclosure requirements related to guarantees, effective for
financial periods ended after December 15, 2002. Additionally, FIN 45 outlined
provisions for initial recognition and measurement of the liability incurred in
providing a guarantee. These provisions are applied to guarantees issued or
modified after December 31, 2002. The Company has adopted the disclosure
requirements of FIN No. 45 and the provisions for initial recognition and
measurement for all guarantees issued or modified after December 31, 2002. The
adoption of FIN 45 did not have a significant impact on the Company's financial
position or results of operations.

In January of 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51 ("ARB No. 51")" ("FIN No. 46"). As a general rule,
ownership by the parent, either directly or indirectly, of over fifty percent of
the outstanding voting shares of a subsidiary is a condition pointing toward
preparation of consolidated financial statements of the parent and its
subsidiary. FIN No. 46 clarifies the exceptions to this general rule, as
enunciated in paragraph 2 of ARB No. 51. FIN No. 46 requires an entity to
consolidate a variable interest entity ("VIE") even though the entity does not,
either directly or indirectly, own over fifty percent of the outstanding voting
shares.

FIN No. 46 defines a VIE as one in which a) the equity investment is not
sufficient to permit the entity to finance its activities without additional
subordinated financial support from other parties which is provided through
other interests that will absorb some or all of the expected losses of the
entity or b) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest i) direct

37

or indirect ability to make decisions about the entity's activities through
voting rights or similar rights or ii) the obligation to absorb the expected
losses of the entity, if they occur or receive residual returns of the entity,
if they occur or iii) the right to receive the expected residual returns of the
entity if they occur. The primary beneficiary of a VIE is required to
consolidate the results of operations of the VIE. Financial statements issued
are required to disclose the nature, purpose, activities and size of the VIE and
maximum exposure to loss as a result of its involvement with the VIE. The
Company has adopted FIN No. 46. In December 2003, the FASB issued a revision to
FIN No. 46 ("Fin No. 46R") that further clarified the application of ARB No. 51.
The Company has adopted FIN No. 46R. The Company is neither a primary
beneficiary of a VIE nor does it have a significant involvement with a VIE.

In December 2002, the FASB issued SFAS No. 148 entitled "Accounting for
Stock-Based Compensation, Transition and Disclosure" ("SFAS No.148"). SFAS No.
148 provides alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation.
SFAS No. 148 also amends the disclosure requirements of SFAS No. 123,
"Accounting for Stock-Based Compensation", to require prominent disclosures in
both annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The Company adopted this standard beginning with the 2002 annual
financial statements. The Company has not adopted fair value accounting in 2003.
The Company applies APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations, in accounting for its plans as allowed
for under the provisions of SFAS No. 123. Accordingly, no compensation cost has
been recognized for its stock-based incentive plans as the exercise price of the
granted options equals the market price at the grant date. The following table
illustrates the effect on net income and earnings per share data if the Company
had applied the fair value recognition provisions of SFAS No. 123 to stock based
compensation under the Company's stock-based compensation plan.

In April of 2003, the FASB issued SFAS No. 149 entitled "Amendment of
Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS No.
149"). SFAS No. 149 amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under SFAS No. 133 entitled "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 149 is effective
for contracts entered into or modified after June 30, 2003 and for hedging
relationships designated after June 30, 2003. Adoption of SFAS No. 149 did not
have a significant impact on the Company's financial position or results of
operations.

In May of 2003, the FASB issued SFAS No. 150 entitled "Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity" ("SFAS No. 150"). SFAS No. 150 establishes standards for how an issuer
of financial instruments classifies and measures in its statement of financial
position certain instruments with characteristics of both liabilities and
equity. SFAS No. 150 modifies the accounting and financial statement disclosures
of certain financial instruments that, under previous guidance, issuers could
account for as equity. SFAS No. 150 affects the issuer's accounting for three
types of financial instruments that are required to be accounted for as
liabilities.

SFAS No. 150 was effective for all financial instruments entered into or
modified after May 31, 2003. For all financial instruments entered into prior to
May 31, 2003, SFAS 150 is effective at the beginning of the first interim period
beginning after June 15, 2003, which for CNA Surety began July 1, 2003. The
Company does

38

not have any financial instruments outstanding to which provisions of SFAS 150
apply. Therefore the adoption of SFAS 150 did not have any impact on the
Company's financial position or results of operations.

In November of 2003, the Emerging Issues Task Force ("EITF") reached
consensus on EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary
Impairment and its Application to Certain Investments" ("EITF 03-1") that
certain quantitative and qualitative disclosures are required for equity and
fixed maturity securities that are impaired at the balance sheet date but for
which an other-than-temporary impairment has not been recognized. The guidance
requires companies to disclose the aggregate amount of unrealized losses and the
related fair value of investments with unrealized losses for securities that
have been in an unrealized loss position for less than 12 months and separately
for those that have been in an unrealized loss position for over 12 months, by
investment category. The Company has adopted the disclosure requirements in
these financial statements. Further discussion on the meaning of
other-than-temporary impairments for EITF 03-1 is expected at a future EITF
meeting.

In December of 2003, the FASB revised SFAS No. 132 entitled "Employers'
Disclosures about Pensions and Other Postretirement Benefits (SFAS No. 132) to
require additional disclosures related to pensions and post retirement benefits.
While retaining the existing disclosure requirements for pensions and
postretirement benefits, additional disclosures are required related to pension
plan assets, obligations, contributions and net benefit costs, beginning with
fiscal years ending after December 15, 2003. Additional disclosures pertaining
to benefit payments are required for fiscal years ending after June 30, 2004.
The SFAS No. 132 revisions also include additional disclosure requirements for
interim financial reports beginning after December 15, 2003. The Company has
implemented the revised disclosures required for fiscal years ending after
December 15, 2003 in these financial statements and will implement the interim
disclosure requirements and annual benefit payment disclosures in all subsequent
interim and annual financial statements.

FORWARD-LOOKING STATEMENTS

This report includes a number of statements which relate to anticipated
future events (forward-looking statements) rather than actual present conditions
or historical events. Forward-looking statements generally include words such as
"believes," "expects," "intends," "anticipates," "estimates," and similar
expressions. Forward-looking statements in this report include expected
developments in the Company's insurance business, including incurred losses and
loss and loss adjustment expense reserves; the impact of routine ongoing
insurance reserve reviews being conducted by the Company; the ongoing state
regulatory examinations of the Company's primary insurance company subsidiaries,
and the Company's responses to the results of those reviews and examinations;
the Company's expectations concerning its revenues, earnings, expenses and
investment activities; expected cost savings and other results from the
Company's expense reduction and restructuring activities; and the Company's
proposed actions in response to trends in its business.

Forward-looking statements, by their nature, are subject to a variety of
inherent risks and uncertainties that could cause actual results to differ
materially from the results projected. Many of these risks and uncertainties
cannot be controlled by the Company. Some examples of these risks and
uncertainties are:

- general economic and business conditions;

- changes in financial markets such as fluctuations in interest rates,
long-term periods of low interest rates, credit conditions and currency,
commodity and stock prices;

- the effects of corporate bankruptcies, such as Enron and WorldCom, on
surety bond claims, as well as on capital markets;

- changes in foreign or domestic political, social and economic conditions;

- regulatory initiatives and compliance with governmental regulations,
judicial decisions, including interpretation of policy provisions,
decisions regarding coverage, trends in litigation and the outcome of any
litigation involving the Company, and rulings and changes in tax laws and
regulations;

39

- regulatory limitations, impositions and restrictions upon the Company,
including the effects of assessments and other surcharges for guaranty
funds and other mandatory pooling arrangements;

- the impact of competitive products, policies and pricing and the
competitive environment in which the Company operates, including changes
in the Company's books of business;

- product and policy availability and demand and market responses,
including the level of ability to obtain rate increases and decline or
non-renew underpriced accounts, to achieve premium targets and
profitability and to realize growth and retention estimates;

- development of claims and the impact on loss reserves, including changes
in claim settlement practices;

- the performance of reinsurance companies under reinsurance contracts with
the Company;

- results of financing efforts, including the availability of bank credit
facilities;

- changes in the Company's composition of operating segments;

- the sufficiency of the Company's loss reserves and the possibility of
future increases in reserves;

- the risks and uncertainties associated with the Company's loss reserves
as outlined in the Reserves section of this MD&A; and,

- the possibility of further changes in the Company's ratings by ratings
agencies, including the inability to access certain markets or
distribution channels and the required collateralization of future
payment obligations as a result of such changes, and changes in rating
agency policies and practices.

Any forward-looking statements made in this report are made by the Company
as of the date of this report. The Company does not have any obligation to
update or revise any forward-looking statement contained in this report, even if
the Company's expectations or any related events, conditions or circumstances
change.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCUSSIONS ABOUT 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 credit worthiness 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 5 years, consistent with the expected duration of its
insurance and other liabilities.

The tables below summarize 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, 2003. Significant
variations in market interest rates could produce changes in the timing of
repayments due to

40

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.

41

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Shareholders
CNA Surety Corporation

We have audited the accompanying consolidated balance sheets of CNA Surety
Corporation and subsidiaries, as of December 31, 2003 and 2002, and the related
consolidated statements of income, stockholders' equity, and cash flows for each
of the three years in the period ended December 31, 2003. 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 auditing standards generally
accepted in the United States of America. 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.

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, 2003 and 2002, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2003 in conformity with accounting principles generally accepted in
the United States of America.

As discussed in Note 1 of the consolidated financial statements, the
Company changed its method of accounting for goodwill and indefinite-lived
intangible assets in 2002.

DELOITTE & TOUCHE LLP

Chicago, Illinois
March 12, 2004

42

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these consolidated financial
statements.
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CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

The accompanying notes are an integral part of these consolidated financial
statements.
44

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

The accompanying notes are an integral part of these consolidated financial
statements.
45

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these consolidated financial
statements.
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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SIGNIFICANT ACCOUNTING POLICIES

Formation of CNA Surety Corporation and Merger

In December 1996, CNA Financial Corporation ("CNAF") and Capsure agreed to
merge (the "Merger") the surety business of CNAF with Capsure Holdings Corp.'s
("Capsure") insurance subsidiaries, Western Surety Company ("Western Surety")
and Universal Surety of America ("USA"), into CNA Surety. CNAF, through its
operating subsidiaries, writes multiple lines of property and casualty
insurance, including surety business that is reinsured by Western Surety. CNAF
owns approximately 64% of the outstanding common stock of CNA Surety. Loews
Corporation ("Loews") owns approximately 90% of the outstanding common stock of
CNAF. The principal operating subsidiaries of CNAF that wrote the surety line of
business for their own account prior to the Merger were CCC and CIC.

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 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.

Investments

Management believes the Company has the ability to hold all fixed income
securities to maturity. However, the Company may dispose of securities prior to
their scheduled maturity due to changes in interest rates, prepayments, tax and
credit considerations, liquidity or regulatory capital requirements, or other
similar factors. As a result, the Company considers all of its fixed income
securities (bonds and redeemable preferred stocks) and equity securities as
available-for-sale. These securities are reported at fair value, with unrealized
gains and losses, net of deferred income taxes, reported as a separate component
of stockholders' equity. Cash flows from purchases, sales and maturities are
reported gross in the investing activities section of the cash flow statement.

The amortized cost of fixed income securities is determined based on cost
and the cumulative effect of amortization of premiums and accretion of discounts
to maturity. Such amortization and accretion are included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective-yield method based on estimated cash flows. All
securities transactions are recorded on the trade date. Investment gains or
losses realized on the sale of securities are determined using the specific
identification method. Investments with an other-than-temporary decline in value
are written down to fair value, resulting in losses that are included in
realized investment gains and losses.

Short-term investments that generally include U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents, are carried at amortized cost which approximates fair value.

Deferred Policy Acquisition Costs

Policy acquisition costs, consisting of commissions, premium taxes and
other underwriting expenses that vary with, and are primarily related to, the
production of business, net of reinsurance commissions, are

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

deferred and amortized as a charge to income as the related premiums are earned.
Anticipated investment income is considered in the determination of the
recoverability of deferred acquisition costs.

Intangible Assets

CNA Surety's Consolidated Balance Sheet as of December 31, 2003 includes
goodwill and identified intangibles of approximately $138.8 million. These
amounts represent goodwill and identified intangibles arising from the
acquisition of Capsure Holdings Corp. ("Capsure"). Prior to 2002, goodwill from
this and other acquisitions were generally amortized as a charge to earnings
over periods not exceeding 30 years. Under Statement of Financial Accounting
Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets"
("SFAS No. 142"), which was adopted by CNA Surety as of January 1, 2002,
periodic amortization ceased, in accordance with an impairment-only accounting
model.

A significant amount of judgment is required in performing goodwill
impairment tests. Such tests include periodically determining or reviewing the
estimated fair value of CNA Surety's reporting units. Under SFAS No. 142, fair
value refers to the amount for which the entire reporting unit may be bought or
sold. There are several methods of estimating fair value, including market
quotations, asset and liability fair values and other valuation techniques, such
as discounted cash flows and multiples of earnings or revenues. If the carrying
amount of a reporting unit, including goodwill, exceeds the estimated fair
value, then individual assets, including identifiable intangible assets, and
liabilities of the reporting unit are estimated at fair value. The excess of the
estimated fair value of the reporting unit over the estimated fair value of net
assets would establish the implied value of goodwill. The excess of the recorded
amount of goodwill over the implied value of goodwill is charged-off as an
impairment loss.

The Company completed its annual goodwill impairment testing as of October
1, 2003 whereby no impairment was indicated.

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
period 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 in proportion to the insurance protection provided. 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 determined on a
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

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

expenses. Amounts recoverable from reinsurers are estimated in a manner
consistent with the claim liability associated with the reinsured policy and are
reported as reinsurance receivables.

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

The Company accounts for income taxes under the liability method. Under the
liability method, 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 unearned premium reserves and deferred policy
acquisition costs. 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

The computation of earnings (loss) per share is as follows (amounts in
thousands, except for per share data):

No adjustments were made to reported net income (loss) in the computation
of earnings per share.

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Accounting Changes

In August 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 143 entitled
"Accounting for Asset Retirement Obligations" ("SFAS No 143"). SFAS No. 143
addresses accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. The Company adopted the provisions of SFAS No.143 effective January 1,
2003. The adoption of SFAS No. 143 did not have an impact on the Company's
financial position or results of operations.

In November of 2002, the FASB issued FASB Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (an interpretation of FASB SFAS
No. 5, 57, and 107 and rescission of FASB Interpretation No. 34)" ("FIN No.
45"). FIN No. 45 clarifies the requirements of FASB SFAS No. 5, "Accounting for
Contingencies" ("SFAS No. 5") relating to a guarantor's accounting for, and
disclosure of, the issuance of certain types of guarantees. FIN 45 provided for
additional disclosure requirements related to guarantees, effective for
financial periods ended after December 15, 2002. Additionally, FIN 45 outlined
provisions for initial recognition and measurement of the liability incurred in
providing a guarantee. These provisions are applied to guarantees issued or
modified after December 31, 2002. The Company has adopted the disclosure
requirements of FIN No. 45 and the provisions for initial recognition and
measurement for all guarantees issued or modified after December 31, 2002. The
adoption of FIN 45 did not have a significant impact on the Company's financial
position or results of operations.

In January of 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51 ("ARB No. 51")" ("FIN No. 46"). As a general rule,
ownership by the parent, either directly or indirectly, of over fifty percent of
the outstanding voting shares of a subsidiary is a condition pointing toward
preparation of consolidated financial statements of the parent and its
subsidiary. FIN No. 46 clarifies the exceptions to this general rule, as
enunciated in paragraph 2 of ARB No. 51. FIN No. 46 requires an entity to
consolidate a variable interest entity ("VIE") even though the entity does not,
either directly or indirectly, own over fifty percent of the outstanding voting
shares.

FIN No. 46 defines a VIE as one in which a) the equity investment is not
sufficient to permit the entity to finance its activities without additional
subordinated financial support from other parties which is provided through
other interests that will absorb some or all of the expected losses of the
entity or b) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest i) direct or indirect
ability to make decisions about the entity's activities through voting rights or
similar rights or ii) the obligation to absorb the expected losses of the
entity, if they occur or receive residual returns of the entity, if they occur
or iii) the right to receive the expected residual returns of the entity if they
occur. The primary beneficiary of a VIE is required to consolidate the results
of operations of the VIE. Financial statements issued are required to disclose
the nature, purpose, activities and size of the VIE and maximum exposure to loss
as a result of its involvement with the VIE. The Company has adopted FIN No. 46.
The Company is neither a primary beneficiary of a VIE nor does it have a
significant involvement with a VIE.

In December 2002, the FASB issued SFAS No. 148 entitled "Accounting for
Stock-Based Compensation, Transition and Disclosure" ("SFAS No.148"). SFAS No.
148 provides alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation.
SFAS No. 148 also amends the disclosure requirements of SFAS No. 123,
"Accounting for Stock-Based Compensation", to require prominent disclosures in
both annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The Company adopted this standard beginning with the 2002 annual
financial statements. The Company has not adopted fair value accounting in 2003.
The Company applies APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations, in accounting for its plans as
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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

The following table illustrates the effect on net income and earnings per
share data if the Company had applied the fair value recognition provisions of
SFAS No. 123 to stock based compensation under the Company's stock-based
compensation plan.

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Company's insurance subsidiaries, as required by state law, deposit
certain securities with state insurance regulatory authorities. At December 31,
2003, securities on deposit had an aggregate carrying value of $3.9 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, 2003 and 2002 are shown below. Actual
maturities may differ from contractual maturities as borrowers may have the
right to call or prepay obligations with or without call or prepayment penalties
(dollars in thousands):

Major categories of net investment income and gross realized investment
gains and (losses) from sales of available-for-sale securities were as follows
(dollars in thousands):

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Net unrealized gain and loss on securities included in stockholders' equity
at December 31, 2003 and 2002 was comprised of the following (dollars in
thousands):

The following table provides the composition of fixed maturity securities
with an unrealized loss at December 31, 2003 in relation to the total of all
fixed maturity securities by contractual maturities:

There were no non-investment grade fixed maturities or equity securities in
an unrealized loss position at December 31, 2003.

3. DEBT

On September 30, 2002, the Company refinanced $65 million in outstanding
borrowings under its previous credit facility with a new credit facility (the
"2002 Credit Facility"). The 2002 Credit Facility, as amended September 30,
2003, provides an aggregate of up to $50 million in borrowings divided between a
revolving credit facility (the "Revolving Credit Facility") of $30 million and a
term loan facility (the "Term Loan Facility") of $20 million. The Revolving
Credit Facility matures on September 30, 2005. The Revolving Credit Facility may
be increased from time to time by the amount of amortization under the Term Loan
Facility up to an additional $10 million. Such increase is subject to consent by
each bank participating in the Revolving Credit Facility, and will take place
upon receipt by the banks of the respective installment payments under the Term
Loan Facility.

Effective January 30, 2003, the Company entered into an interest rate swap
on the Term Loan. As a result, the current effective interest rate on the term
loan as of December 31, 2003 was 2.76%.

The Term Loan Facility balance was reduced by $10 million through December
31, 2003 according to the scheduled amortization and payment schedules. Further
amortization and payment of the Term Loan Facility will take place at $10
million per year, in equal semi-annual installments of $5 million on the
following dates:

The interest rate on borrowings under the 2002 Credit Facility may be
fixed, at CNA Surety's option, for a period of one, two, three, or six months
and is based on, among other rates, the London Interbank Offered Rate ("LIBOR"),
plus the applicable margin. The margin, including a facility fee and utilization
fee on the Revolving Credit Facility, was 1.30% at December 31, 2003 and can
vary based on CNA Surety's leverage ratio (debt to total capitalization) from
1.15% to 1.45%. The margin on the Term Loan, was 0.625% at December 31, 2003 and
can vary based on CNA Surety's leverage ratio (debt to total capitalization)
from 0.48% to 0.80%. As of December 31, 2003, the weighted average interest rate
was 2.4% on the $50 million of outstanding borrowings. As of December 31, 2002,
the weighted average interest rate on the 2002 Credit Facility was 1.9% on the
$60 million of outstanding borrowings.

The 2002 Credit Facility contains, among other conditions, limitations on
CNA Surety with respect to the incurrence of additional indebtedness and
maintenance of a rating of at least "A" by A.M. Best for each of the Company's
insurance subsidiaries. The 2002 Credit Facility also requires the maintenance
of certain financial ratios as follows: a) maximum funded debt to total
capitalization ratio of 25%, b) minimum net

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

worth of $350.0 million and c) minimum fixed charge coverage ratio of 2.5 times.
Due to the net loss reported for the third quarter of 2003, the Company was in
violation of the minimum fixed charge coverage test. The lenders granted the
Company a waiver for this violation and amended the 2002 Credit Facility to
replace the fixed charge coverage ratio requirement for the next three quarters
with a minimum earnings requirement. At December 31, 2003 and 2002, CNA Surety
was in compliance with all restrictive debt covenants in effect at those times.

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 December 31, 2003 was $0.4 million.

The consolidated balance sheet reflects total debt of $50.4 million at
December 31, 2003 and $60.8 million at December 31, 2002. The weighted average
interest rate on outstanding borrowings was 2.6% and 2.0% at December 31, 2003
and December 31, 2002 respectively.

4. 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 such as insurance contracts and all non-financial
instruments from fair value disclosure. Therefore, these fair value amounts
cannot be aggregated to determine the underlying economic value of the Company.

The carrying amounts and estimated fair values of financial instruments at
December 31, 2003 and 2002 were as follows (dollars in thousands):

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.

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

5. DEFERRED POLICY ACQUISITION COSTS AND OTHER OPERATING EXPENSES

Policy acquisition costs deferred and the related amortization of deferred
policy acquisition costs were as follows (dollars in thousands):

Net commissions, brokerage and other underwriting expenses were comprised
as follows (dollars in thousands):

6. REINSURANCE

The Company's insurance subsidiaries, in the ordinary course of business,
cede insurance to other insurance companies and affiliates. 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 insurance ceded to the
extent that any reinsurer is unable to meet the obligations assumed under the
reinsurance contracts. The Company evaluates the financial condition of its
reinsurers, establishes allowances for uncollectible amounts and monitors
concentrations of credit risk. At December 31, 2003, CNA Surety's largest
reinsurance receivable from an affiliate, CCC, an A (Excellent) rated company by
A.M. Best Company, Inc. ("A.M. Best"), was approximately $18.4 million. At
December 31, 2003, CNA Surety's largest reinsurance receivable from a
non-affiliate reinsurer was approximately $31.4 million with a company rated A++
(Superior) by A.M. Best.

The effect of reinsurance on premiums written and earned was as follows
(dollars in thousands):

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Assumed premiums primarily includes all surety business written or renewed,
net of reinsurance, by CCC and CIC, and their affiliates, after the Merger Date
that is reinsured by Western Surety pursuant to inter-company reinsurance and
related agreements.

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):

The Company's reinsurance program is predominantly comprised of excess of
loss reinsurance contracts that limit the Company's retention on a per principal
basis. The Company's reinsurance coverage is provided by third party reinsurers
and related parties. Due to the terms of conditions of these excess of loss
treaties, reinsurers may cover some principals in one year but then exclude
these same principals in subsequent years. As a result the Company may have
exposures to these principals that have limited or no reinsurance coverage.

Excess of Loss Reinsurance

2003 Third Party Reinsurance Compared to 2002 Third Party Reinsurance

Effective January 1, 2003, CNA Surety entered into a new excess of loss
treaty ("2003 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal to $15 million with a 5%
co-participation in the $45 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaced the $40
million excess of $20 million per principal coverage ("2002 Excess of Loss
Treaty"). The material differences between the new excess of loss reinsurance
program and the Company's 2002 Excess of Loss Treaty were as follows. The annual
aggregate coverage increased from $100 million in 2002 to $110 million in 2003.
The minimum annual premium for the 2003 Excess of Loss Treaty was $38.0 million
compared to $30.0 million of reinsurance premiums paid in 2002. The 2003 Excess
of Loss Treaty provided the Company with coverage on a per principal basis of
95% of $45 million excess of $15 million retained by the Company.

The contract also included similar special acceptance provisions for larger
contract accounts contained in the 2002 Excess of Loss Treaty. In addition to
the one large national contract principal and the two commercial principals
excluded (based upon class of business in 2002), the Company's reinsurers also
excluded three other contract principals from the 2003 Excess of Loss Treaty for
a total of six excluded principals. Of the two commercial principals, one is a
domestic electric utility with an estimated bonded exposure of $49 million and
is currently rated B by Standard and Poor's ("S&P"). The bonded exposure will
decline over the term of the bond which extends until 2007. The other is a
foreign industrial enterprise with an estimated bonded exposure of $31 million.
The remaining $31 million of the bonded exposure is expected to be discharged by
June 30, 2004. Each of the four contract principals continues to perform their
contractual obligations underlying the Company's surety bonds. With respect to
the three contract principals other than the large national contractor
(described later), two principals have substantially completed asset sales, debt
reductions and other reorganization efforts.

The third contract principal went into claim during 2003. Although in claim
and experiencing financial difficulties, the contractor continued to perform
substantially all of its contractual obligations underlying the

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Company's surety bonds. This contractor filed for bankruptcy in late September
of 2003. Based upon currently available information, management believes its net
exposure to loss on this contractor could be up to $15 million. This claim
exposure was considered in the Company's net reserve addition in the third
quarter of 2003 for the 2003 accident year.

Related Party Reinsurance

Intercompany reinsurance agreements together with the Services and
Indemnity Agreement that are described below provide for the transfer of the
surety business written by CCC and CIC to Western Surety. All of these
agreements originally were entered into on September 30, 1997 (the "Merger
Date"): (i) the Surety Quota Share Treaty (the "Quota Share Treaty"); (ii) the
Aggregate Stop Loss Reinsurance Contract (the "Stop Loss Contract"); and (iii)
the Surety Excess of Loss Reinsurance Contract (the "Excess of Loss Contract").
All of these contracts have expired. Some have been renewed on different terms
as described below.

The Services and Indemnity Agreement provides the Company's insurance
subsidiaries with the authority to perform various administrative, management,
underwriting and claim functions in order to conduct the business of CCC and CIC
and to be reimbursed by CCC for services rendered. In consideration for
providing the foregoing services, CCC has agreed to pay Western Surety a
quarterly fee of $50,000. This agreement was renewed on January 1, 2004 and
expires on December 31, 2004; and is annually renewable thereafter. There was no
amount due to the CNA Surety insurance subsidiaries as of December 31, 2003.

Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all
surety business written or renewed by CCC and CIC after the Merger Date. CCC and
CIC transfer the related liabilities of such business and pay to Western Surety
an amount in cash equal to CCC's and CIC's net written premiums written on all
such business, minus a quarterly ceding commission to be retained by CCC and CIC
equal to $50,000 plus 28% of net written premiums written on such business.

Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and
loss adjustment expense reserves transferred to Western Surety as of September
30, 1997 by agreeing to pay Western Surety, within 30 days following the end of
each calendar quarter, the amount of any adverse development on such reserves,
as re-estimated as of the end of such calendar quarter. There was not any
adverse reserve development for the period from September 30, 1997 (date of
inception) through December 31, 2003.

The Quota Share Treaty had an original term of five years from the Merger
Date and was renewed on October 1, 2002 on substantially the same terms with an
expiration date of December 31, 2003. The Quota Share Treaty was again renewed
on January 1, 2004 on substantially the same terms with an expiration date of
December 31, 2004; and is annually renewable thereafter. The ceding commission
paid to CCC and CIC by Western Surety remained at 28% of net written premiums
and contemplates an approximate 4% override commission for fronting fees to CCC
and CIC on their actual direct acquisition costs.

The Stop Loss Contract terminated on December 31, 2000 and was not renewed.
The Stop Loss Contract protected the insurance subsidiaries from adverse loss
experience on certain business underwritten after the Merger Date. The Stop Loss
Contract between the insurance subsidiaries and CCC limited the insurance
subsidiaries' prospective net loss ratios with respect to certain accounts and
lines of insured business for three full accident years following the Merger
Date. In the event the insurance subsidiaries' accident year net loss ratio
exceeds 24% in any of the accident years 1997 through 2000 on certain insured
accounts (the "Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end
of each calendar quarter following the Merger Date, to pay to the insurance
subsidiaries a dollar amount equal to (i) the amount, if any, by which their
actual accident year net loss ratio exceeds the applicable Loss Ratio Cap,
multiplied by (ii) the applicable net earned premiums. In consideration for the
coverage provided by the Stop Loss Contract, the insurance subsidiaries paid to
CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have
paid

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

CCC all required annual premiums. As of December 31, 2003, the Company had
billed $54.9 million under the Stop Loss Contract and had received $24.9
million.

The Excess of Loss Contract provided the insurance subsidiaries of CNA
Surety with the capacity to underwrite large surety bond exposures by providing
reinsurance support from CCC. The Excess of Loss Contract provided $75 million
of coverage for losses in excess of the $60 million per principal. Subsequent to
the Merger Date, the Company entered into a second excess of loss contract with
CCC ("Second Excess of Loss Contract"). The Second Excess of Loss Contract
provided additional coverage for principal losses that exceed the foregoing
coverage of $75 million per principal provided by the Excess of Loss Contract,
or aggregate losses per principal in excess of $135 million. In consideration
for the reinsurance coverage provided by the Excess of Loss Contracts, the
insurance subsidiaries paid to CCC, on a quarterly basis, a premium equal to 1%
of the net written premiums applicable to the Excess of Loss Contract, subject
to a minimum premium of $20,000 and $5,000 per quarter under the Excess of Loss
Contract and Second Excess of Loss Contract, respectively. The two Excess of
Loss Contracts collectively provided coverage for losses discovered on surety
bonds in force as of the Merger Date and for losses discovered on new and
renewal business written during the term of the Excess of Loss Contracts. Both
Excess of Loss Contracts commenced following the Merger Date and continued until
September 30, 2002. The discovery period for losses covered by the Excess of
Loss Contracts extends until September 30, 2005.

Effective October 1, 2002, the Company secured replacement excess of loss
protection from CCC for per principal losses that exceed $60 million in two
parts -- a) $40 million excess of $60 million and b) $50 million excess of $100
million. This excess of loss protection is primarily necessary to support
contract surety accounts with bonded backlogs or work-in-process in excess of
$60 million. The Company generally limits support for new large commercial
surety accounts to $25 million. In addition to the foregoing structural changes
in its high layer excess of loss reinsurance programs, the cost for these
protections increased significantly as compared to the cost of the previous two
Excess of Loss Contracts. The $40 million excess of $60 million contract is for
a three year term beginning October 1, 2002 and provides annual aggregate
coverage of $80 million and $120 million aggregate coverage for the entire three
year term. The Company paid annual reinsurance premiums of $3.8 million (net of
expected return premium) in year one to CCC.

The reinsurance premium for the coverage provided by the $50 million excess
of $100 million contract was $6.0 million. This contract expired on December 31,
2003. The Company and CCC entered into a new $50 million excess of $100 million
contract for the period of January 1, 2004 to December 31, 2004.

Effective October 1, 2003, the Company entered into a $3 million excess of
$12 million excess of loss contract with CCC. The reinsurance premium for the
coverage provided by the $3 million excess of $12 million contract was $0.3
million plus, if applicable, additional premiums based on paid losses. The
contract provided for aggregate coverage of $12 million. This contract
effectively lowered the Company's net retention per principal for the remainder
of 2003 to $12 million plus a 5% co-participation in the $45 million layer of
excess reinsurance with third party reinsurers. This contract was to expire on
December 31, 2004. Effective January 1, 2004, the Company obtained replacement
coverage from third party reinsurers. As of December 31, 2003 and December 31,
2002, CNA Surety had an insurance receivable balance from CCC and CIC of $71.1
million and $51.7 million, respectively. CNA Surety had no reinsurance payables
to CCC and CIC as of December 31, 2003 and had reinsurance payables of $21.3
million to CCC and CIC as of December 31, 2002.

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Large National Contractor

The Company has provided significant surety bond protection guaranteeing
projects undertaken by the large national contract principal that is excluded
from the Company's third party insurance. The related party reinsurance
available to the Company for this principal and the credit extended to the
principal by affiliates of the Company are described below.

Reinsurance

If the Company should suffer any losses that are discovered prior to
September 30, 2005 arising from bonds issued to the contractor with effective
dates of September 30, 2002 and prior, the Company would retain the first $60
million of losses on bonds written, and CCC would incur 100% of losses above $60
million pursuant to the extended discovery provisions of the two Excess of Loss
treaties that expired on September 30, 2002. Any losses discovered after
September 30, 2005 on bonds with effective dates prior to September 30, 2002
would be covered up to $150 million pursuant to the $50 million excess of $100
million contract with CCC described above and a twelve month contract with CCC
effective January 1, 2004 that provides $40 million excess of $60 million
reinsurance coverage exclusively for the national contractor.

For bonds that the Company has written after September 30, 2003, in
addition to the coverage provided by excess of loss reinsurance treaties
described above ($40 million excess of $60 million and $50 million excess of
$100 million) the Company and CCC have entered into facultative reinsurance in
connection with larger bonds. The Company's exposure on bonds written from
October 1, 2002 through October 31, 2003 was limited to $20 million per bond.
For bonds written subsequent to November 1, 2003, and for bonds the company may
write in 2004, the Company's exposure will be limited to $14.5 million per bond.

CNAF Credit Facility

In December 2002 and January 2003, CNAF, parent of CCC, provided loans in
an aggregate amount of approximately $45 million to the national contractor. The
loans were provided by CNAF to help the contractor meet its liquidity needs. The
loans are evidenced by demand notes and until replaced by the credit facility
described below, accrue interest at 10%. In March 2003, CNAF entered into a
credit facility with the contractor under which CNAF has agreed to provide up to
$86 million of loans to the contractor and certain of its subsidiaries,
including the refinancing of the already advanced $45 million of credit
described above. The credit facility matures in March of 2006. CNAF has been
granted a security interest in substantially all of the assets of the contractor
to secure borrowings under the new credit facility. Loews, parent of CNAF, and
CNAF have entered into a participation agreement, pursuant to which Loews has
purchased a one-third participation share in CNAF's position in the credit
facility, on a dollar-for-dollar basis, up to a maximum of $25 million. Although
Loews does not have rights against the contractor directly under the
participation agreement, it shares recoveries and fees under the facility on a
proportional basis with CNAF. In March 2003, CNAF also purchased approximately
$28 million of the contractor's outstanding bank debt for $16.4 million. Under
the new credit facility CNAF agreed to sell the bank debt to the contractor for
$16.4 million, with $11.4 million funded under the new credit facility and $5
million from money loaned to the contractor by its owners. Under its purchase
agreement with the banks CNAF is also required to reimburse the banks for any
draws upon approximately $6.5 million in outstanding letters of credit issued by
the banks for the contractor's benefit that expire between May and August 2003.
Any CNAF reimbursements for draws upon the banks' letters of credit will become
obligations of the contractor to CNAF as draws upon the credit facility. As of
December 31, 2003, CNAF has credit exposure of $55 million under the credit
facility, net of participation by Loews, in the amount of $25 million, for total
outstanding of $80 million. As of February 27, 2004, $83 million was the total
outstanding under the credit facility.

The contractor has initiated a restructuring plan that is intended to
reduce costs and improve cash flow, and a chief restructuring officer has been
appointed to manage execution of the plan. CNA Surety intends to
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CNA SURETY CORPORATION AND SUBSIDIARIES

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continue to provide surety bonds on behalf of the contractor during this
restructuring period, subject to the contractor's initial and ongoing compliance
with CNA Surety's underwriting standards. Indemnification and subrogation
rights, including rights to contract proceeds on construction projects in the
event of default, exist that reduce CNA Surety's exposure to loss. While the
Company believes that the contractor's restructuring efforts will be successful
and provide sufficient cash flow for its operations and for repayment of its
borrowings, the contractor's failure to achieve its restructuring plan could
have a material adverse effect on CNA Surety's future results of operations,
cash flow and capital. If such failures occur, the Company estimates that
possible losses, net of indemnification and subrogation recoveries, but before
recoveries under reinsurance contracts, could be up to $200 million. However,
the related party reinsurance treaties discussed above should limit the
Company's per principal exposure to approximately $60 million.

7. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES

Activity in the reserves for unpaid losses and loss adjustment expenses was
as follows (dollars in thousands):

The Company recorded net unfavorable loss reserve development which
resulted in increases in the estimated liability of $39.3 million, $6.2 million
and $4.8 million for the years ended December 31, 2003, 2002 and 2001,
respectively. Adverse claim trends in more recent accident years, particularly
increased claim severity on large commercial accounts, have resulted in
increased gross and net incurred loss and loss adjustment expenses for the two
years ended December 31, 2003.

Incurred loss and loss adjustment expenses for the year ended December 31,
2003 includes net adverse development on prior accident years of $39.3 million
that primarily relates to accident years 2001 and 2002 and changes in estimates
of large losses resulting from the material adverse claim activity in the third
quarter of 2003. This change in estimated net losses reflects the recent receipt
of a payment demand with respect to a portion of an aggregate $45 million
insurance program bond. Net adverse development also includes approximately $8
million of claims pertaining to self-insured workers' compensation bonds issued
in the 1980's on behalf of companies now in bankruptcy. In addition to the net
unfavorable loss reserve development in 2003, the higher net loss ratio in 2003
primarily relates to net reserve additions of approximately $49.0 million for
the current accident year due to material adverse loss severity on the Company's
branch commercial and

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CNA SURETY CORPORATION AND SUBSIDIARIES

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contract business. The net additions to reserves for the current accident year
primarily relate to two large claims totaling $23 million incurred in the
quarter and changes in estimates of large losses resulting from this significant
adverse claim activity. Approximately $15 million of net additions relate to a
net loss with respect to an insurance program bond for a now bankrupt large
commercial account. The other $8 million relates to a contract claim. A portion
of the remaining change in estimated net losses for the current accident year
relates to a contractor that went into claim during 2003. Incurred loss and loss
adjustment expenses for the year ended December 31, 2002 include $17 million on
a gross basis and $12 million on a net basis (after reinsurance) related to the
September 2002 bankruptcy of a large national trucking concern.

On January 2, 2003, CNA Surety settled litigation brought by J.P. Morgan
Chase & Co. ("Chase") in connection with three surety bonds issued on behalf of
Enron Corporation subsidiaries. The penal sums of the three bonds totaled
approximately $78 million. The Company paid Chase approximately $40.7 million
and assigned its recovery rights in the Enron bankruptcy to Chase in exchange
for a full release of its obligations under the bonds. The Company has no other
exposure related to the Enron Corporation. CNA Surety's net loss related to the
settlement, after anticipated recoveries under excess of loss reinsurance
treaties, was previously fully reserved. Immediately upon execution of the
settlement documents, the Company sent written notice for reimbursement to its
reinsurers. As of December 31, 2003, the Company has billed a total of $37.1
million to its reinsurers. Four reinsurers responsible for payment of 46% of the
treaty proceeds have paid their portions of the claim. The Company has initiated
reinsurance arbitration proceedings against all reinsurers who have not paid
their portions of the claim. Management believes none of the reinsurers have
valid defenses under the reinsurance treaties to avoid payment, and that the
Company will fully recover all reinsurance recoverables recorded related to this
settlement. As such, the Company has not recorded a reduction with respect to
these reinsurance recoverables as of December 31, 2003.

8. COMMITMENTS AND CONTINGENCIES

At December 31, 2003 the future minimum commitment under operating leases
was as follows: 2004 -- $1.7 million; 2005 -- $1.6 million; 2006 -- $1.4
million, 2007 -- $1.1 million and 2008 -- $1.0 million and thereafter -- $3.7
million. Total rental expense for the years ended December 31, 2003, 2002 and
2001 was $4.6 million, $4.0 million, and $4.4 million, respectively.

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.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

9. INCOME TAXES

The components of deferred income taxes as of December 31, 2003 and 2002
were as follows (dollars in thousands):

CNA Surety and its subsidiaries file a consolidated federal income tax
return.

The income tax provisions consisted of the following (dollars in
thousands):

A reconciliation from the federal statutory tax rate to the effective tax
rate is as follows:

10. EMPLOYEE BENEFITS

CNA Surety sponsors a tax deferred savings plan ("401(k) plan") covering
substantially all of its employees. Prior to December 31, 1999, the Company
matched 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 to 100% of the participating employees contribution up to 3%
of eligible compensation and 50% of the participating employees contribution
between 3% and 6% of eligible compensation (4.5% maximum matching). In addition,
the Company may also make an annual discretionary profit

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 2.3 million, $2.9 million and $2.8 million for
the years ended December 31, 2003, 2002 and 2001, respectively.

CNA Surety established the CNA Surety Corporation Deferred Compensation
Plan, effective April 1, 2000. The Company established and maintains the Plan as
an unfunded, nonqualified deferred compensation plan for a select group of
management or highly compensated employees. The purpose of the Plan is to permit
designated employees of the Company and participating affiliates to accumulate
additional retirement income through a nonqualified deferred compensation plan
that enables them to defer compensation to which they will become entitled in
the future. The Company holds equity securities with a fair value of $1.1
million as of December 31, 2003 in respect of this deferred compensation plan.

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.

Western Surety uses a December 31 measurement date for both of its
post-retirement benefit plans.

The following table sets forth the plans' combined accumulated
postretirement benefit obligation at the beginning and end of the last two
fiscal years (dollars in thousands):

The following table sets forth the plans' combined funded status reconciled
with the amount shown in the Company's statement of financial position at
December 31, 2003 and December 31, 2002 (dollars in thousands):

The Company expects to contribute $0.3 million to the post-retirement
benefit plans to pay benefits in 2004.

The Company's post-retirement health care plan is unfunded; the accumulated
post-retirement benefit obligation and plan assets for that plan are $5.4
million and $0, respectively.

The Company's post-retirement sick leave plan is unfunded; the accumulated
post-retirement benefit obligation and plan assets for that plan are $0.6
million and $0, respectively.

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CNA SURETY CORPORATION AND SUBSIDIARIES

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The plans' combined net periodic post-retirement benefit cost for the last
three fiscal years included the following components (dollars in thousands):

The health care cost trend rate assumption has an effect on the amounts
reported. To illustrate, increasing the assumed health care cost trend rates by
1 percentage point in each year would increase the benefit obligation as of
December 31, 2003 by $1.0 million and increase the aggregate of service cost and
interest cost for the year then ended by $0.1 million. Decreasing the assumed
health care cost trend rates by 1 percentage point in each year would decrease
the benefit obligation as of December 31, 2003 by $0.8 million and decrease the
aggregate of service cost and interest cost for the year then ended by $0.1
million.

11. 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 initially 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 Section 382 of the Internal Revenue Code of 1986, as amended. All
non-qualified stock options and incentive stock options granted under

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

The following table summarizes stock option activity for the three years
ending December 31, 2003.

As of December 31, 2003, the number of shares available for granting of
options under the Plan was 733,932.

The following table summarizes information about stock options outstanding
at December 31, 2003:

The weighted average fair market value (at grant date) per option granted
was $3.72, $3.69 and $3.72 respectively, for options granted during 2003, 2002
and 2001. 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, 2003: risk free interest rate of
1.1%; dividend yield of 0.0%; expected option life of six years; and volatility
of 39.8%. Similar assumptions for the years ended December 31, 2002 and 2001
were: risk free interest rate of 1.10% and 1.50%; dividend yield of 0.0% and
4.0%; expected option life of 6 years; and volatility of 39.8% and 38.7%,
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.

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table illustrates the effect on net income and earnings per
share data if the Company had applied the fair value recognition provisions of
SFAS No. 123 to stock based compensation under the Company's stock-based
compensation plan.

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, 2003 were 12,932. Common Stock Units are convertible into CNA
Surety common stock at the election of the director.

12. 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 $4.8
billion in direct written premiums, comprised of approximately $3.8 billion in
surety premiums and $1.0 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 is
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.

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The following tables set forth gross and net written premiums, dollars in
thousands, by product and between domestic and international risks and the
respective percentage of the total for the past three years.

Gross Written Premium

Net Written Premium

Approximately $61.2 million, or 16.5%, of gross written premiums were
generated from national insurance brokers in 2003 with the single largest
national broker production comprising $19.2 million, or 5.2%, of gross written
premiums.

13. STATUTORY FINANCIAL DATA (UNAUDITED)

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
Company's insurance subsidiaries follow two permitted accounting practices which
did not have a material effect on reported statutory surplus or income. The
Company was given permission to report activity in the Small Business
Administration's Surety Bond Guarantee program as a reinsurance program and to
report all salvage and subrogation recoveries as recoveries of loss rather than
allocating recoveries between loss and loss adjustment expenses. Historically,
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.

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table reconciles consolidated stockholders' equity at
December 31, 2003 and 2002 as reported herein in conformity with GAAP with total
statutory capital and surplus of CNA Surety's insurance subsidiaries, determined
in accordance with statutory accounting practices prescribed or permitted by
insurance regulatory authorities (dollars in thousands):

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 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
a company or regulators. As of December 31, 2003, 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 2004, CNA Surety's insurance subsidiaries may pay dividends of $19.0
million in the aggregate. Combined statutory surplus for the insurance
subsidiaries at December 31, 2003 was $190.4 million.

14. RELATED PARTY TRANSACTIONS

The Company has the following related party transactions not previously
described in Note 6. Reinsurance.

Effective January 1, 2001, CNA Surety renewed an Administrative Services
Agreement with CCC. The agreement allows the Company to purchase and/or have
access to certain services provided by CNAF. The Company will also pay CNAF a
management fee for its proportionate share of administrative and overhead costs
incurred in supporting the services provided pursuant to this agreement. The
management fee for the year 2004 is $1.8 million that shall be paid by CNA
Surety to CNAF in equal monthly installments by the last day of each month. The
management fee shall be increased as of January 1, the "adjustment date", of
each

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year this Administrative Services Agreement is in force by the greater of 5% or
the amount of the increase in the Consumer Price Index for All Urban Consumers
for the Chicago, Illinois area as reported by the Bureau of Labor Statistics for
the 12 month period immediately preceding the adjustment date. The agreement was
amended in 2003 to allow CCC to purchase services from the Company. In 2003, CCC
paid the Company $0.2 million for services in connection with licensing and
appointing CCC's insurance producers as required by state insurance laws. This
agreement shall be effective so long as CNAF or their affiliates or shareholders
shall continue to own a majority interest in CNA Surety. This agreement may be
terminated by either party upon the provision of 30 days prior notice of such
termination to the other party.

The Company was charged $6.1 million, $5.2 million, and $5.7 million for
the years ended December 31, 2003, 2002 and 2001, respectively, for rents and
services provided under a previous Administrative Services Agreement. In
addition, the Company was charged $1.4 million, $1.0 million and $2.1 million
for direct costs incurred by CCC on the Company's behalf during 2003, 2002 and
2001, respectively. The Company had a payable balance to CCC of $0.3 million
that was reflected in other liabilities in the Company's Consolidated Balance
Sheet at December 31, 2003.

Western Surety has entered into a series of business transactions with
entities in which an affiliate of CCC has an interest. The first series involves
five separate real estate residual value insurance policies issued by R.V.I.
America Insurance Company ("RVI -- America") reinsured by Western Surety through
the Quota Share Treaty. RVI America is a wholly owned subsidiary of R.V.I.
America Corporation, which is a wholly owned subsidiary of R.V.I. Guaranty
Company Ltd. of Bermuda ("RVI -- Bermuda"), an unconsolidated affiliate of CCC.
The transactions involve policies with limits totaling approximately $11.5
million. CCC is reinsuring the full extent of RVI -- America's exposure on the
policies. Pursuant to the Quota Share Treaty, Western Surety is, in turn,
reinsuring all of CCC's exposures on the policies. Western Surety is reinsuring
all of its exposure on the policies with RVI-Bermuda, a non-admitted reinsurer.
The policy limits range from $119,785 to $2,954,164 with an average policy limit
of approximately $1.8 million and total limits of all policies of $8,997,395.
Net premium amounts retained in 2000 relative to these reinsurance transactions
totaled $519,278 as follows: RVI -- America, $51,928; CCC, $130,858; Western
Surety, $67,298; and RVI -- Bermuda, $269,194.

In addition from time to time Western Surety provided surety bonds
guaranteeing insurance payments of certain companies to CCC and its affiliates
under retrospectively rated insurance policies underwritten by CCC and its
affiliates. Under the terms of these bonds, referred to as insurance program
bonds, if the principal, the insured company, failed to make required a required
premium payment, CCC and its affiliates would have a claim against the Company
under the bond. The Company now has a policy not to issue such bonds to
companies insured by CCC and its affiliates. The last such bond was written in
2001 and currently bonds with $44.5 million of total penal sums remain.

Western Surety from time to time provides license and permit bonds and
appeal bonds to CCC and its affiliates and to clients of CCC and its affiliates.
Under procedures established by the Audit Committee, the Company may issue
appeal bonds for CCC and its affiliates and their clients with penal sums of $10
million or less without prior audit committee approval as long as those bonds
meet the Company's normal underwriting standards, the rates charged are market
rates and that the Company has received the indemnity of CCC. Bonds greater than
$10 million require the prior approval of the Audit Committee. As of December
31, 2003, the total amount of the outstanding appeal and license and permit
bonds written on behalf of CCC and its affiliates was approximately $81 million,
which was comprised of 39 bonds. Western Surety has entered into indemnity
agreements with CCC and its affiliates indemnifying Western Surety for any loss
arising from the issuance of appeal bonds for CCC and its affiliates. The
premium for these bonds was approximately $440,000 in 2003.

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15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

The following is a summary of the results of operations of CNA Surety for
the years ended December 31, 2003, 2002, and 2001 (Dollars in thousands, except
per share amounts):

72

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

The Company maintains a system of disclosure controls and procedures which
are designed to ensure that information required to be disclosed by the Company
in reports that it files or submits to the Securities and Exchange Commission
under the Securities and Exchange Act of 1934, including this report, is
recorded, processed, summarized and reported on a timely basis. These disclosure
controls and procedures include controls and procedures designed to ensure that
information required to be disclosed under the Exchange Act is accumulated and
communicated to the Company's management on a timely basis to allow decisions
regarding required disclosure.

The Company's principal executive officer and its principal financial
officer undertook an evaluation of the Company's disclosure controls and
procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d - 15(e)) as of
the end of the period covered by this report and concluded that the Company's
controls and procedures were effective.

There were no changes in the Company's internal control over financial
reporting that occurred during the Company's last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.

PART III.

ITEMS 10, 11, 12, 13, AND 14. DIRECTORS AND EXECUTIVE OFFICERS OF THE
REGISTRANT, EXECUTIVE COMPENSATION, SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS,
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS,
AND PRINCIPAL ACCOUNTANT FEES AND SERVICES

The Company will file a definitive proxy statement with the Securities and
Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act
of 1934 (the "Proxy Statement") relating to the Company's Annual Meeting of
Stockholders to be held on May 11, 2004, not later than 120 days after the end
of the fiscal year covered by this Form 10-K. Information required by Items 10
through 14 will appear in the Proxy Statement and is incorporated herein by
reference.

73

PART IV.

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(b) Reports on Form 8-K:

November 3, 2003: CNA Surety announces third quarter results.

November 13, 2003: Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for the
Chief Executive Officer and the Chief Financial Officer issued on November
13, 2003.

74

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders of
CNA Surety Corporation

We have audited the consolidated financial statements of CNA Surety
Corporation and subsidiaries (the "Company") as of December 31, 2003 and 2002,
and for each of the three years in the period ended December 31, 2003, and have
issued our report thereon dated March 12, 2004 (which report expresses an
unqualified opinion and includes an explanatory paragraph relating to a change
in accounting for goodwill and indefinite-lived intangible assets in 2002); such
consolidated financial statements and report are included in Item 8 of this Form
10-K. Our audits also included the financial statement schedules of CNA Surety
Corporation and subsidiaries, listed in Item 15. These financial statement
schedules are the responsibility of the Company's management. Our responsibility
is to express an opinion based on our audits. In our opinion, such financial
statement schedules, when considered in relation to the basic consolidated
financial statements included in Item 8 of the Form 10-K taken as a whole,
present fairly in all material respects the information set forth therein.

DELOITTE & TOUCHE LLP

Chicago, Illinois
March 12, 2004

75

SCHEDULE I

CNA SURETY CORPORATION AND SUBSIDIARIES

SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
AS OF DECEMBER 31, 2003 AND 2002

76

SCHEDULE II

CNA SURETY CORPORATION

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY)
BALANCE SHEETS

77

SCHEDULE II

CNA SURETY CORPORATION

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) -- (CONTINUED)
STATEMENTS OF INCOME

78

SCHEDULE II

CNA SURETY CORPORATION

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) -- (CONTINUED)
STATEMENTS OF CASH FLOWS

79

SCHEDULE II

NOTES TO CONDENSED FINANCIAL INFORMATION

1. RESTRICTED CASH AND SHORT TERM INVESTMENTS

As of December 31, 2003 and December 31, 2002, parent company short-term
investments and cash included $6.6 million and $4.8 million, respectively, of
restricted cash related to premium receipt collections ultimately due to the
Company's insurance subsidiaries.

80

SCHEDULE III

CNA SURETY CORPORATION AND SUBSIDIARIES

SUPPLEMENTARY INSURANCE INFORMATION
CNA SURETY CORPORATION AS OF AND FOR THE YEARS ENDED
DECEMBER 31, 2003, 2002 AND 2001

81

SCHEDULE IV

CNA SURETY CORPORATION AND SUBSIDIARIES

REINSURANCE
CNA SURETY CORPORATION FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001

- ---------------

* From Affiliates

82

SCHEDULE V

CNA SURETY CORPORATION AND SUBSIDIARIES

VALUATION AND QUALIFYING ACCOUNTS
CNA SURETY CORPORATION AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND
2001

- ---------------

(1) Accounts charged against allowance.

83

SCHEDULE VI

CNA SURETY CORPORATION AND SUBSIDIARIES

SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY
INSURANCE OPERATIONS
CNA SURETY CORPORATION AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND
2001

84

(A)(3) EXHIBITS

87

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.

CNA SURETY CORPORATION

/s/ JOHN F. WELCH
--------------------------------------
John F. Welch
President and Chief Executive Officer
(Principal Executive Officer)

/s/ JOHN F. CORCORAN
--------------------------------------
John F. Corcoran.
Senior Vice President and Chief
Financial Officer
(Principal Financial and Accounting
Officer)

Dated: March 15, 2004

Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed below by the following persons on behalf of
the Registrant and in the capacities and on the dates indicated.