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, 2004

[ ] 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 CENTER, 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 non-affiliates was $209.0
million based upon the closing price of $13.33 per share on February 22, 2005,
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 February 22, 2005, 43,104,070 shares of the Registrant's Common Stock
were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the CNA Surety Corporation Proxy Statement prepared for the 2005
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

1

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 9.2% market
share (based upon 2003 Surety Association of America ("SAA") 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"), Surety Bonding Company
of America ("Surety Bonding") 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 91% 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

The Company's corporate objective is to be the leading provider of surety
and surety-related products in North America and to be the surety of choice for
its customers and independent agents and brokers. 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 Surety Bonding. 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. Surety Bonding is licensed in 28 states
and the District of Columbia. USA is licensed in 44 states and the District of
Columbia.

FINANCIAL STRENGTH RATINGS

A.M. BEST COMPANY, INC.

Western Surety is currently rated A (Excellent) with a negative rating
outlook, by A.M. Best Company, Inc. ("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.

2

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 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.
3

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 addition, the Company markets surety related products such as fidelity
bonds and 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 2004, no individual agency generated more than 1.7% of aggregate gross
written premiums. Approximately $68.1 million, or 17.5%, of gross written
premiums were generated from national insurance brokers in 2004 with the single
largest national broker production comprising $18.5 million, or 4.7%, 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 35 local branch offices.

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:

5

Contract Surety

With respect to standard contract surety, the core target customers for the
Company are 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. The Company's marketing emphasis continues to be on small
and medium contractors, however the Company does have exposure to larger
contractors. These exposures are measured in terms of bonded backlog which is an
indication of the Company's exposure in event of default before indemnification
and salvage and subrogation recoveries. At December 31, 2004, the Company has 13
accounts each with a bonded backlog in excess of $150 million and 14 accounts
each with a bonded backlog between $100 million and $150 million. The Company
actively monitors 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. Through these
programs, the SBA assumes 70% to 90% of the coverage in exchange for 10% to 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 76% of the Company's commercial
gross written premiums and 33% 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'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 notary bonds, mortgage broker compliance
bonds and grain warehouse dealer bonds (protecting funds associated with grain
storage).

CNA Surety also maintains a specific underwriting staff in Chicago
dedicated to middle market and "Fortune 1000" accounts. The Company's large
commercial account business is estimated to represent approximately 24% of the
Company's commercial gross written premiums and 10% 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.

6

COMPETITION

The surety and fidelity market is highly competitive. According to 2003
data from the SAA, the U.S. market aggregates approximately $5.0 billion in
direct written premiums, comprised of approximately $3.7 billion in surety
premiums and approximately $1.3 billion in fidelity premiums. The large
diversified insurance companies hold the largest market shares. For example, the
20 largest surety companies account for approximately 79% of the domestic surety
market and 97% of the domestic fidelity market. In 2003, CNA Surety was the
third largest surety provider with a 9.2% 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, monitors concentrations of credit risk and establishes allowances
for uncollectible amounts when indicated. At December 31, 2004 the Company holds
approximately $1.6 million of Letters of Credit as collateral for reinsurance
receivables.

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 of the Notes to the
Consolidated Financial Statements, Reinsurance, for further discussion.

CNA Surety's largest reinsurance receivable from an affiliate, CCC, an A
rated company by A.M. Best, was approximately $5.4 million and $52.7 million at
December 31, 2004 and 2003, respectively.

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

The Company retains an independent actuarial firm of national standing to
perform periodic actuarial analysis of the Company's loss reserves. This
analysis is based on a variety of techniques that involve detailed statistical
analysis of past reporting, settlement activity, and salvage and subrogation
activity, as well as 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. While techniques may
vary, each employs significant judgments and assumptions. The independent
actuarial firm provides annually actuarial certification as to the
reasonableness

7

of actuarial assumptions used and the sufficiency of year-end reserves for each
of the Company's 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 of the Notes 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 practices ("SAP") as of December 31, 2004
(dollars in thousands):

Net reserves at end of year, GAAP basis..................... $ 246,556
Ceded reinsurance, net of salvage and subrogation........... 116,831
---------
Gross reserves at end of year, GAAP basis................... 363,387
Estimated reinsurance recoverable netted against gross
reserves for SAP.......................................... (116,831)
Net reserves on retroactive reinsurance assumed............. (10,492)
---------
Net reserves at end of year, SAP basis...................... $ 236,064
=========

The following loss reserve development table 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.

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 1994 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.

8

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
for the Company's contract and large commercial account business is performed in
Chicago. Claims for the Company's small commercial bonds and the related
fidelity bonds and E&O insurance are handled in Sioux Falls. 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.

9

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 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 $12.0 million as of
December 31, 2004.

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. Surety Bonding 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 of the
Notes to the Consolidated Financial Statements, Statutory Financial Data.
Without prior regulatory approval in 2005, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $46.8 million in the aggregate. For the year
ended December 31, 2004, CNA Surety received no 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. During 2003, both the South
Dakota Department of Commerce and Regulation-Insurance Division and the Texas
Department of Insurance issued their respective reports of examination for the
five-year period ended December 31, 2001. The points noted in their reviews were
largely administrative in nature and have been addressed by management. In
connection with an examination of the insurance subsidiaries of CNAF undertaken
by the Illinois Department of Insurance in 2004, both the South Dakota
Department of Commerce and Regulation-Insurance Division and the Texas
Department of Insurance initiated financial

10

examinations as of December 31, 2003 of Western Surety, Surety Bonding, and USA.
The review of USA is currently in progress. The review of Western Surety and
Surety Bonding was completed on January 21, 2005. The points noted in these
reviews were largely administrative in nature and are being addressed by
management. The points noted do not have a material impact on the insurance
subsidiaries' statutory surplus, nor have they resulted in any fines or
penalties to CNA Surety or any of its subsidiaries. The report did address the
Company's exposure to the large national contractor (discussed later) that had
previously been discussed with the regulators. The Company has agreed to provide
the regulators with an ongoing update and review of this exposure.

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 2004.

Western Surety and Surety Bonding 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 and
Surety Bonding, based on each insurer's statutory surplus, were $21.9 million
and $0.5 million, respectively, for the twelve-month period ended June 30, 2004.
Effective July 1, 2004 through June 30, 2005, the underwriting limitations of
Western Surety and Surety Bonding are $18.5 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,
2004 through June 30, 2005, the underwriting limitations of CCC and its
affiliates total $591.1 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, 2004, the Company employed 724 persons. CNA Surety has
not experienced any work stoppages. Management of CNA Surety believes its
relations with its employees are good.

11

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 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 91,800 square feet and
related personal property at 33 branch locations and its home and executive
offices (20,484 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 2005, 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, 2004. CNA Surety also
leases space for contract and commercial branch offices in Tallahassee, Florida,
New York, New York; Troy, Michigan; Roseville, California; Houston, Texas; and
San Juan, Puerto Rico. Annual rent for these offices was $0.5 million with
leases terminating in 2005, 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 February 22, 2005, the last reported sale
price for the Common Stock was $13.33 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 2004 and 2003.

The number of stockholders of record of Common Stock on February 22, 2005,
was approximately 404.

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, 2004, 2003, 2002, 2001 and 2000.

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

(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 a reduction of $613, or 0.2%, for the year ended
December 31, 2004, 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, and a reduction of $7,093, 2.4%, for the year ended
December 31, 2000.

(2) As of January 1, 2002, the Company adopted 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 after 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 and 2000 would have been $42.6 million
or $0.99 per share, and $59.3 million or $1.38 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 "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.

Exposure to Loss on Principals Excluded from Reinsurance Programs

Beginning in 2002, the Company's unaffiliated 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, only one remains excluded from the 2005 reinsurance program. This
account is a large national contractor that is discussed in detail on page 25.

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 2004 and 2005, with substantial cost savings achieved
for 2005 relative to 2004. The availability and cost of reinsurance protection
for 2006 and beyond will depend on a number of factors such as the Company's
loss experience, the surety industry's loss experience, the number of reinsurers
willing to provide coverage, and broader economic conditions.

Financial Strength Ratings

Surety bond principals and obligees often refer to the financial strength
ratings assigned by A.M. Best Company, Inc. ("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") to serve larger accounts, the insurer financial strength rating
of both the Company and CCC factor into customers' decisions. After reporting a
significant net 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 net 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 downgrades has been
reduced by ongoing efforts to reduce large exposures, lower per principal
retentions under the 2004

15

and 2005 reinsurance programs, the reduction in the number of principals
excluded from reinsurance programs and increased statutory surplus and capital.

Economic Conditions

The Company's results of operations are impacted by general corporate
credit conditions, as well as by the condition of the public construction
segment of the economy. Corporate credit default rates have improved from the
historically high levels of 2002 and 2003, and the amount of new public
construction spending appears to be strong. An improvement in overall corporate
default rates could be expected to have a favorable impact on the Company's loss
costs. Strong public construction spending could be expected to benefit the
Company's written premium production and loss costs. Changes in these factors
could have a material impact on the Company's financial condition and results of
operations. Management believes that the diversification of the Company's book
of business, with approximately 40% 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. Based on analysis of
current competitive factors in the marketplace, the Company does not expect to
achieve significant rate increases, 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 balances 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.

Reported claims are in various stages of the settlement process. Due to the
nature of surety, which is the relationship among three parties whereby the
surety guarantees the performance of the principal to a third party (the
obligee), the investigation of claims and the establishment of case estimates on
claim files can be a complex process that can occur over a period of time
depending on the type of bond(s) and the facts and circumstances involving the
particular bond(s), the claim(s) and the principal. Case reserves are typically
established after a claim is filed and an investigation and analysis has been
conducted as to the validity of the claim, the principal's response to the claim
and the principal's financial viability. To the extent it is determined that
there are no bona fide defenses to the claim and the principal is unwilling or
financially unable to resolve the claim, a case estimate is established on the
claim file for the amount the Company estimates it will have to pay to honor its
obligations under the provisions of the bond(s).

16

While the Company intends to establish initial case reserve estimates that
are sufficient to cover the ultimate anticipated loss on a file, some estimates
need to be adjusted during the life cycle of the file as matters continue to
develop. Factors that can necessitate case estimate increases or decreases are
the complexity of the bond(s) and/or underlying contract(s), if additional
and/or unexpected claims are filed, if the financial condition of the principal
or obligee changes or as claims develop and more information is discovered that
was unknown and/or unexpected at the time the initial case reserve estimate was
established. Ultimately, claims are resolved through payment and/or a
determination that, based on the information available, a case reserve is no
longer required.

As of any balance sheet date, not all claims have 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 ("IBNR")
claims. The following table shows the estimated liability as of December 31,
2004 for unpaid claims applicable to reported claims and to IBNR (dollars in
thousands) for each sub-line of business:

The Company retains an independent actuarial firm of national standing to
perform periodic actuarial analysis of the Company's loss reserves. This
analysis is based on a variety of techniques that involve detailed statistical
analysis of past claim reporting, settlement activity, and salvage and
subrogation activity, as well as 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. While
techniques may vary, each employs significant judgments and assumptions. This
analysis results in both a range of reasonable loss reserve estimates as well as
a point estimate of the indicated loss reserves. Surety results, especially for
contract and certain commercial products like insurance program bonds, workers
compensation insurance bonds and reclamation bonds, tend to be impacted by
fewer, but more severe, losses. With this type of loss experience, it is more
difficult to estimate the required reserves, particularly for the most current
accident years which may have few reported claims. As a result, the range of
reasonable loss reserve estimates may be broader than that associated with
traditional property/casualty insurance products.

The independent actuarial firm's analysis is the primary tool that
management utilizes in determining its best estimate of loss reserves. However,
the carried reserve may differ from the independent actuarial firm's point
estimate as a result of management's consideration of the impact of factors such
as the following, especially as they relate to the current accident year:

- Current claim activity, including the frequency and severity of current
claims

- Changes in underwriting standards and business mix such as the Company's
efforts to reduce exposures to large commercial bonds

- Changes in the claims handling process

- Current economic conditions, especially corporate default rates and the
condition of the construction economy

Management believes that the impact of the factors listed above, and
others, may not be fully quantifiable through actuarial analysis. Accordingly,
management may apply its judgment of the impact of these factors, and others, to
its selection of the recorded loss reserves.

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

17

reinsurer is unable to perform under the contract. Reinsurance contracts do not
relieve the ceding company of its obligations to indemnify its own
policyholders.

The Company's Consolidated Balance Sheet includes estimated liabilities for
unpaid losses and loss adjustment expenses of $363.4 million and reinsurance
receivables related to unpaid losses of $116.8 million at December 31, 2004
compared to estimates of $413.5 million and $158.4 million, respectively, at
December 31, 2003.

At December 31, 2004, the range of reasonable loss reserve estimates, net
of reinsurance receivables, calculated by the independent actuarial firm and
adopted by management was from $199 million to $305 million. Ranges of
reasonable loss reserve estimates are not calculated for the sub-lines of
business. Management believes that the range calculated over total reserves
provides the most meaningful information due to the importance of correlation of
losses between the sub-lines of business related to the impact of general
economic conditions. 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 and financial
condition. 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 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 materially affect the
amounts reported in the Consolidated Balance Sheets and Consolidated Statements
of Income.

Intangible Assets

CNA Surety's Consolidated Balance Sheet as of December 31, 2004 includes
intangible assets of $138.8 million. These amounts represent goodwill and
identified intangibles with indefinite useful lives arising from the acquisition
of 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 142"), which was adopted by CNA
Surety as of January 1, 2002, periodic amortization ceased, in accordance with
an impairment-only accounting model.

18

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 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 intangible assets over the implied value of intangible assets 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. The Company
periodically tests that deferred acquisition costs are recoverable based on the
expected profitability embedded in the reserve for unearned premium. If the
expected profitability is less than the balance of deferred acquisition costs, a
charge to net income is taken and the deferred acquisition cost balance is
reduced to the amount determined to be recoverable. Anticipated investment
income is considered in the determination of the recoverability of deferred
acquisition costs.

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 the results of its
insurance operations 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.

19

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

While management uses various GAAP and non-GAAP financial measures to
monitor various aspects of the Company's performance, net income is the most
directly comparable GAAP measure and represents a more comprehensive measure of
operating performance. Management believes that its process of evaluating
performance through the use of these non-GAAP financial measures provides a
basis for enhanced understanding of its operating performance and the impact to
net income as a whole. Management also believes that investors may find these
widely used financial measures described above useful in interpreting the
underlying trends and performance, as well as to provide visibility into the
significant components of net income.

COMPARISON OF CNA SURETY ACTUAL RESULTS FOR THE YEARS ENDED DECEMBER 31, 2004,
2003 AND 2002

Analysis of Net Income (Loss)

The Company had net income of $39.7 million for the year ended December 31,
2004 as compared to a net loss of $14.2 million for the year ended December 31,
2003, and net income of $30.1 million for the year ended December 31, 2002. The
increase in 2004 reflects the absence of material adverse loss development which
occurred during the third quarter of 2003, higher net earned premium and higher
net investment income, partially offset by higher expenses. The decrease in 2003
compared to 2002 was driven by higher incurred losses and lower investment
income.

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,
2004, 2003 and 2002 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

20

also writes fidelity bonds that cover losses arising from employee dishonesty
and other insurance products that are generally companion products to certain
surety bonds. For example, the Company writes surety bonds for notaries and also
offers related errors and omissions ("E&O") insurance coverage.

The Company assumes significant amounts of premiums primarily from
affiliates. This 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 reinsurance and related agreements.
Because of certain regulatory restrictions that limit the Company's ability to
write business on a direct basis, the Company continues to utilize the
underwriting capacity available through these agreements. The Company is in full
control of all aspects of the underwriting and claim management of the assumed
business.

Gross written premiums for the years ended December 31, 2004, 2003 and 2002
are shown in the table below (dollars in thousands) for each sub-line of
business:

Gross written premiums for the year ended December 31, 2004 increased 4.9%
to $389.4 million as compared to 2003. Gross written premiums for contract
surety increased 6.3% to $221.6 million, due primarily to improving rates on
large contract bonds. Commercial surety premiums increased 1.6% to $135.9
million as continued strong volume growth in small commercial products more than
offset the volume decline due to the Company's ongoing efforts to reduce
aggregate exposures to large commercial accounts. Fidelity and other premiums
increased by 7.7% in 2004 primarily due to the volume growth of related small
commercial products.

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. 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 that are
related to small commercial surety bonds.

Net written premiums for the years ended December 31, 2004, 2003 and 2002
are shown in the table below (dollars in thousands) for each sub-line of
business:

For the year ended December 31, 2004, net written premiums decreased
slightly to $318.3 million as compared to 2003, reflecting higher reinsurance
costs. Ceded written premiums increased $19.0 million to $71.1 million for the
year ended December 31, 2004 compared to 2003 primarily due to the Company's
decision to reduce its per principal retention by purchasing additional
reinsurance protection. Net written premiums for contract surety business
decreased 6.6% to $172.3 million due to a higher allocation of reinsurance costs
in 2004. Because of the significant reductions in exposures to large commercial
bonds, a

21

greater share of the reinsurance protection is related to contract bonds. Net
written premiums for commercial surety increased 8.0% to $115.5 million for the
year ended December 31, 2004. Fidelity and other products increased 9.7% to
$30.5 million for the year 2004 as compared to 2003.

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. Ceded written premiums decreased $1.0 million
to $52.2 million for the year ended December 31, 2003. 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 primarily due to the aforementioned gross
production.

Excess of Loss Reinsurance

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. At December 31, 2004, American Reinsurance Company, General Reinsurance
Corporation, Swiss Reinsurance America Corporation, and XL Reinsurance
Corporation (all rated at least A by A.M. Best) were the four reinsurers from
which the Company had its largest reinsurance receivables.

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 replaced the $45
million excess of $15 million per principal coverage, as well as the $40 million
excess of $60 million per principal and the $3 million excess of $12 million
coverage that had been provided by CCC. The material differences between the
2004 Excess of Loss Treaty excess of loss reinsurance program and the Company's
2003 Excess of Loss Treaty are as follows. The annual aggregate coverage
increased from $110 million in 2003 to $157 million in 2004. The premium for the
2004 Excess of Loss Treaty was $50.6 million (net of expected return premium)
compared to a total of $42.0 million of reinsurance 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 included an optional twelve month extended discovery period,
for an additional premium (a percentage of the original premium based on any
unexhausted aggregate limit by layer), which would provide coverage for losses
discovered in 2005 on bonds that were in force during 2004. The Company did not
elect to purchase the extended discovery period because it obtained coverage for
2005 under a new treaty. The 2004 Excess of Loss Treaty also provided for
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,
for a total of six excluded principals. The one large contract principal and the
two commercial principals remained excluded from the 2004 Excess of Loss Treaty.
Of the two commercial principals, one is a domestic electric utility with an
estimated bonded exposure of $38 million and is currently rated B- by S&P. This
rating was increased from CCC+ during the third quarter of 2004 due to
significant recapitalization efforts by the principal. The bonded exposure will
decline over the term of the bond which extends until 2007. The other commercial
principal is a foreign industrial enterprise that fulfilled its bonded
obligations in the second quarter of 2004, so the Company no longer has any
exposure.

With respect to the three contract principals other than the large national
contractor, two contract principals that have completed asset sales and other
reorganization efforts have been accepted into the 2004 Excess of Loss Treaty.
The Company received claims related to the third contract principal in 2003,
making it ineligible for inclusion in the 2004 Excess of Loss Treaty. The
Company believes it is adequately reserved for any exposure related to this
principal and is not currently providing bonds to this contractor.

22

2005 Third Party Reinsurance Compared to 2004 Third Party Reinsurance

Effective January 1, 2005, CNA Surety entered into a new excess of loss
treaty ("2005 Excess of Loss Treaty") with a group of third party reinsurers on
terms similar to the 2004 Excess of Loss Treaty. Under the 2005 Excess of Loss
Treaty, the Company's net retention per principal remains at $10 million with a
5% co-participation in the $90 million layer of third party reinsurance coverage
above the Company's retention. The material differences between the 2005 Excess
of Loss Treaty and the Company's 2004 Excess of Loss Treaty are as follows. The
annual aggregate coverage increases from $157 million in 2004 to $185 million in
2005. The base annual premium for the 2005 Excess of Loss Treaty is $40.7
million compared to the actual cost of the 2004 Excess of Loss Treaty of $50.6
million (net of expected return premium). The contract again includes an
optional twelve month extended discovery period, for an additional premium (a
percentage of the original premium based on any unexhausted aggregate limit by
layer) which will provide coverage for losses discovered in 2006 on bonds that
were in force during 2005. In addition, the 2005 Excess of Loss Treaty provides
coverage for one commercial principal that had been excluded from the 2004
Excess of Loss Treaty. The Company no longer has exposure to a second commercial
principal that was excluded from the 2004 Excess of Loss Treaty. Only the large
national contractor (described later) that was excluded from the 2004 Excess of
Loss Treaty remains excluded from the 2005 Excess of Loss Treaty.

Related Party Reinsurance

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, 2005 and
expires on December 31, 2005; and is annually renewable thereafter. There was no
amount due to the CNA Surety insurance subsidiaries as of December 31, 2004.

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 has not been any
adverse reserve development for the period from September 30, 1997 (date of
inception) through December 31, 2004.

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. Due to lower commissions paid
to producers on the business covered by the Quota Share Treaty, the actual
override commission paid to CCC and CIC for 2004 was approximately 7%. The Quota
Share Treaty was renewed for one year on January 1, 2005 on substantially the
same terms except that the ceding commission to CCC and CIC was reduced to 25%
in order to provide an approximate 4% override commission to CCC and CIC.

23

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 CCC all required annual premiums. As of December 31, 2004, the Company had
billed $54.9 million under the Stop Loss Contract which has been paid by CCC,
including $29.9 million received in 2004.

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 unlimited 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 originally extended until September 30,
2005. On January 1, 2005, CCC agreed to extend the discovery period to September
30, 2006 in return for an additional premium of $75,000.

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 was entitled to a
commutation payment of $10.9 million from CCC that was 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 was effective from January 1,
2004 to December 31, 2004. The premium for this contract was $3.0 million. If a
loss is ceded under this contract, an additional premium of $6.0 million is due.
The Company and CCC entered into a new contract covering the one large national
contractor effective January 1, 2005 to December 31, 2005 on the same terms as
the 2004 contract.

24

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 was $6.0 million plus an additional premium of $14.0 million if a
loss is ceded under this contract. Effective January 1, 2005, the Company and
CCC entered into a new $50 million excess of $100 million contract in force
through December 31, 2005. The premium for this contract is $4.75 million plus
an additional premium of $14.0 million if a loss is ceded under this contract.
The reduction in premium for 2005 reflects the reduction in the Company's
exposures, particularly large commercial exposures.

The Company and CCC are presently discussing a possible restructuring of
the reinsurance arrangements described in the preceding two paragraphs under
which all bonds written for the large national contractor would be reinsured by
CCC under an excess of $60 million treaty and other CNA Surety accounts would be
covered by a separate $50 million excess of $100 million treaty.

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, but was commuted effective January 1, 2004, when the Company
obtained replacement coverage from third party reinsurers as part of the 2004
Excess of Loss Treaty.

As of December 31, 2004 and December 31, 2003, CNA Surety had an insurance
receivable balance from CCC and CIC of $16.4 million and $71.1 million,
respectively. CNA Surety had reinsurance payables to CCC and CIC of $0.3 million
as of December 31, 2004. CNA Surety had no reinsurance payables to CCC and CIC
as of December 31, 2003.

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, 2006 arising from bonds issued to the large national 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, 2006 on bonds with effective dates of September
30, 2002 and prior 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, 2005 that provides $40 million
excess of $60 million reinsurance coverage exclusively for the large national
contractor.

For bonds that the Company has written after September 30, 2002, 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 through December 31, 2004, the
Company's exposure is limited to $14.7 million per bond. For bonds the Company
may write in 2005, the Company's exposure will be limited to 10% of its
statutory surplus.

25

CNAF Credit Facility

Commencing in 2003, CNAF has provided loans through a credit facility in
order to help the large national contractor meet its liquidity needs and
complete projects which had been bonded by CNA Surety. In December of 2004, the
credit facility was amended to increase the maximum available loans to $106
million from $86 million at December 31, 2003. The amendment also provides that
CNAF may in its sole discretion further increase the amounts available for loans
under the credit facility, up to an aggregate maximum of $126 million. As of
December 31, 2004 and 2003, $99 million and $80 million had been advanced under
the credit facility. Loews, through a participation agreement with CNAF,
provided funds for and owned a participation of $29 million and $26 million of
the loans outstanding as of December 31, 2004 and 2003, respectively, and has
agreed to a participation of one-third of any additional loans which may be made
above the original $86 million credit facility limit up to the $126 million
maximum available line.

Loans under the credit facility are secured by a pledge of substantially
all of the assets of the contractor and certain of its affiliates. In connection
with the credit facility, CNAF has also guaranteed or provided collateral for
letters of credit which are charged against the maximum available line and, if
drawn upon, would be treated as loans under the credit facility. As of December
31, 2004 and 2003, these guarantees and collateral obligations aggregated $13
million and $7 million.

The contractor implemented a restructuring plan intended to reduce costs
and improve cash flow, and appointed a chief restructuring officer to manage
execution of the plan. In the course of addressing various expense, operational
and strategic issues, however, the contractor has decided to substantially
reduce the scope of its original business and to concentrate on those segments
determined to be potentially profitable. As a consequence, operating cash flow,
and in turn the capacity to service debt, has been reduced below previous
levels. Restructuring plans have also been extended to accommodate these
circumstances. In light of these developments, CNAF recorded an impairment
charge of $56 million pretax ($36 million after-tax) for the fourth quarter of
2004, net of the participation by Loews, with respect to amounts loaned under
the credit facility. Any draws under the credit facility beyond $106 million or
further changes in the large national contractor's business plan or projections
may necessitate further impairment charges.

The Company intends to continue to provide surety bonds on behalf of the
contractor during the restructuring period, subject to the contractor's initial
and ongoing compliance with the Company'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,
the contractor's failure to achieve its extended restructuring plan or perform
its contractual obligations under the Company's surety bonds could have a
material adverse effect on CNA Surety's results of operations, cash flow and
equity. If such failures occur, the Company estimates that possible losses, net
of indemnification and subrogation recoveries, but before recoveries under
reinsurance contracts, to be approximately $200 million pretax. However, the
related party reinsurance treaties discussed above should limit the Company's
per principal loss exposure to approximately $60 million. After consideration of
the additional premium due in the event of losses under the reinsurance treaties
discussed above, the Company estimates that the financial statement impact of a
failure by this contractor would be approximately $52 million after tax.

The Company has had discussions with its insurance regulatory authorities
regarding the level of bonds provided for this principal and will continue to
keep the insurance regulators informed of its ongoing exposure to this account.

Net Loss Ratio

The loss ratios for the years ended December 31, 2004, 2003 and 2002 were
27.5%, 56.7% and 31.6%, respectively. The loss ratios reflect $0.6 million of
favorable loss reserve development for the year ended December 31, 2004, and
$39.3 million and $6.2 million in net unfavorable loss reserve development for
the years ended December 31, 2003 and 2002, respectively.

The improvement in the loss ratio from 2003 to 2004 is primarily due to the
absence of both the adverse development on prior accident years that was
recorded in 2003 and other large losses related to accident year 2003. Past
changes in the Company's business mix and reinsurance program along with
increased corporate
26

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.

Reported claim activity improved dramatically in 2004. Management believes
that this is a result of ongoing efforts to reduce its exposures to large
corporate clients, continued underwriting discipline in its traditional contract
and small commercial products and a reduction in corporate default rates.
Management anticipates that these factors, along with a further reduction in the
Company's per principal retention for most accounts to $10 million for the 2004
and 2005 reinsurance programs will reduce the volatility of the Company's
results.

The favorable loss development recorded in 2004 for prior accident years
resulted from loss adjustment expense payments related to prior years that were
lower than previously expected. The adverse development on prior accident years
that occurred in 2003 was directly related to a significant increase in large
claim activity. Management concluded that this claim activity exceeded the
assumptions regarding the frequency of severe losses used in determining the
then existing reserves. First, additional contract bond claims were received
during the third quarter of 2003 on a contractor that had filed for bankruptcy
in February, 2003. Upon review and verification of these new claims, the
existing case reserve was increased by $7.2 million, net of applicable
reinsurance. Second, a demand was made during the third quarter of 2003 against
a $45 million insurance program bond issued on behalf of a national trucking
concern that was now in bankruptcy. This demand was in contradiction of previous
information provided by the obligee on the bond. Based on this new information,
management reserved the full remaining limits on this bond which resulted in $15
million of net adverse development after the application of available
reinsurance. Third, claims were also received in the third quarter of 2003 on
worker's compensation self insurance bonds written between 1975 and 1986 on
behalf of two principals. After verifying coverage and obtaining supporting
actuarial information on the underlying workers' compensation claims, the
Company increased the case reserves on these bonds by $8.4 million, net of
applicable reinsurance. Fourth, after receiving a demand on another insurance
program bond in the third quarter of 2003, management identified an outstanding
insurance program bond written on behalf of a contractor now in bankruptcy.
Based on recent experience with this type of bond, which typically has few
defenses available to the surety, and in particular with the obligee on this
bond, management recorded a loss provision on this bond of $6 million. Finally,
management determined that the case reserve on a particular claim was
insufficient due to the amount of legal fees that the Company was incurring on
the case. Based on their estimate of future legal expenses, management increased
the reserve on this bond by $3 million.

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 2003 accident year due to material adverse loss severity
on the Company's branch commercial and contract business. The net additions to
reserves for the 2003 accident year resulted from three large contract bond
claims totaling $28 million incurred in 2003, an approximately $15 million net
loss on an insurance program bond for a now bankrupt large commercial account,
and changes in estimates of large losses resulting from this significant adverse
claim activity.

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. In addition to the net unfavorable loss reserve development, the loss
ratio for the 2002 accident year was adversely impacted by the occurrence of a
$12.0 million loss resulting from the bankruptcy of a national trucking concern.
Due to the occurrence of this loss, other adverse loss trends and the uncertain
outlook for

27

the economy and credit markets at that time, the Company increased the 2002
accident year loss ratio assumption on contract and large commercial business.

On January 2, 2003, CNA Surety settled litigation brought by J.P. Morgan
Chase & Co. ("Chase") in connection with three surety bonds issued on behalf of
Enron Corporation subsidiaries. The penal sums of the three bonds totaled
approximately $78 million. 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, 2004, the Company has billed a total of $37.1
million to its reinsurers. Seven reinsurers responsible for payment of 63% of
the treaty proceeds either have paid their portions of the claim or have reached
agreement with the Company and paid the Company to commute the entire
reinsurance treaty under which the Enron claim was made. Pursuant to the treaty,
the Company demanded and began arbitration proceedings against the two other
reinsurers who have not paid their portions of the claim or commuted their
treaties. Management believes that these reinsurers do not 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 the remaining
reinsurance recoverables of $13.7 million as of December 31, 2004.

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. No reinsurance recoveries from CCC were recorded in 2004. As of
December 31, 2004, there was no unpaid balance related to amounts due under the
Stop Loss Contract.

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, before the effects of reinsurance, by 43%
in 2004 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 bonded backlog of less than $30 million. Bonded
backlog is a measure of the Company's exposure in the event of default before
indemnification, salvage and subrogation recoveries. The Company does have a
number of accounts with higher bonded backlogs. For example, the Company has 13
accounts each with a bonded backlog in excess of $150 million and 14 accounts
each with a bonded backlog of between $100 million and $150 million.

28

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.

Expense Ratio

The expense ratio increased to 65.2% for the year ended December 31, 2004
as compared to 62.6% for 2003. The increase in the expense ratio for the year
ended December 31, 2004 primarily reflects the impact of higher reinsurance
costs on net earned premiums and higher operating expenses. Ceded earned premium
increased by $10.5 million in 2004, primarily due to the Company's decision to
reduce its per principal retention from $15 million in 2003 to $10 million in
2004. The higher ceded earned premium increased the 2004 expense ratio by 2.1
percentage points. Operating expenses increased 8.6% for the year ended December
31, 2004 primarily due to a 6.6% increase in gross earned premium. 2004
operating expenses were impacted by a $4.9 million increase to the accrual for
policyholder dividends. This increase added approximately 1.5 percentage points
to the 2004 expense ratio. The Company streamlined its field office structure
during 2004 in order to add consistency to operations and to reduce expenses. No
significant expense impact occurred in 2004 due to severance costs associated
with this effort.

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. Ceded earned premium
increased by $13.3 million in 2003, due to the Company's decision to reduce its
per principal retention from $20 million in 2002 to $15 million in 2003 and
costs associated with the purchase of an extended discovery period on a 2001
treaty. The higher ceded earned premium increased the 2003 expense ratio by 2.6
percentage points. Operating expenses increased 6.1% for the year ended December
31, 2003 primarily due to a 5.6% increase in gross earned premium. 2003
operating expenses were impacted by a $1.9 million accrual for post-employment
benefits for three former senior executives that increased the 2003 expense
ratio by 0.6 percentage points.

Investment Income

For 2004, net investment income was $30.2 million compared to net
investment income for 2003 and 2002 of $26.3 million and $27.8 million,
respectively. The annualized pretax yield was 4.5%, 4.4% and 4.8% for 2004, 2003
and 2002, respectively. The annualized after-tax yield was 3.7%, 3.6% and 3.8%
for 2004, 2003 and 2002, respectively. The increase in investment income for
2004 is attributable to higher overall invested assets resulting primarily from
significant cash flow from operations. The decrease in investment income for
2003 is attributable to the impact of lower investment yields in part due to
increased investment in tax-exempt securities.

Net realized investment gains/losses were $2.8 million and $1.8 million in
gains for 2004 and 2003, respectively, and $7.6 million in losses for 2002. The
net gains realized in 2004 and 2003 resulted from opportunities to sell
securities that the Company believed would maximize the total return on its
portfolio. The net realized investment losses in 2002 reflect the Company's
insurance subsidiaries' decision to liquidate their common equity portfolios
during 2002. The volatility of the equity markets was adversely impacting the
Company's reported regulatory capital.

The following summarizes net realized investment gains (losses) for the
years ended December 31, 2004, 2003, and 2002:

29

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.

Interest Expense

Interest expense increased $0.7 million, or 48.4%, for 2004 compared to
2003, primarily due to higher outstanding debt levels and the higher interest
rate associated with long-term debt issued in 2004. The weighted average
interest rate for 2004 was 3.6% compared to 2.4% and 2.2% for the periods ended
December 31, 2003 and 2002, respectively. Interest expense decreased $0.2
million, or 10.8%, for 2003 compared to the same period in 2002, due primarily
to lower outstanding debt levels. Average debt outstanding was $60.9 million in
2004 compared to $55.6 million and $73.4 million in 2003 and 2002, respectively.

Income Taxes

The Company's income tax expense was $14.3 million for the year ended
December 31, 2004, as compared to an income tax benefit of $18.0 million for
2003 and income tax expense of $12.6 million for 2002. The effective income tax
rates were 26.5%, (56.0)% and 29.6% for the years ended December 31, 2004, 2003
and 2002, respectively. The 2004 effective tax rate is impacted by the Company's
significant investments in tax-exempt securities. The change in the effective
tax rate in 2003 primarily relates to taxable losses from insurance underwriting
and greater investments in tax-exempt securities as compared 2002.

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, recoveries under reinsurance
contracts 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. If cash requirements unexpectedly exceed cash inflows, the Company
may raise additional cash by liquidating fixed income securities ahead of their
scheduled maturity. Depending on the interest rate environment at that time, the
Company could generate realized gains or losses that would increase or decrease
net income for the period. The extent of these gains or losses would depend on a
number of factors such as the prevailing interest rates and credit spreads, the
duration of the assets sold, and the marketability of the assets. The need to
liquidate fixed income securities would be expected to cause a reduction in
future investment income.

30

The Company might also access available or new credit facilities to meet
cash needs. This would increase interest expense by increasing the amount of
debt outstanding and potentially increasing the interest rate on previously
outstanding debt. The Company currently has $5 million of borrowing capacity on
existing facilities. The Company's ability to enter into new facilities is
limited by covenants in the existing facility.

At December 31, 2004, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $722.0 million of fixed income
securities, $22.7 million of short-term investments, $1.1 million of other
investments and $5.6 million of cash. 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.

During the fourth quarter of 2004, the Company reached agreement with the
obligee on a bond in claim regarding certain aspects of the claim resolution. As
part of this agreement, the Company will place approximately $34 million of
government securities in trust to fund future payments under the bond. This
claim was previously fully reserved.

Cash flow at the parent company level is derived principally from dividend
and tax sharing payments from its insurance subsidiaries, and to a lesser
extent, investment income. 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, 2004, the parent company's invested
assets consisted of $6.3 million of fixed income securities, $1.2 million of
equity securities, $5.8 million of short-term investments and $1.7 million of
cash. 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. As of December
31, 2004 and December 31, 2003, parent company short-term investments and cash
included $5.1 million and $6.6 million, respectively, of restricted cash
primarily 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 $108.0 million, $25.2 million and $85.5 million for 2004, 2003 and 2002,
respectively. The increase in net cash flow provided by operating activities in
2004 primarily relates to higher premiums received, lower loss payments,
receipts from reinsurers and an income tax refund related to the operating loss
of 2003. The decrease in cash flow provided in 2003 is primarily due to
increased loss payments.

In May of 2004, the Company, through a wholly-owned trust, privately issued
$30 million of preferred securities through two pooled transactions. These
securities bear interest at a rate of the London Interbank Offered Rate
("LIBOR") plus 337.5 basis points with a 30-year term and are redeemable after
five years. The securities were issued by CNA Surety Capital Trust I (the
"Issuer Trust"). The sole asset of the Issuer Trust consists of $30.9 million
junior subordinated debenture issued by the Company to the Issuer Trust. The
subordinated debentures bear interest at a rate of LIBOR plus 337.5 basis points
and mature in April of 2034. As of December 31, 2004 the interest rate on the
junior subordinated debentures was 5.665%. The proceeds from the debt issuance
were used to reduce the outstanding balance of a revolving credit facility of
$30 million (the "Revolving Credit Facility") by $10.0 million and to increase
the statutory surplus of the Company's insurance subsidiaries by $20.0 million.

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
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 repayments 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 Facility. As a result, the current effective interest rate on
the term loan as of December 31, 2004 was 2.77%.

31

In June 2004, the Company reduced the outstanding Revolving Credit Facility
by $10.0 million to $20 million. In September of 2004, the Company increased the
outstanding Revolving Credit Facility by $5.0 million. At December 31, 2004, the
amount outstanding under the Revolving Credit Facility was $25.0 million.

The Term Loan Facility balance was reduced by $20 million through December
31, 2004 to $10 million according to scheduled repayment. Further repayment of
the Term Loan Facility will take place in equal semi-annual installments of $5
million on the following dates:

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

(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

32

Western Surety and Surety Bonding are domiciled, insurance companies may only
pay dividends from earned surplus excluding surplus arising from unrealized
capital gains or revaluation of assets. In Texas, where USA is domiciled, an
insurance company may only declare or pay dividends to stockholders from the
insurer's earned surplus. The insurance subsidiaries may pay dividends without
obtaining prior regulatory approval only if such dividend or distribution
(together with dividends or distributions made within the preceding 12-month
period) is less than, as of the end of the immediately preceding year, the
greater of (i) 10% of the insurer's surplus to policyholders or (ii) statutory
net income. In South Dakota, net income includes net realized capital gains in
an amount not to exceed 20% of net unrealized capital gains. All dividends must
be reported to the appropriate insurance department prior to payment.

The dividends that may be paid without prior regulatory approval are
determined by formulas established by the applicable insurance regulations, as
described above. The formulas that determine dividend capacity in the current
year are dependent on, among other items, the prior year's ending statutory
surplus and statutory net income. Dividend capacity for 2005 is based on
statutory surplus and income at and for the year ended December 31, 2004.
Without prior regulatory approval in 2005, CNA Surety's insurance subsidiaries
may pay to CNA Surety dividends of $46.8 million in the aggregate. CNA Surety
received no dividends from its insurance subsidiaries in 2004. CNA Surety
received dividends of $28.5 million from its insurance subsidiaries in 2003.

Combined statutory surplus totaled $252.4 million at December 31, 2004,
resulting in a net written premium to statutory surplus ratio of 1.3 to 1.
Insurance regulations restrict Western Surety's maximum net retention on a
single surety bond to 10 percent of statutory surplus. Under the 2005 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
requirement may limit the amount of future dividends Western Surety could
otherwise pay to CNA Surety.

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 $10.9 million for 2004 and $7.4
million for 2003.

Western Surety and Surety Bonding 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, 2004 through June 30, 2005, the
underwriting limitations of Western Surety and Surety Bonding are $18.5 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, 2004 through June 30, 2005, the underwriting limitations of
CCC and its affiliates total $591.1 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.

33

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, 2004
and 2003 (dollars in thousands):

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.

CNA Surety classifies its fixed income securities and its equity securities
as available-for-sale, and as such, they are carried at fair value. The
amortized cost of fixed income securities is adjusted for amortization of
premiums and accretion of discounts to maturity, which is included in net
investment income. Changes in fair value are reported as a component of other
comprehensive income.

34

The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety by investment category, were as follows (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, 2004 and 2003 (dollars in thousands):

35

As of December 31, 2004 and 2003, 99% of the Company's fixed income
securities were considered investment grade by S&P or Moody's and 85% and 79%
were rated at least AA by those agencies for 2004 and 2003, respectively. The
Company's investments in fixed income securities do not contain any industry
concentration of credit risk.

As of December 31, 2004, municipal securities of the State of Florida, the
State of Texas, the State of Illinois, and the State of Michigan and each
state's related political subdivisions each represent 4.2%, 4.1%, 3.5% and 3.4%,
respectively, of the estimated fair value of the Company's fixed income
securities. Municipal securities of each other state individually represent less
than 3.3% of the Company's fixed income portfolio.

The following table provides the composition of fixed income securities
with an unrealized loss at December 31, 2004 in relation to the total of all
fixed maturity securities by contractual maturities:

The following table summarizes for fixed income securities in an unrealized
loss position at December 31, 2004 and 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 one other
executive officer 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.

36

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 net
realized gains/losses in the Consolidated Statements of Operations.

For the years ended December 31, 2004, 2003, and 2002, the Company had no
other-than-temporary declines in the value of its investment securities.

Reserves for Unpaid Losses and Loss Adjustment Expenses

The Company retains an independent actuarial firm of national standing to
perform periodic actuarial analysis of the Company's loss reserves. This
analysis is based on a variety of techniques that involve detailed statistical
analysis of past claim reporting, settlement activity, and salvage and
subrogation activity, as well as 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. While
techniques may vary, each employs significant judgments and assumptions. The
independent actuarial firm provides annually 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.

The independent actuarial firm's analysis is the primary tool that
management utilizes in determining its best estimate of loss reserves. However,
the carried reserve may differ from the independent actuarial firm's point
estimate as a result of management's consideration of the impact of factors such
as the following, especially as they relate to the current accident year:

- Current claim activity, including the frequency and severity of current
claims

- Changes in underwriting standards and business mix such as the Company's
efforts to reduce exposures to large commercial bonds

- Changes in the claims handling process

- Current economic conditions, especially corporate default rates and the
condition of the construction economy

Management believes that the impact of the factors listed above, and
others, may not be fully quantifiable through actuarial analysis. Accordingly,
management may apply its judgment of the impact of these factors, and others, to
its selection of the recorded loss reserves.

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 and financial condition.
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.

The Company recorded net loss reserve development which resulted in a
decrease in the estimated liability of $0.6 million in the year ended December
31, 2004 and increases of $39.3 million and $6.2 million for the years ended
December 31, 2003 and 2002, respectively. Note 7 to the accompanying
Consolidated Financial Statements presents a table of the activity in the
reserves for unpaid losses and loss adjustment

37

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, 2004, 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, 2004, Western Surety and its insurance
subsidiaries had a combined statutory surplus of $252.4 million and a net
written premiums to surplus ratio of 1.3 to 1. On December 31, 2003, CNA Surety
had a combined statutory surplus of $190.4 million and a net written premium to
surplus ratio of 1.7 to 1. The 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 2004 and 2003, most of the ratios for Western Surety, USA and
Surety Bonding were within the "usual" ranges as defined by the NAIC, except as
noted. In 2004, Western Surety's Investment Yield was outside the usual range
due to a concentration of short-term and tax-exempt investments. Also, the Two
Year Reserve Development to Policyholders' Surplus was outside the usual range
due to adverse claim development in the third quarter of 2003. 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
Policyholders' Surplus was outside the usual range due to prior year adverse
claim development. In 2003, USA's Change in Net Writings was outside the usual
range due to decreased writings of contract surety bonds. In 2003, USA's
Two-Year Overall Operating ratio was outside of the usual range, primarily due
to increases in the loss and expense ratios. Surety Bonding's Investment Yield
for 2003 was outside of the usual range primarily due to generally lower
investment rates along with a concentration of short-term investments.

IMPACT OF PENDING ACCOUNTING STANDARDS

In March of 2004, the Emerging Issues Task Force (EITF) reached consensus
on the guidance provided in EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and its Application to Certain Investments (EITF
03-1), as applicable to debt and equity securities that are within the scope of
SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities
(SFAS 115) and equity securities that are accounted for using the cost method
specified in Accounting Principles Board Opinion No. 18, The Equity Method of
Accounting for Investments in Common Stock. Under EITF 03-1 an investment is
impaired if the fair value of the investment is less than its cost including
adjustments for amortization, accretion, foreign exchange, and hedging. An
impairment would be considered other-than-temporary unless a) the investor has
the ability and intent to hold an investment for a reasonable period of time
sufficient for the recovery of the fair value up to (or beyond) the cost of the
investment and b) evidence indicating that the cost of the investment is
recoverable within a reasonable period of time outweighs evidence to the
contrary. This new guidance for determining whether impairment is
other-than-temporary was to be
38

effective for reporting periods beginning after June 15, 2004. In September of
2004, the Financial Accounting Standards Board ("FASB") issued FASB Staff
Position EITF Issue 03-1-1, which delayed the effective date for the measurement
and recognition guidance included in EITF Issue 03-1 related to
other-than-temporary impairment until additional implementation guidance is
provided. As a result of the delay, during 2004, the Company continued to apply
existing accounting literature for determining when a decline in fair value is
other-than-temporary.

The Company continues to evaluate the impact of this new accounting
standard on its process for determining other-than-temporary impairment of
equity and fixed maturity securities, including the potential impacts from any
revisions to the original guidance issued. Adoption of this standard as
originally issued may cause the Company to recognize impairment losses in the
Consolidated Statements of Operations which would not have been recognized under
the current guidance or to recognize such losses in earlier periods, especially
those due to increases in interest rates, and could also impact the recognition
of investment income on impaired securities. Such an impact would likely
increase earnings volatility in future periods. However, since fluctuations in
the fair value for available-for-sale securities are already recorded in
Accumulated Other Comprehensive Income, adoption of this standard is not
expected to have a significant impact on equity.

In December of 2004, the FASB issued SFAS No. 123 (revised 2004),
"Share-Based Payment ("SFAS 123R"), that amends SFAS No. 123 ("SFAS 123"), as
originally issued in May of 1995. SFAS 123R addresses the accounting for
share-based payment transactions in which an enterprise receives employee
services in exchange for (a) equity instruments of the enterprise or (b)
liabilities that are based on the fair value of the enterprise's equity
instruments or that may be settled by the issuance of such equity instruments.
SFAS 123R supercedes APB No. 25, "Accounting for Stock Issued to Employees"
("APB No. 25"). After the effective date of this standard, entities will not be
permitted to use the intrinsic value method specified in APB 25 to measure
compensation expense and generally would be required to measure compensation
expense using a fair-value based method. Public companies are to apply this
standard using either the modified prospective method or the modified
retrospective method. The modified prospective method requires a company to (a)
record compensation expense for all awards it grants after the date it adopts
the standard and (b) record compensation expense for the unvested portion of
previously granted awards that remain outstanding at the date of adoption. The
modified retrospective method requires companies to record compensation expense
to either (a) all prior years for which SFAS 123 was effective (i.e. for all
fiscal years beginning after December 15, 2004) or (b) only to prior interim
periods in the year of initial adoption if the effective date of SFAS 123R does
not coincide with the beginning of the fiscal year. SFAS 123R is effective for
interim or annual periods beginning after June 15, 2005. Adoption of this
standard is not expected to have a material impact on the Company's results of
operations and/or equity.

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;

39

- the ability of the Company's contract principals to fulfill their bonded
obligations;

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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, 2004. 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

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois

We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that CNA
Surety Corporation and subsidiaries (the "Company") maintained effective
internal control over financial reporting as of December 31, 2004, based on
criteria established in Internal Control -- Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission. The Company's
management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
management's assessment and an opinion on the effectiveness of the Company's
internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinions.

A company's internal control over financial reporting is a process designed
by, or under the supervision of, the company's principal executive and principal
financial officers, or persons performing similar functions, and effected by the
company's board of directors, management, and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial
reporting, including the possibility of collusion or improper management
override of controls, material misstatements due to error or fraud may not be
prevented or detected on a timely basis. Also, projections of any evaluation of
the effectiveness of the internal control over financial reporting to future
periods are subject to the risk that the controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.

In our opinion, management's assessment that the Company maintained
effective internal control over financial reporting as of December 31, 2004, is
fairly stated, in all material respects, based on the criteria established in
Internal Control -- Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Also in our opinion, the Company
maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2004, based on the criteria established in Internal
Control -- Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated financial
statements and financial statement schedules as of and for the year ended
December 31, 2004 of the Company and our report dated February 25, 2005
expressed an unqualified opinion on the consolidated financial statements and
financial statement schedules.

Deloitte & Touche LLP

Chicago, Illinois
February 25, 2005
42

MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of CNA Surety Corporation (CNAS) and subsidiaries is
responsible for establishing and maintaining adequate internal control over
financial reporting. CNAS' internal control system was designed to provide
reasonable assurance to the Company's management, its Audit Committee and Board
of Directors regarding the preparation and fair presentation of published
financial statements.

There are inherent limitations to the effectiveness of any internal control
or system of control, however well designed, including the possibility of human
error and the possible circumvention or overriding of such controls or systems.
Moreover, because of changing conditions the reliability of internal controls
may vary over time. As a result even effective internal controls can provide no
more than reasonable assurance with respect to the accuracy and completeness of
financial statements and their process of preparation.

CNAS management assessed the effectiveness of the Company's internal
control over financial reporting as of December 31, 2004. In making this
assessment, it used the criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) in Internal
Control -- Integrated Framework. Based on our assessment we believe that, as of
December 31, 2004, the Company's internal control over financial reporting is
effective based on those criteria.

CNAS' independent registered public accountant, Deloitte & Touche LLP, has
issued an audit report covering our assessment of the Company's internal control
over financial reporting. This report appears on page 42.

CNA Surety Corporation

Chicago, Illinois
February 25, 2005

43

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois

We have audited the accompanying consolidated balance sheets of CNA Surety
Corporation and subsidiaries (the "Company") as of December 31, 2004 and 2003,
and the related consolidated statements of income, stockholders' equity, and
cash flows for each of the three years in the period ended December 31, 2004.
Our audits also included the financial statement schedules listed in the Index
at Item 15. These financial statements and financial statement schedules are the
responsibility of the Company's management. Our responsibility is to express an
opinion on the financial statements and financial statement schedules based on
our audits.

We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). 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 the 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, 2004 and 2003, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2004, in conformity with accounting principles generally accepted
in the United States of America. Also, in our opinion, such financial statement
schedules, when considered in relation to the basic consolidated financial
statements taken as a whole, present fairly, in all material respects, the
information set forth therein.

We have also audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the effectiveness of the
Company's internal control over financial reporting as of December 31, 2004,
based on criteria established in Internal Control -- Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission and our
report dated February 25, 2005 expressed an unqualified opinion on management's
assessment of the effectiveness of the Company's internal control over financial
reporting and an unqualified opinion on the effectiveness of the Company's
internal control over financial reporting.

Deloitte & Touche LLP

Chicago, Illinois
February 25, 2005

44

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

The accompanying notes are an integral part of these consolidated financial
statements.
46

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

The accompanying notes are an integral part of these consolidated financial
statements.
47

CNA SURETY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these consolidated financial
statements.
48

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 Holdings
Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF
with Capsure's insurance subsidiaries, Western Surety Company ("Western Surety")
Surety Bonding Company of America ("Surety Bonding") and Universal Surety of
America ("USA"), into CNA Surety Corporation ("CNA Surety" or "Company"). CNAF,
through its operating subsidiaries, writes multiple lines of property and
casualty insurance, including surety business that is reinsured by Western
Surety. CNAF owns approximately 64% of the outstanding common stock of CNA
Surety. Loews Corporation ("Loews") owns approximately 91% 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").

Principles of Consolidation

The consolidated financial statements include the accounts of CNA Surety
and all majority-owned subsidiaries.

Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles ("GAAP") requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

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.

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 net
realized investment gains/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.

49

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 deferred and
amortized as the related premiums are earned. The Company periodically tests
that deferred acquisition costs are recoverable based on the expected
profitability embedded in the reserve for unearned premium. If the expected
profitability is less than the balance of deferred acquisition costs, a charge
to net income is taken and the deferred acquisition cost balance is reduced to
the amount determined to be recoverable. 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, 2004 includes
intangible assets of $138.8 million. These amounts represent goodwill and
identified intangibles with indefinite useful lives arising from the acquisition
of 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 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 intangible asset
impairment tests. Such tests include periodically determining or reviewing the
estimated fair value of CNA Surety's reporting units. Under SFAS 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 intangible assets. The excess of the
recorded amount of intangible assets over the implied value of intangible assets
is charged-off as an impairment loss.

The Company completed its annual intangible asset impairment test as of
October 1, 2004, 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 recorded amounts. The methods of determining such estimates
and the resulting estimated liability are regularly reviewed and updated.
Changes in the estimated liability are reflected in the Statement of 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

50

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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
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 SFAS No. 123, "Accounting for Stock-Based Compensation"
("SFAS 123"), the Company accounts for its stock option plans in accordance with
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued
to Employees" ("APB 25"). 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.
Depreciation expense for 2004, 2003, and 2002 was $4.5 million, $4.2 million,
and $3.9 million, respectively. 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.

51

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

Accounting Pronouncements

In August 2001, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 143 entitled "Accounting for Asset Retirement Obligations" ("SFAS
143"). SFAS 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 143 effective
January 1, 2003. The adoption of SFAS 143 did not have an impact on the
Company's financial position or results of operations.

In November 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 Nos. 5, 57,
and 107 and rescission of FASB Interpretation No. 34)" ("FIN 45"). FIN 45
clarifies the requirements of FASB SFAS No. 5, "Accounting for Contingencies"
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 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 2003, FASB issued FASB Interpretation ("FIN") No. 46,
"Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin ("ARB") No. 51" ("ARB No. 51") ("FIN No. 46"). In December of
2003, the FASB issued a revision to FIN No. 46 ("FIN No. 46R"), which superceded
FIN No. 46 and further clarified the application of ARB No. 51. Per ARB No. 51,
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. However, application of the majority voting
interest requirement of ARB No. 51 to certain types of entities may not identify
the party with a controlling financial interest because the controlling
financial interest may be achieved through arrangements that do not involve
voting interest. FIN No. 46R clarifies the applicability of ARB No. 51 to
entities in which the equity investors do not have the characteristics of a

52

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support. FIN No. 46R requires an entity to consolidate a variable interest
entity ("VIE") in which it is the primary beneficiary even though the entity
does not, either directly or indirectly, own over fifty percent of the
outstanding voting shares.

FIN 46R 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 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 148"). SFAS 148
provides alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation. SFAS 148
also amends the disclosure requirements of SFAS 123 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 disclosure standard beginning
with the 2002 annual financial statements. The Company has not adopted fair
value accounting. The Company applies APB 25 and related interpretations, in
accounting for its plans as allowed for under the provisions of SFAS 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.

In April 2003, the FASB issued SFAS No. 149 entitled "Amendment of
Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS 149").
SFAS 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 133"). SFAS 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 149 did not have a significant
impact on the Company's financial position or results of operations.

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

SFAS 150 is effective for all financial instruments entered into or
modified after May 31, 2003. For all financial instruments entered into prior to
May 31, 2003, SFAS 150 was effective at the beginning of the first interim
period beginning after June 15, 2003, which for CNA Surety began July 1, 2003.
The Company does not have any financial instruments outstanding to which
provisions of SFAS 150 apply, therefore the adoption of SFAS 150 did not have
any impact on the Company's financial position or results of operations.

In March 2004, the Emerging Issues Task Force ("EITF") reached consensus on
the disclosure guidance provided in EITF Issue No. 03-1, "The Meaning of
Other-Than-Temporary Impairment and its

53

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Application to Certain Investments" ("EITF 03-1"). Under EITF 03-1 an investment
is impaired if the fair value of the investment is less than its cost including
adjustments for amortization, accretion, foreign exchange, and hedging. An
impairment would be considered other-than-temporary unless a) the investor has
the ability and intent to hold an investment for a reasonable period of time
sufficient for the recovery of the fair value up to (or beyond) the cost of the
investment and b) evidence indicating that the cost of the investment is
recoverable within a reasonable period of time outweighs evidence to the
contrary. This new guidance for determining whether the decline in the fair
value of the investment is other-than-temporary was to be effective for
reporting periods beginning after June 15, 2004. In September of 2004, the FASB
issued FSP EITF Issue 03-1-1, which delayed the effective date for the
measurement and recognition guidance included in EITF Issue 03-1 related to
other-than-temporary impairment pending additional implementation guidance. As a
result of the delay the Company continues to apply existing accounting
literature for determining when a decline in fair value is other-than-temporary.

In May of 2004, the FASB revised FASB Staff Position ("FSP") 106-1,
"Accounting and Disclosure Requirements Related to the Medicare Prescription
Drug, Improvement and Modernization Act of 2003" and issued FSP 106-2,
"Accounting and Disclosure Requirements Related to the Medicare Prescription
Drug, Improvement and Modernization Act of 2003" (FSP 106-2). The FSP provides
accounting guidance to employers who sponsor postretirement health care plans
that provide prescription drug benefits and the prescription drug benefit
provided by the employer is "actuarially equivalent" to Medicare Part D and
hence qualifies for the subsidy under the Medicare amendment act. This FSP was
effective for the Company as of July 1, 2004, and its adoption did not have a
material impact on the Company's results of operations or equity.

In December of 2004, the FASB issued SFAS No. 123 (revised 2004),
"Share-Based Payment ("SFAS 123R"), that amends SFAS No. 123 ("SFAS 123"), as
originally issued in May of 1995. SFAS 123R addresses the accounting for
share-based payment transactions in which an enterprise receives employee
services in exchange for (a) equity instruments of the enterprise or (b)
liabilities that are based on the fair value of the enterprise's equity
instruments or that may be settled by the issuance of such equity instruments.
SFAS 123R supercedes APB No. 25, "Accounting for Stock Issued to Employees"
("APB No. 25"). After the effective date of this standard, entities will not be
permitted to use the intrinsic value method specified in APB 25 to measure
compensation expense and generally would be required to measure compensation
expense using a fair-value based method. Public companies are to apply this
standard using either the modified prospective method or the modified
retrospective method. The modified prospective method requires a company to (a)
record compensation expense for all awards it grants after the date it adopts
the standard and (b) record compensation expense for the unvested portion of
previously granted awards that remain outstanding at the date of adoption. The
modified retrospective method requires companies to record compensation expense
to either (a) all prior years for which SFAS 123 was effective (i.e. for all
fiscal years beginning after December 15, 2004) or (b) only to prior interim
periods in the year of initial adoption if the effective date of SFAS 123R does
not coincide with the beginning of the fiscal year. SFAS 123R is effective for
interim or annual periods beginning after June 15, 2005. Adoption of this
standard is not expected to have a material impact on the Company's results of
operations and/or equity.

Reclassifications

Certain amounts in 2003 and 2002 have been reclassified to conform with the
current year presentation.

54

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

2. INVESTMENTS

The estimated fair value and amortized cost of fixed income and equity
securities held by investment category, were as follows (dollars in thousands):

55

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,
2004, securities on deposit had an aggregate carrying value of $3.4 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, 2004 and 2003 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):

56

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Major categories of net investment income of available-for-sale securities
were as follows (dollars in thousands):

Net unrealized investment gains and losses and the net change in unrealized
gains and losses of available-for-sale securities were as follows (dollars in
thousands):

57

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table provides the composition of fixed income securities
with an unrealized loss at December 31, 2004 in relation to the total of all
fixed income securities by contractual maturities:

There were no non-investment grade fixed income or equity securities in an
unrealized loss position at December 31, 2004 or 2003.

3. DEBT

In May 2004, the Company, through a wholly-owned trust, privately issued
$30 million of preferred securities through two pooled transactions. These
securities bear interest at a rate London Interbank Offered Rate ("LIBOR") plus
337.5 basis points with a 30-year term and are redeemable after five years. The
securities were issued by CNA Surety Capital Trust I (the "Issuer Trust"). The
sole asset of the Issuer Trust consists of a $30.9 million junior subordinated
debenture issued by the Company to the Issuer Trust. The Company has also
guaranteed the dividend payments and redemption of the preferred securities
issued by the Issuer Trust. The maximum amount of undiscounted future payments
the Company could make under the guarantee is $75.0 million, consisting of
annual dividend payments of $1.5 million over 30 years and the redemption value
of $30.0 million. Because payment under the guarantee would only be required if
the Company does not fulfill its obligations under the debentures held by the
Issuer Trust, the Company has not recorded any additional liabilities related to
this guarantee.

The subordinated debenture bears interest at a rate of LIBOR plus 337.5
basis points and matures in April of 2034. As of December 31, 2004, the interest
rate on the junior subordinated debenture was 5.665%.

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 $50.0 million in borrowings divided between
a revolving credit facility (the "Revolving Credit Facility") of $30.0 million
and a term loan facility (the "Term

58

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Loan Facility") of $20.0 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 repayments under the Term Loan Facility up to an
additional $10.0 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 Facility which fixed the previously floating interest rate. As
a result, the effective interest rate on the term loan as of December 31, 2004
was 2.77%.

In June 2004, the Company reduced the outstanding Revolving Credit Facility
by $10.0 million to $20 million. In September of 2004, the Company increased the
outstanding Revolving Credit Facility by $5.0 million. The Term Loan Facility
balance was reduced by $20 million through December 31, 2004 according to the
scheduled repayments and payment schedules. Further repayments and payment of
the Term Loan Facility will take place in equal semi-annual installments of $5.0
million on the following dates:

The Company has a total of $35 million of debt maturing in 2005. No other
debt matures in the next five years.

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 nine months
and is based on, among other rates, 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, 2004 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 Facility was 0.625% at December 31, 2004 and can vary based on CNA
Surety's leverage ratio (debt to total capitalization) from 0.48% to 0.80%. As
of December 31, 2004, the weighted average interest rate was 3.2825% on the
$35.0 million of outstanding borrowings. As of December 31, 2003, the weighted
average interest rate on the 2002 Credit Facility was 2.4% on the $50.0 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 March 31, 2004, the Company was in violation of this minimum
earnings requirement and received a waiver for this requirement in the second
quarter of 2004. The Company is in compliance with the debt covenants as of and
for the quarter ended December 31, 2004.

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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, 2004 and 2003 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.

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):

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CNA SURETY CORPORATION AND SUBSIDIARIES

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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 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,
assesses the need for allowances for uncollectible amounts and monitors
concentrations of credit risk. At December 31, 2004, 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 $5.4 million. At
December 31, 2004, CNA Surety's largest reinsurance receivable from a
non-affiliate reinsurer was approximately $16.9 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):

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. Because of certain regulatory restrictions that limit the
Company's ability to write business on a direct basis, the Company continues to
utilize the underwriting capacity available through these agreements. The
Company is in full control of all aspects of the underwriting and claim
management of the assumed business.

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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):

During 2004, the Company reduced certain gross reserves, with corresponding
reductions in ceded reserves, reflecting changes in estimates of
incurred-but-not-reported reserves for large losses and the associated estimates
of reinsurance recoverables. Although there is no impact to net losses and loss
adjustment expenses, these actions did result in unusual fluctuations in the
gross and ceded amounts shown above. The reduction in reinsurance recoverables
in 2002 resulted from the settlement of claims related to the bankruptcy of
Enron Corporation. This settlement resulted in the reduction of previously
established gross loss reserves and a corresponding reduction to previously
established reinsurance recoverables.

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

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 million per principal and the $3 million excess of $12 million
coverage that had been provided by CCC. The significant differences between the
2004 Excess of Loss Treaty and the Company's 2003 Excess of Loss Treaty are as
follows. The annual aggregate coverage increased from $110 million in 2003 to
$157 million in 2004. The premium for the 2004 Excess of Loss Treaty was $50.6
million (net of expected return premium) compared to a total of $42.0 million of
reinsurance 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 included an optional
twelve-month extended discovery period, for an additional premium (a percentage
of the original premium based on any unexhausted aggregate limit by layer),
which will provide coverage for losses discovered in 2005 on bonds that were in
force during 2004. The Company did not elect to purchase the extended discovery
period because it obtained coverage for 2005 under a new treaty. The 2004 Excess
of Loss Treaty also provided for somewhat less restrictive special acceptance
provisions for larger contract accounts than those contained in the 2003 Excess
of Loss Treaty 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 as the
"large national contractor") 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, for a total of six
excluded principals. The

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

large national contractor and the two commercial principals remain excluded from
the 2004 Excess of Loss Treaty. Of the two commercial principals, one is a
domestic electric utility with an estimated bonded exposure of $38 million as of
December 31, 2004 and is currently rated B- by Standard and Poor's ("S&P"). This
rating was increased from CCC+ during the third quarter of 2004 due to
significant recapitalization efforts by the principal. The bonded exposure will
decline over the term of the bond that extends until 2007. The other is a
foreign industrial enterprise that fulfilled its bonded obligations in the
second quarter of 2004, so the Company no longer has any exposure.

With respect to the three excluded contract principals other than the large
national contractor, two contract principals have completed asset sales and
other reorganization efforts and have been accepted into the 2004 Excess of Loss
Treaty. The Company received claims related to the third contract principal in
2003, making it ineligible for inclusion in the 2004 Excess of Loss Treaty. The
Company believes it is adequately reserved for any exposure related to this
principal and is currently not providing bonds to this principal.

Related Party Reinsurance

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, 2004.

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 has been no
adverse reserve development for the period from September 30, 1997 (date of
inception) through December 31, 2004.

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
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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

full accident years following the Merger Date. In the event the insurance
subsidiaries' accident year net loss ratio exceeded 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 CCC all required annual
premiums. As of December 31, 2004, the Company had billed and received $54.9
million under the Stop Loss Contract, of which $29.9 million was received in
2004.

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 unlimited 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, 2006.

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 exposure on 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 two previous
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.

Effective October 1, 2003, the Company entered into a $3 million excess of
$12 million 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. Accordingly,
the $40 million excess of $60 million contract with CCC was commuted effective
January 1, 2004. As part of this commutation, the Company has received a
commutation payment of $10.9 million from CCC. 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

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

January 1, 2004 to December 31, 2004. The premium for this contract is $3.0
million plus an additional premium of $6 million if a loss is ceded under 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 of $14 million if a
loss is ceded under this contract.

As of December 31, 2004 and December 31, 2003, CNA Surety had an insurance
receivable balance from CCC and CIC of $16.4 million and $71.1 million. CNA
Surety had reinsurance payables to CCC and CIC of $0.3 million as of December
31, 2004. CNA Surety had no reinsurance payables to CCC and CIC as of December
31, 2003.

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 reinsurance. 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.

If the Company should suffer any losses that are discovered prior to
September 30, 2006 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, 2006 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 between November 1, 2003 and December 31, 2004, the Company's
exposure was $14.7 million. For bonds written subsequent to December 31, 2004,
the Company's exposure will be limited to 10% of policyholders' surplus.

CNAF Credit Facility

Commencing in 2003, CNAF has provided loans through a credit facility in
order to help the large national contractor meet its liquidity needs and
complete projects which had been bonded by CNA Surety. In December of 2004, the
credit facility was amended to increase the maximum available loans to $106
million from $86 million at December 31, 2003. The amendment also provides that
CNAF may in its sole discretion further increase the amounts available for loans
under the credit facility, up to an aggregate maximum of $126 million. As of
December 31, 2004 and 2003, $99 million and $80 million had been advanced under
the credit facility. Loews, through a participation agreement with CNAF,
provided funds for and owned a participation of $29 million and $26 million of
the loans outstanding as of December 31, 2004 and 2003, respectively, and has
agreed to a participation of one-third of any additional loans which may be made
above the original $86 million credit facility limit up to the $126 million
maximum available line.

Loans under the credit facility are secured by a pledge of substantially
all of the assets of the contractor and certain of its affiliates. In connection
with the credit facility, CNAF has also guaranteed or provided
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CNA SURETY CORPORATION AND SUBSIDIARIES

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collateral for letters of credit which are charged against the maximum available
line and, if drawn upon, would be treated as loans under the credit facility. As
of December 31, 2004 and 2003, these guarantees and collateral obligations
aggregated $13 million and $7 million.

The contractor implemented a restructuring plan intended to reduce costs
and improve cash flow, and appointed a chief restructuring officer to manage
execution of the plan. In the course of addressing various expense, operational
and strategic issues, however, the contractor has decided to substantially
reduce the scope of its original business and to concentrate on those segments
determined to be potentially profitable. As a consequence, operating cash flow,
and in turn the capacity to service debt, has been reduced below previous
levels. Restructuring plans have also been extended to accommodate these
circumstances. In light of these developments, CNAF has recorded an impairment
charge of $56 million pretax ($36 million after-tax) in the fourth quarter of
2004, net of the participation by Loews, with respect to amounts loaned under
the credit facility. Any draws under the credit facility beyond $106 million or
further changes in the large national contractor's business plan or projections
may necessitate further impairment charges.

The Company intends to continue to provide surety bonds on behalf of the
contractor during the restructuring period, subject to the contractor's initial
and ongoing compliance with the Company'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,
the contractor's failure to achieve its extended restructuring plan or perform
its contractual obligations under the Company's surety bonds could have a
material adverse effect on CNA Surety's results of operations, cash flow and
equity. If such failures occur, the Company estimates that possible losses, net
of indemnification and subrogation recoveries, but before recoveries under
reinsurance contracts, to be approximately $200 million pretax. However, the
related party reinsurance treaties discussed above should limit the Company's
per principal loss exposure to approximately $60 million.

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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 loss reserve development which resulted in a
decrease of the estimated liability of $0.6 million for the year ended December
31, 2004 and increases in the estimated liability of $39.3 million, $6.2 million
for the years ended December 31, 2003 and 2002, respectively. The decrease in
the estimated liability recorded in 2004 for prior accident years resulted from
loss adjustment expense payments related to prior accident years that were lower
than previously expected. Adverse claim trends in the 2001 and 2002 accident
years, particularly increased claim severity on large commercial accounts, had
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 included 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. The $39.3 million of net adverse development recorded in 2003
was a result of previously unexpected claim activity reported during the third
quarter of 2003. First, additional contract bond claims were received during the
third quarter of 2003 on a contractor that had filed for bankruptcy in February,
2003. Upon review and verification of these new claims, the existing case
reserve was increased by $7.2 million, net of applicable reinsurance. Second, a
demand was made during the third quarter of 2003 against a $45 million insurance
program bond issued on behalf of a national trucking concern that was now in
bankruptcy. This demand was in contradiction of previous information provided by
the obligee on the bond. Based on this new information, management reserved the
full remaining limits on this bond which resulted in $15 million of net adverse
development after the application of available reinsurance. Third, claims were
also received in the third quarter of 2003 on worker's compensation self
insurance bonds written between 1975 and 1986 on behalf of two principals. After
verifying coverage and obtaining supporting actuarial information on the
underlying

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workers' compensation claims, the Company increased the case reserves on these
bonds by $8.4 million, net of applicable reinsurance. Fourth, after receiving a
demand on another insurance program bond in the third quarter of 2003,
management identified an outstanding insurance program bond written on behalf of
a contractor now in bankruptcy. Based on recent experience with this type of
bond, which typically has few defenses available to the surety, and in
particular with the obligees on this bond, management recorded a loss provision
on this bond of $6 million. Finally, management determined that the case reserve
on a particular claim was insufficient due to the amount of legal fees that the
Company was incurring on the case. Based on their estimate of future legal
expenses, management increased the reserve on this bond by $3 million.

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 2003 accident year due to material adverse loss severity
on the Company's branch commercial and contract business. The net additions to
reserves for the 2003 accident year resulted from three large contract bond
claims totaling $28 million incurred in 2003, an approximately $15 million net
loss on an insurance program bond for a now bankrupt large commercial account,
and changes in estimates of large losses resulting from this significant adverse
claim activity.

Incurred loss and loss adjustment expenses for the year ended December 31,
2002 included $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 ("Enron") 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, 2004, the Company has billed a total of
$37.1 million to its reinsurers. Seven reinsurers responsible for payment of 63%
of the treaty proceeds either have paid their portions of the claim or have
reached agreement with the Company and paid the Company to commute the entire
reinsurance treaty under which the Enron claim was made. Pursuant to the treaty,
the Company demanded and began arbitration proceedings against the two other
reinsurers who have not paid their portions of the claim or commuted their
treaties. Management believes that these reinsurers do not have valid defenses
under the reinsurance treaties to avoid payment, and that the Company will fully
recover all reinsurance recoverable recorded related to this settlement. As
such, the Company has not recorded a reduction with respect to these reinsurance
recoverable of $13.7 million as of December 31, 2004.

8. COMMITMENTS AND CONTINGENCIES

At December 31, 2004 the future minimum commitment under operating leases
was as follows: 2005 -- $1.6 million; 2006 -- $1.4 million; 2007 -- $1.1
million, 2008 -- $1.0 million and 2009 -- $1.0 million and thereafter -- $2.7
million. Total rental expense for 2004, 2003 and 2002 was $5.1 million, $4.6
million, and $4.0 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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9. INCOME TAXES

The components of deferred income taxes as of December 31, 2004 and 2003
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

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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 employee's contribution up to 3% of eligible compensation and 50%
of the participating employee's contribution between 3% and 6% of eligible
compensation (4.5% maximum matching). Effective January 1, 2004, the Company
implemented an additional basic contribution for eligible 401(k) plan
participants of 3% (if under age 45) or 5% (if 45 or older) of eligible
compensation. In addition, the Company may also make an annual discretionary
profit sharing contribution to the 401(k) plan, subject to the approval of the
Company's Board of Directors. The profit sharing contribution may be restricted
by plan and regulatory limitations. The Company contribution, including profit
sharing, to the 401(k) plan was $3.5 million, $2.3 million, and $2.9 million for
the years ended December 31, 2004, 2003 and 2002, 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 $1.2
million as of December 31, 2004 in respect of this deferred compensation plan.

The post retirement benefit plan that provides medical benefits has been
determined to be actuarially equivalent to Medicare Part D on an estimated basis
under the rules provided in final regulations issued January 21, 2005. As such,
the federal subsidy to plan sponsors under the Medicare Modernization Act
("MMA") has been recognized in the accounting for that 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):

70

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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, 2004 and December 31, 2003 (dollars in thousands):

The Company expects to contribute $0.2 million to the post-retirement
benefit plans to pay benefits in 2005. The following benefit payments, which
reflect expected future service, as appropriate, are expected to be paid. These
amounts are shown both gross and net of the federal subsidy to plan sponsors
under the MMA.

The Company's post-retirement health care plan is unfunded; the accumulated
post-retirement benefit obligation and plan assets for that plan are $4.6
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.

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

The 2005 benefit cost is expected to be reduced by approximately $.2
million as a result of the MMA.

71

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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, 2004 by $0.8 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, 2004 by $0.7 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 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 2004, 2003 and
2002.

72

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

As of December 31, 2004, the number of shares available for granting of
options under the Plan was 741,502.

]The following table summarizes information about stock options outstanding at
December 31, 2004:

The weighted average fair market value (at grant date) per option granted
was $3.82, $3.72 and $3.69 respectively, for options granted during 2004, 2003
and 2002. 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, 2004: risk free interest rate of
1.1%; dividend yield of 0.0%; expected option life of six years; and volatility
of 30.4%. Similar assumptions for the years ended December 31, 2003 and 2002
were: risk free interest rate of 1.10% and 1.50%; dividend yield of 0.0%;
expected option life of 6 years; and volatility of 39.8%.

The Company applies the intrinsic value method per APB 25 and related
interpretations, in accounting for its plans as allowed for under the provisions
of SFAS 123 with respect to its stock-based incentive plans. 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 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, 2004 and 2003 were 15,079 and 12,932, respectively. 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 the Surety Association of America ("SAA"), the
surety and fidelity segment of the domestic property and

73

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

casualty insurance industry aggregates approximately $5.0 billion in direct
written premiums, comprised of approximately $3.7 billion in surety premiums and
$1.3 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.

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.

74

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Approximately $68.1 million, or 17.5%, of gross written premiums were
generated from national insurance brokers in 2004 with the single largest
national broker production comprising $18.5 million, or 4.7%, of gross written
premiums. In 2003, approximately $61.2 million, or 16.5%, of gross written
premiums were generated from national insurance brokers with the single largest
national broker production comprising $19.2 million, or 5.2%, of gross written
premiums. In 2002, approximately $72.4 million, or 20.1%, of gross written
premiums were generated from national insurance brokers with the single largest
national broker production comprising $28.3 million, or 7.9%, 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 three 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. Also, Surety
Bonding has been given permission to report ceding commissions received from
Western Surety that exceed the acquisition costs related to the business ceded
as a reduction to commission expense. 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, deferred
income taxes are recorded but there are limitations as to the amount of deferred
tax assets that may be reported as "admitted" assets and fixed income securities
are generally carried at amortized cost in statutory financial statements.

The following table reconciles consolidated stockholders' equity at
December 31, 2004 and 2003 as reported herein in conformity with GAAP with total
statutory capital and surplus of CNA Surety's insurance

75

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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, 2004 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 2005, CNA Surety's insurance subsidiaries may pay dividends of $46.8
million in the aggregate. Combined statutory surplus for the insurance
subsidiaries at December 31, 2004 was $252.4 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 2005 is $1.9 million that shall be paid by CNA
Surety to CNAF in equal monthly installments by the last day of each month. The
amounts paid were $1.8 million, $1.7 million, and $1.6 million for 2004, 2003,
and 2002, respectively. The management fee shall be increased as of January 1,
the "adjustment date", of each year this Administrative Services Agreement is in
force by the greater of 5% or the amount of the increase in

76

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 2004 and 2003, CCC paid the
Company $0.5 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 $7.4 million, $6.1 million, and $5.2 million for
the years ended December 31, 2004, 2003 and 2002, respectively, for rents and
services provided under the Administrative Services Agreement. In addition, the
Company was charged $0.8 million, $1.4 million and $1.0 million for direct costs
incurred by CCC on the Company's behalf during 2004, 2003 and 2002,
respectively. The Company had no payable balance to CCC related to the
Administrative Services Agreement as of December 31, 2004.

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 $1,665,077 to $2,954,164 with an average policy
limit of approximately $2.3 million and total limits of all policies of
$11,539,510. 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 $13.9 million of total penal sums remain as of
December 31, 2004.

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, 2004, the total amount of the outstanding appeal and license and permit
bonds written on behalf of CCC and its affiliates was approximately $65.3
million, which was comprised of 42 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 $503,000 in 2004 and $440,000 in
2003.

77

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

The following is a summary of the quarterly results of operations for the
years ended December 31, 2004, 2003, and 2002 (dollars in thousands, except per
share amounts):

16. SUBSEQUENT EVENT

On October 27, 2004, the Company announced that it had tentatively agreed
to sell all of its financial interest in United Kingdom ("UK") based DeMontfort
Group, Ltd. to HCC Insurance Holdings, Inc. The agreement covers CNA Surety's
34% ownership in the common shares and certain preferred shares and indebtedness
of the DeMontfort Group. The transaction settled on January 5, 2005. The Company
expects to realize a gain of approximately $2.0 million before the effect of
income taxes in the first quarter 2005, however the decision to sell the
investment is not otherwise expected to have a material impact on the Company's
ongoing operations or financial position.

78

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

None.

ITEM 9A. CONTROLS AND PROCEDURES

As of December 31, 2004, the Company's management, including the Company's
Chief Executive Officer (CEO) and Chief Financial Officer (CFO) have conducted
an evaluation of the effectiveness of its disclosure controls and procedures (as
such term is defined in Rules 13a-15 (e) and 15d-15 (e) under the Securities
Exchange Act of 1934, as amended ("the Exchange Act"). Based on their
evaluation, the CEO and CFO concluded that the Company's disclosure controls and
procedures are effective in ensuring that all material information required to
be filed in this Annual Report has been made to them in a timely manner.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, the Company
included a report of management's assessment of the design and effectiveness of
its internal controls as part of this Annual Report on Form 10-K for the fiscal
year ended December 31, 2004. The independent registered public accounting firm
of the Company also attested to, and reported on, management's assessment of the
effectiveness of internal control over financial reporting. Management's report
and the independent registered public accounting firm's attestation report are
included in the Company's 2004 Financial Statements under the captions entitled
"Management's Report on Internal Control Over Financial Reporting" and "Report
of Independent Registered Public Accounting Firm on Internal Control Over
Financial Reporting" and are incorporated herein by reference.

There were no changes in the Company's internal control over financial
reporting (as defined in Rules 13a-15 (f) and 15d-15 (f) under the Exchange Act)
during the quarter ended December 31, 2004 that has materially affected, or is
reasonably likely to materially affect, the Company's internal control over
financial reporting.

ITEM 9B. OTHER INFORMATION

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 April 26, 2005, 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.

79

PART IV.

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

80

SCHEDULE I

CNA SURETY CORPORATION AND SUBSIDIARIES

SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
AS OF DECEMBER 31, 2004 AND 2003

81

SCHEDULE II

CNA SURETY CORPORATION

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY)
BALANCE SHEETS

The accompanying note is an integral part of these condensed financial
statements.
82

SCHEDULE II

CNA SURETY CORPORATION

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

The accompanying note is an integral part of these condensed financial
statements.
83

SCHEDULE II

CNA SURETY CORPORATION

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

The accompanying note is an integral part of these condensed financial
statements.
84

CNA SURETY CORPORATION

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

SCHEDULE II

NOTE TO CONDENSED FINANCIAL INFORMATION

1. RESTRICTED CASH AND SHORT TERM INVESTMENTS

As of December 31, 2004 and December 31, 2003, short-term investments and
cash included $5.1 million and $6.6 million, respectively, of restricted cash
related to premium receipt collections ultimately due to the Company's insurance
subsidiaries.

85

SCHEDULE III

CNA SURETY CORPORATION AND SUBSIDIARIES

SUPPLEMENTARY INSURANCE INFORMATION
AS OF AND FOR THE YEARS ENDED
DECEMBER 31, 2004, 2003 AND 2002

86

SCHEDULE IV

CNA SURETY CORPORATION AND SUBSIDIARIES

REINSURANCE
FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002

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

(1) Primarily from affiliates.

87

SCHEDULE V

CNA SURETY CORPORATION AND SUBSIDIARIES

VALUATION AND QUALIFYING ACCOUNTS
AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002

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

(1) Write-offs charged against allowance.

88

SCHEDULE VI

CNA SURETY CORPORATION AND SUBSIDIARIES

SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY
INSURANCE OPERATIONS
AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002

89

(a)(3) EXHIBITS

92

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 1, 2005

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.