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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, 1997
[ ] 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 (I.R.S. Employer
or organization) Identification No.)
CNA PLAZA, CHICAGO, ILLINOIS 60685
(Address of principal executive offices) (Zip Code)
(312) 822-5000
(Registrant's telephone number, including area code)
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)
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. [ ]
The aggregate market value of voting stock held by nonaffiliates was $202.3
million based upon the closing price of $16.00 per share on March 6, 1998, using
beneficial ownership of stock rules adopted pursuant to Section 13 of the
Securities Exchange Act of 1934 to exclude voting stock owned by Directors,
Officers and Major Stockholders, some of whom may not be held to be affiliates
upon judicial determination.
At March 6, 1998, 43,375,931 shares of the Registrant's Common Stock were
outstanding.
Documents Incorporated By Reference:
Part III incorporates by reference the Registrants Proxy Statement relating
to the Annual Meeting of Shareholders to be held May 19, 1998.
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CNA SURETY CORPORATION AND SUBSIDIARIES
TABLE OF CONTENTS
PAGE
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PART I.
Item 1. Business.................................................... 3
General................................................... 3
Formation of CNA Surety and Merger........................ 3
Description of Business................................... 3
Business Strategy......................................... 4
A.M. Best Ratings......................................... 5
Product Information....................................... 5
Marketing................................................. 7
Underwriting.............................................. 9
Competition............................................... 9
Reinsurance............................................... 9
Reserves for Unpaid Losses and Loss Adjustment Expenses... 10
Asbestos and Environmental Claims......................... 11
Regulation................................................ 12
Investments............................................... 13
Net Operating Tax Loss Carryforwards...................... 13
Employees................................................. 13
Item 2. Properties.................................................. 14
Item 3. Legal Proceedings........................................... 14
Item 4. Submission of Matters to a Vote of Security Holders......... 14
PART II.
Market for the Registrant's Common Stock and Related
Item 5. Stockholder Matters......................................... 14
Item 6. Selected Financial Data..................................... 15
Management's Discussion and Analysis of Financial Condition
Item 7. and Results of Operations................................... 17
Quantitative and Qualitative Discussions About Market
Item 7a. Risk........................................................ 32
Item 8. Financial Statements and Supplementary Data................. 32
Changes in and Disagreements with Accountants on Accounting
Item 9. and Financial Disclosure.................................... 32
PART III.
Item 10. Directors and Executive Officers of the Registrant.......... 32
Item 11. Executive Compensation...................................... 32
Security Ownership of Certain Beneficial Owners and
Item 12. Management.................................................. 32
Item 13. Certain Relationships and Related Transactions.............. 32
PART IV.
Exhibits, Financial Statement Schedules, and Reports on Form
Item 14. 8-K......................................................... 33
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CNA SURETY CORPORATION AND SUBSIDIARIES
PART I
ITEM 1. BUSINESS
GENERAL
CNA Surety Corporation ("CNA Surety" or "Company") is a surety organization
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 an 8.6% market share. Its wide
selection of 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 Holdings
Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF
with Capsure's insurance subsidiaries, Western Surety Company ("Western Surety")
and Universal Surety of America ("USA"), which are owned by a newly-formed
holding company, CNA Surety Corporation. CNAF, through its operating
subsidiaries, writes multiple lines of property and casualty insurance,
including surety business that is reinsured by Western Surety. Loews Corporation
owns approximately 84% of the outstanding common stock of CNAF. The principal
operating subsidiaries of CNAF that wrote the surety line of business for their
own account prior to the Merger were Continental Casualty Company and its
property and casualty affiliates (collectively, "CCC") and The Continental
Insurance Company and its property and casualty affiliates (collectively,
"CIC"). CIC was acquired by CNAF on May 10, 1995. The combined surety operations
of CCC and CIC are referred to herein as CCC Surety Operations ("Predecessor").
Pursuant to a reorganization agreement, CCC Surety Operations and Capsure
merged their respective operations at the close of business on September 30,
1997 ("Merger Date"). CNAF, through its property and casualty subsidiaries, CCC
and CIC contributed $52.25 million of capital to CNA Surety. Through reinsurance
agreements, CCC and CIC ceded to Western Surety all of their net unearned
premiums and loss and loss adjustment expense reserves, as of the Merger Date,
and will cede to Western Surety all surety business written or renewed by CCC
and CIC for a period of five years thereafter. Further, CCC and CIC have agreed
to assume the obligation for any adverse development on recorded reserves for
CCC Surety Operations as of the Merger Date, to limit the loss ratio on certain
defined business written by CNA Surety through December 31, 2000 and to provide
certain additional excess of loss reinsurance. CCC also agreed to provide
certain administrative services at specified rates, subject to inflationary
increases, for three years after the Merger, if CNA Surety chooses to purchase
such services.
Immediately after the Merger, CCC and CIC owned, on a diluted basis, 61.75%
of CNA Surety's common stock and the stockholders and option holders of Capsure
owned 38.25% of CNA Surety's common stock on a diluted basis. The reorganization
agreement provides for a mechanism, referred to as the "Lookback Adjustment",
described in Management's Discussion and Analysis of Financial Condition and
Results of Operations and Note 16 to the Consolidated Financial Statements,
which could adjust the number of shares of CNA Surety common stock owned by CCC
in the event that either or both of Capsure's and the CCC Surety Operations'
actual net written premiums for 1997 varied from certain targets.
DESCRIPTION OF BUSINESS
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 37,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety and
USA. Western Surety writes, on a direct basis or as business assumed from CCC
and CIC, small fidelity and noncontract surety bonds, referred to as commercial
bonds; small, medium and large contract bonds; international surety and credit
insurance; and errors and omissions ("E&O") liability
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insurance, as a licensed insurer in all 50 states and the District of Columbia.
Western Surety's affiliated company, Surety Bonding Company of America ("SBCA"),
writes principally small commercial surety business and is licensed in 22
states. USA specializes in the underwriting of small contract and commercial
surety bonds. USA is licensed in 41 states and the District of Columbia with
most of its business generated in Texas.
The Company's strategy is to continue the underwriting focus of each of its
operating units and to achieve growth from cross-marketing opportunities and
building upon the established traditions of high-quality service and long-term
relationships.
BUSINESS STRATEGY
CNA Surety management believes the Merger resulted in the combination of
three complementary businesses, each with distinct strengths, product focuses
and marketing strategies. The combination of these businesses resulted in a
single, larger entity focused on serving the needs of virtually all segments of
the surety market, in terms of the types of products offered and the size of
bonds available, as well as the potential realization of synergies that exist
among the businesses, including expanded distribution channels for all products,
administrative efficiencies and expense savings.
Historically, the CCC Surety Operations' contract surety business has been
focused upon the medium to large contract surety business, generally contractors
with contracted work in progress of $50 million or less. USA has focused its
marketing on smaller contractors, typically those with contracted work in
progress of $3 million or less. In addition, USA's business has had a strong
South-Central U.S. regional orientation, although in recent years it has
increased its efforts to expand nationally through its alliance with Western
Surety. The combined contract surety business of CNA Surety will more thoroughly
cover the full contract surety market, ranging from very small to very large
contractors. USA operations will benefit from CNA Surety's anticipated increased
underwriting capacity to service the needs of its larger customers and breadth
and depth of underwriting and marketing resources. Management believes the
geographic expansion of USA's surety business currently underway will be aided
significantly by the existing local presence and market knowledge of its 41
branch offices.
Management believes that Western Surety is the largest writer of smaller
commercial surety bonds with strong capabilities in marketing, distribution and
service. CNA Surety management believes that as a result of the Merger, the
distribution network of Western Surety, comprised of 61 marketing
representatives across the country and approximately 37,000 independent
agencies, will gain immediate access to increased capacity to write bonds and
policies for larger exposures, in reliance on CNA Surety's greater financial
resources and underwriting capabilities. Western Surety marketing
representatives will receive support and training from branch office personnel,
enabling greater cross-marketing opportunities. In addition, in light of its
focused market and its need for immediate response, Western Surety has developed
expertise and systems that allow it to service the commercial surety needs of
smaller customers efficiently and quickly. CNA Surety expects to rely on this
expertise and service orientation to better compete in the commercial surety
market generally. For instance, the CCC Surety Operations have focused on
serving the surety needs of "Fortune 1000" companies, and with the expertise and
capabilities developed by Western Surety, CNA Surety management believes that
CNA Surety will be able to better support these companies. CNA Surety management
anticipates that it will be able to capitalize on the computer systems expertise
and the strong processing capabilities of Western Surety to improve its service
orientation to all customers, including the expansion of its surety product
offerings, the implementation of new programs and the expansion of existing
opportunities for the international operations of its U.S. customers.
While CNA Surety management intends to focus its attention on building upon
the synergies that exist among the businesses, management also expects that the
Merger will result in certain expense savings as CNA Surety will consolidate
certain functions, including administration, agency licensing, collections and
accounting. CNA Surety expects to eliminate redundant computer system
applications, move toward a common computer system architecture and enhance
communications and processing capabilities throughout the combined entity.
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Management does not, however, intend to centralize all operations.
Management believes that while each of the businesses can learn from the
respective strengths, capabilities and resources of the others, CNA Surety's
long-term strategies will best be served by maintaining the marketing and
underwriting operations of the businesses in substantially their current form.
A.M. BEST RATINGS
Western Surety and USA are currently rated A+ (Superior) and A (Excellent),
respectively, by A.M. Best Company, Inc. ("A.M. Best"). Through intercompany
reinsurance and related agreements, CNA Surety's customers will continue to have
access to CCC's broader underwriting capacity. CCC is currently rated A by A.M.
Best. A.M. Best's letter ratings range from A++ (Superior) to C- (Fair) with A++
being highest. An A+ (Superior) rating is assigned to those companies which A.M.
Best believes have achieved superior overall performance when compared to the
norms of the property and casualty insurance industry. A+ (Superior) rated
insurers have been shown to be among the strongest in ability to meet
policyholder and other contractual obligations. A rating of A (Excellent) is
assigned to those companies which A.M. Best believes have achieved excellent
overall performance when compared to the norms of the property and casualty
insurance industry and generally have demonstrated a strong ability to meet
their respective policyholder and other contractual obligations.
PRODUCT INFORMATION
According to the Surety Association of America ("SAA") industry estimates,
approximately 80% of the $2.7 billion 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.
The surety business is comprised of contract surety business and commercial
surety business, although the products comprising each are sold through the same
distribution system.
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.
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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.
Public Official bonds: required by statutes and ordinances to
guarantee the lawful and faithful performance of the duties of office by
public officials.
Fidelity bonds: cover losses arising from employee dishonesty.
Examples of purchasers of fidelity bonds are law firms, insurance agencies
and janitorial service companies.
In 1997, CNA Surety expanded into the international surety and credit
insurance market through a 50% U.S. dollar denominated quota share treaty with
an affiliate of CCC, CNA Reinsurance Company Limited (London). Western Surety
assumed $10.1 million of premium through this relationship. The assumed business
is predominately European based risks, approximately 87% of which is credit
insurance and 13% is surety and fidelity.
CNA Surety also writes E&O policies through its subsidiary Western Surety
for three classes of insureds: notaries public, tax preparers and insurance
agents and brokers. 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. Western Surety introduced an insurance
agents' and brokers' E&O insurance product in 1994 and expanded this product to
39 states as of December 31, 1997.
The following tables set forth, for each principal class of bonds, gross
written premiums, net written premiums, net earned premiums and number of bonds
and policies in force and the respective percentages of the total for the past
two years. All tables in this section contain information reflecting the pro
forma combined operations of CNA Surety, including Western Surety and USA
results prior to the Merger Date. As such, the financial information is not
necessarily indicative of the financial results that would have occurred under
the ownership and management of CNA Surety (amounts in thousands, except average
bond amounts):
PRO FORMA GROSS WRITTEN PREMIUMS
-----------------------------------
% OF % OF
1997 TOTAL 1996 TOTAL
-------- ----- -------- -----
Contract................................................ $123,014 46.2% $124,477 49.6%
Commercial:
License and permit.................................... 64,614 24.3 61,163 24.3
Judicial and fiduciary................................ 26,555 10.0 25,512 10.1
Public official....................................... 17,703 6.6 16,819 6.7
International and other............................... 11,788 4.4 1,907 0.8
-------- ----- -------- -----
Total commercial...................................... 120,660 45.3 105,401 41.9
-------- ----- -------- -----
Fidelity................................................ 15,762 5.9 15,134 6.0
E&O policies and other.................................. 6,982 2.6 6,402 2.5
-------- ----- -------- -----
$266,418 100.0% $251,414 100.0%
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PRO FORMA NET WRITTEN PREMIUMS
-----------------------------------
% OF % OF
1997 TOTAL 1996 TOTAL
-------- ----- -------- -----
Contract................................................ $118,138 45.9% $118,268 50.3%
Commercial.............................................. 118,160 46.0 97,407 41.4
Fidelity................................................ 15,750 6.1 15,090 6.4
E&O policies and other.................................. 5,019 2.0 4,421 1.9
-------- ----- -------- -----
$257,067 100.0% $235,186 100.0%
======== ===== ======== =====
PRO FORMA NET EARNED PREMIUMS
-----------------------------------
% OF % OF
1997 TOTAL 1996 TOTAL
-------- ----- -------- -----
Contract................................................ $122,042 50.2% $117,649 49.4%
Commercial.............................................. 101,372 41.6 101,640 42.6
Fidelity................................................ 15,398 6.3 14,701 6.2
E&O policies and other.................................. 4,613 1.9 4,340 1.8
-------- ----- -------- -----
$243,425 100.0% $238,330 100.0%
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PRO FORMA
DOMESTIC BOND/POLICIES IN FORCE
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% OF % OF
1997 TOTAL 1996 TOTAL
-------- ----- -------- -----
Contract................................................ 30 1.7% 26 1.5%
Commercial.............................................. 1,475 82.2 1,470 84.1
Fidelity................................................ 95 5.3 94 5.4
E&O policies and other.................................. 193 10.8 157 9.0
-------- ----- -------- -----
1,793 100.0% 1,747 100.0%
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Average domestic bond penalty/policy limit(1)........... $ 25,082 $ 24,883
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(1) The average bond penalty is a measure of the average limit of liability
associated with in force contract and commercial surety bonds at each
reporting period.
In 1997, the agency with which CNA Surety did the most business generated
approximately $2.8 million of gross written premiums, or 1.1% of aggregate gross
written premiums. The ten agencies which did the most business with CNA Surety
produced a total of $15.3 million or 5.8% of aggregate 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 37,000 of the approximately
44,000 independent property and casualty insurance agencies in the United
States. In addition, the Company employs 61 full-time salaried marketing
representatives to continually service its vast producer network. Relationships
with these independent producers are maintained through the Company's 49 local
branch offices.
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The following table sets forth the distribution of the pro forma combined
domestic business of CNA Surety, by state based upon gross written premiums in
each of the last two years:
YEARS ENDED
DECEMBER 31,
-------------
1997 1996
----- -----
Pro Forma Gross Written Premiums by State:
Texas..................................................... 12.7% 13.3%
California................................................ 7.0 7.8
Florida................................................... 5.6 5.8
New York.................................................. 4.5 4.8
Illinois.................................................. 4.0 4.1
Pennsylvania.............................................. 3.8 3.6
Michigan.................................................. 3.3 3.1
Louisiana................................................. 3.2 3.5
All Other................................................. 55.9 54.0
----- -----
Total..................................................... 100.0% 100.0%
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CONTRACT SURETY
With respect to the contract surety business, the core focus for the
Company is contractors with less than $50 million in contracted work in
progress. This segment is comprised of small contractors (less than $5 million
in work in progress), medium contractors ($5-$25 million) and the lower end of
the large contractors ($25-$150 million). These small and medium contractors, as
a group, represent a significant portion of the United States construction
market. The Company has a small number of accounts with contracted work in
progress in excess of $150 million, the majority of which have been clients of
the Company's predecessor for more than ten years. 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's USA unit will continue to focus its marketing efforts on
serving the needs of the small contractor. Contract bonds underwritten by USA
are primarily contractor performance and payment bonds in amounts under $3
million. The Company will utilize Western Surety's diverse agency relationships
and its nationwide branch structure to expand the geographic and agency
distribution of USA's small contract surety business.
CNA Surety also participates in the non-standard contract surety market,
utilizing the federal government's Small Business Administration ("SBA") surety
bond guarantee programs. The SBA programs provide 70% - 90% coverage in exchange
for 10% - 30% of the premium.
COMMERCIAL SURETY
A large portion of the commercial surety market is comprised of small
obligations represented by licenses and permits that are routine in nature and
require minimal underwriting. Customers are focused principally on prompt and
efficient service.
The Company's Western Surety unit will continue to focus its marketing
efforts on this small commercial bond market. Western 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.
While a large portion of the commercial surety market is represented by
small entities, CNA Surety will also seek to service the bonding needs of
larger, "Fortune 1000" firms, where a high level of technical and underwriting
skill is required. These larger customers are sophisticated, professional buyers
of commercial surety bonds who demand exceptional service and business expertise
at a reasonable cost. CNA Surety
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maintains a specific underwriting staff in its Chicago home office and other
underwriting centers across the country dedicated to the "Fortune 1000" market.
CNA Surety's insurance subsidiaries will 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, games of chance bonds (guaranteeing payment of prizes from promotional
games) and grain warehouse dealers bonds (protecting funds associated with grain
storage).
UNDERWRITING
The underwriting philosophy of CNA Surety is disciplined, and 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 extensive 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, will vary depending on the class of business and
the type of bond. For example, relatively little underwriting information is
typically required of certain low-exposure risks such as notary bonds.
COMPETITION
The surety and fidelity market is highly competitive. According to 1996
data from A.M. Best, the U.S. market aggregates approximately $3.6 billion in
direct written premiums, comprised of approximately $2.7 billion in surety
premiums and approximately $0.9 billion in fidelity premiums. The large
diversified insurance companies hold the largest market shares. For example, the
20 largest surety companies account for nearly 70% of the surety market. On a
pro forma basis for 1996, CNA Surety was the largest surety provider with an
8.6% market share.
Primary competitors of CNA Surety are approximately 20 national, multi-line
companies participating in the surety market throughout the country. Management
believes that its principal strengths are capacity, diverse product offering,
service and accessibility and long-term relationships with agents and accounts.
While the surety industry has experienced slow premium growth, competition has
increased as a result of ten years of profitable underwriting experience. This
competition has typically manifested itself through reduced premium rates and
greater tolerance for relaxation of underwriting standards. Management believes
such competition will continue.
REINSURANCE
The Company's insurance subsidiaries, in the ordinary course of business,
cede insurance to other insurance companies to limit their exposure to loss,
provide greater diversification of risk and minimize aggregate exposures.
Because the ceding of insurance does not ordinarily discharge the primary
liability of the original insurer, the management of CNA Surety only places
their reinsurance with qualified carriers after conducting a detailed review of
the nature of the obligation and a thorough assessment of the reinsurers' credit
qualifications and claims settlement performance and capabilities. The
reinsurance coverages and terms are tailored to the specific risk
characteristics of the underlying products of the Company.
For contract and commercial surety business, exclusive of USA business, an
excess of loss reinsurance program is in effect. It provides for coverage on a
per principal basis, equal to $55 million in excess of a $5 million retention.
For the USA business only, the Company has per principal reinsurance coverage of
85% of losses up to $4.9 million in excess of $100,000. The Company also has an
excess of loss reinsurance contract with CCC which provides $75 million of
coverage, on a per principal basis, in excess of the $60 million. The Company
limits its net retention on its insurance agents and brokers E&O liability
insurance product to 20% through a third party quota share reinsurance
agreement.
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At December 31, 1997, CNA Surety's largest non-affiliate reinsurance
receivable, including prepaid reinsurance premiums of $1.0 million, was
approximately $2.7 million with Transatlantic Reinsurance Company. Transatlantic
Reinsurance Company is rated A+ (Superior) by A.M. Best.
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, exclusive of reinsurance recoveries which are reported as an asset.
These estimates are determined based on the Company's and surety industry loss
experience as well as consideration of current trends and conditions. The
estimated liability for unpaid losses and loss adjustment expenses is an
estimate and there is the potential that actual future loss payments will differ
significantly from initial estimates. The methods of determining such estimates
and the resulting estimated liability are regularly reviewed and updated.
Changes in the estimated liability are reflected in operating income in the year
in which such changes are determined to be needed.
CNA Surety's insurance subsidiaries employ accepted reserving approaches in
establishing the estimated liability for unpaid loss and loss adjustment
expenses that give consideration to the inherent difficulty and variability in
the estimation process. In addition, CNA Surety utilizes independent actuarial
firms of national standing to conduct periodic reviews of claim procedures and
loss reserving practices, and annually obtains actuarial certification as to the
reasonableness of actuarial assumptions used and the sufficiency of year-end
reserves for each of its principal insurance subsidiaries.
A table is included in both Management's Discussion and Analysis of
Financial Condition and Results of Operations and Note 8 to the Consolidated
Financial Statements which presents a reconciliation of beginning and ending
loss reserve balances of the Company for the period from September 30, 1997
(date of inception) through December 31, 1997 and of the Predecessor for the
nine months ended September 30, 1997 and years ended December 31, 1996 and 1995.
Such tables highlight the impact of favorable development of the estimated
liability established in prior years.
The following table sets forth a reconciliation of the consolidated loss
reserves reported in accordance with generally accepted accounting principles
("GAAP"), and the reserves reported to state insurance regulatory authorities in
accordance with statutory accounting principles ("SAP") for the year ended
December 31, 1997 (dollars in thousands):
Net reserves at end of year, GAAP basis..................... $122,725
Ceded reinsurance, net of salvage and subrogation........... 7,656
--------
Gross reserves at end of year, GAAP basis................... 130,381
Estimated salvage and subrogation recoverable (gross of
reinsurance), not anticipated under SAP................... 8,070
Estimated reinsurance recoverable netted against gross
reserves for SAP.......................................... (8,692)
--------
Gross reserves at end of year, SAP basis.................... $129,759
========
The loss reserve development table below illustrates the change over time
of reserves established for the Company's estimated losses and loss adjustment
expenses at the end of various calendar years. The first section shows the
reserves as originally reported at the end of the stated year. The second
section shows the cumulative amounts paid as of the end of successive years with
respect to that reserve liability. The third section shows re-estimates of the
original recorded reserve as of the end of each successive year which is the
result of management's expanded awareness of additional facts and circumstances
that pertain to the unsettled claims. The last section compares the latest
re-estimated reserve to the reserve originally established, and indicates
whether or not the original reserve was adequate or inadequate to cover the
estimated costs of unsettled claims.
10
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The loss reserve development table is cumulative as of each December 31,
and, therefore, ending balances should not be added since the amount at the end
of each calendar year includes activity for both the current and prior years.
The loss reserve development table reflects, on a pro forma basis, the reserves
of the CCC Surety Operations and Capsure since 1987 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 nor of future operating results.
AS OF DECEMBER 31,
------------------------------------------------------------------------------------
1987 1988 1989 1990 1991 1992 1993 1994
------- ------- ------- ------- ------- ------- ------- -------
(DOLLARS IN THOUSANDS)
Net reserves for losses and loss
adjustment expenses............. $50,609 $60,959 $58,685 $69,733 $60,425 $61,998 $64,627 $70,398
Net Paid (Cumulative) as of:
One year later................... 12,532 11,700 7,618 13,456 16,287 17,636 12,923 12,018
Two years later.................. 20,510 15,221 13,540 22,330 24,295 25,854 19,671 18,149
Three years later................ 22,251 17,823 18,033 26,835 29,857 29,495 21,990 21,229
Four years later................. 23,928 20,723 20,758 31,591 31,273 30,582 23,070 --
Five years later................. 26,152 22,575 22,089 32,133 31,909 30,817 -- --
Six years later.................. 27,312 23,271 25,441 32,352 32,354 -- -- --
Seven years later................ 27,717 24,515 23,457 32,993 -- -- -- --
Eight years later................ 28,616 24,529 23,849 -- -- -- -- --
Nine years later................. 28,606 24,877 -- -- -- -- -- --
Ten years later.................. 29,013 -- -- -- -- -- -- --
Net Reserves Re-estimated as of:
End of initial year.............. 50,609 60,959 58,685 69,733 60,425 61,998 64,627 70,398
One year later................... 48,426 49,285 53,486 50,822 58,644 58,603 54,568 51,471
Two years later.................. 43,530 44,495 39,131 51,330 51,511 54,585 44,749 44,135
Three years later................ 41,032 36,635 39,978 46,439 46,826 47,911 38,972 38,829
Four years later................. 38,256 37,200 34,357 42,946 42,212 42,542 28,094 --
Five years later................. 38,006 32,134 31,405 40,747 39,945 33,699 -- --
Six years later.................. 34,184 29,816 31,777 38,131 36,164 -- -- --
Seven years later................ 33,899 29,392 26,646 36,179 -- -- -- --
Eight years later................ 32,932 26,831 25,464 -- -- -- -- --
Nine years later................. 30,634 25,514 -- -- -- -- -- --
Ten years later.................. 29,580 -- -- -- -- -- -- --
------- ------- ------- ------- ------- ------- ------- -------
Total net (deficiency)
redundancy...................... $21,029 $35,445 $33,221 $33,554 $24,261 $28,299 $36,533 $31,569
======= ======= ======= ======= ======= ======= ======= =======
Cumulative redundancy
(deficiency) as a percentage of
original estimate............... 41.6% 58.1% 56.6% 48.1% 40.2% 45.6% 56.5% 44.8%
======= ======= ======= ======= ======= ======= ======= =======
AS OF DECEMBER 31,
--------------------------------
1995 1996 1997
-------- -------- --------
(DOLLARS IN THOUSANDS)
Net reserves for losses and loss
adjustment expenses............. $147,911 $137,064 $122,725
Net Paid (Cumulative) as of:
One year later................... 42,552 9,866 --
Two years later.................. 43,179 -- --
Three years later................ -- -- --
Four years later................. -- -- --
Five years later................. -- -- --
Six years later.................. -- -- --
Seven years later................ -- -- --
Eight years later................ -- -- --
Nine years later................. -- -- --
Ten years later.................. -- -- --
Net Reserves Re-estimated as of:
End of initial year.............. 147,911 137,064 122,725
One year later................... 132,267 96,178 --
Two years later.................. 103,466 -- --
Three years later................ -- -- --
Four years later................. -- -- --
Five years later................. -- -- --
Six years later.................. -- -- --
Seven years later................ -- -- --
Eight years later................ -- -- --
Nine years later................. -- -- --
Ten years later.................. -- -- --
-------- -------- --------
Total net (deficiency)
redundancy...................... $ 44,445 $ 40,886(1) $ --
======== ======== ========
Cumulative redundancy
(deficiency) as a percentage of
original estimate............... 30.0% 29.8% --
======== ======== ========
- ---------------
(1) The $40.9 million release of prior year reserves is comprised of $35.0
million of CCC Surety Operations favorable development and $5.3 million of
Capsure favorable reserve development in the nine month period of 1997
prior to the Merger and $0.6 million of CNA Surety favorable reserve
development for the period from September 30, 1997 (date of inception)
through December 31, 1997.
ASBESTOS AND ENVIRONMENTAL CLAIMS
The Company does not bond contractors that specialize in environmental
remediation work. The Company does, however, bond several accounts that have
incidental environmental exposure with respect to which the Company provides
limited 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. While no environmental responsibility is overtly provided
11
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by commercial or contract bonds, some risk of environmental exposure may exist
if the surety were to assume certain rights of ownership of the property in the
completion of a defaulted project or through salvage recovery.
To date, the Company has not received any environmental claim notices nor
is management aware of any potential environmental claims.
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 which 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. SBCA is domiciled in South Dakota and licensed in
22 states. USA is domiciled in Texas and licensed in 41 states and the District
of Columbia.
Insurance regulations generally also require registration and periodic
disclosure of certain information concerning ownership, financial condition,
capital structure, general business operations and any material transactions or
agreements by or among affiliates. Such regulation also typically restricts the
ability of any one person to acquire 10% or more, either directly or indirectly,
of a company's stock without prior approval of the applicable insurance
regulatory authority. In addition, dividends and other distributions to
stockholders generally may be paid only out of unreserved and unrestricted
statutory earned surplus. Such distributions may be subject to prior regulatory
approval, including a review of the implications on Risk-Based Capital
requirements. A discussion of Risk-Based Capital requirements for property and
casualty insurance companies is included in both Management's Discussion and
Analysis of Financial Condition and Results of Operations and Note 13 to the
Consolidated Financial Statements. Without prior regulatory approval in 1998,
CNA Surety's insurance subsidiaries may pay stockholder dividends of $16.3
million in the aggregate. For the period from September 30, 1997 (date of
inception) through December 31, 1997, CNA Surety received $5.0 million in
dividends from its insurance subsidiaries.
Since CCC Surety Operations prior to the Merger were conducted through
several wholly-owned insurance subsidiaries of CNAF, and the surety business
only represented a small portion of the business of such subsidiaries and
dividends paid by the insurance subsidiaries to CNAF were not allocated between
lines of insurance, the amounts of dividends paid by the insurance subsidiaries
to CNAF attributable to the CCC Surety Operations cannot be determined for years
prior to the Merger.
CNA Surety's insurance subsidiaries are subject to periodic financial and
market conduct examinations. These examinations are generally performed by the
domiciliary state insurance regulatory authorities. The South Dakota Department
of Commerce and Regulation -- Division of Insurance conducted its last
examination of Western Surety as of December 31, 1991. This examination covered
both financial and market conduct procedures. The Texas Department of Insurance
conducted its last examination of USA as of December 31, 1996. This examination
included financial matters. There were no significant issues noted which
required corrective action by any of the insurance subsidiaries. Financial and
market conduct examinations of Western Surety are currently being conducted for
the five year period ended December 31, 1996.
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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 Capsure's
or the Predecessor's results of operations.
Western Surety and USA each qualifies as an acceptable surety for federal
and other public works project bonds pursuant to U.S. Department of Treasury
regulations. The underwriting limitations of Western Surety and USA, based on
each insurer's statutory surplus, are currently $3.4 million and $1.2 million,
respectively. Through intercompany reinsurance and related agreements with CCC,
CNA Surety has access to CCC's $345.3 million U.S. Treasury underwriting
limitation.
INVESTMENTS
Insurance company investment practices must comply with insurance laws and
regulations and must also comply with certain covenants under CNA Surety's $130
million revolving credit facility. Generally, insurance laws and regulations
prescribe the nature and quality of, and set limits on, the various types of
investments which may be made by CNA Surety's insurance subsidiaries.
The Company's investment portfolios generally are managed to maximize
after-tax investment returns, while minimizing credit risks with investments
concentrated in high quality, fixed income securities. CNA Surety's portfolios
are managed to provide diversification by limiting exposures to any one issue or
issuer, and to provide liquidity by investing in the public securities markets.
The portfolios are structured to support CNA Surety's operations and 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 of the Company's insurance subsidiaries 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.
NET OPERATING TAX LOSS ("NOLS") CARRYFORWARDS
In July 1986, Capsure emerged from voluntary bankruptcy proceedings under
Chapter 11 of the United States Bankruptcy Code. Prior to its emergence, Capsure
was primarily involved in oil and gas production, exploration and development
and providing supplies to the oil and gas industry. Due to a significant
downturn in the oil and gas industry in the early 1980s, Capsure generated
significant losses and was unable to meet its obligations, resulting in its
voluntary bankruptcy filing. Upon emergence from bankruptcy, Capsure had oil and
gas interests and approximately $300 million in NOLs. The IRS has not audited
Capsure's tax returns for the years in which it reported net operating losses.
Capsure had approximately $100.7 million of these NOLs available at
September 30, 1997 to reduce its future federal taxable income, of which $50.7
million expired on December 31, 1997. Under Section 382 of the Code, significant
restrictions on CNA Surety's ability to utilize Capsure's NOL carryovers apply
because of the ownership change as a result of the Merger.
EMPLOYEES
As of December 31, 1997, the Company employed approximately 840 persons.
Since its emergence from bankruptcy in 1986, Capsure has not experienced any
work stoppages nor has CCC Surety Operations ever experienced a work stoppage.
Management of CNA Surety believes its relations with its employees are good.
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ITEM 2. PROPERTIES
CNA Surety leases its executive offices and its shared branch locations
with CCC under an Administrative Services Agreement. CNA Surety currently uses
approximately 72,500 square feet and related personal property at 41 branch
locations and its home and executive offices (15,243 square feet), in Chicago,
Illinois. CNA Surety's annual rent for this space is approximately $1.6 million.
CNA Surety may terminate its use of these locations as set forth in the
Administrative Services Agreement, without penalty, by providing CCC with 60
days written notice.
Western Surety leases office space for its executive offices at 101 South
Phillips Avenue, Sioux Falls, South Dakota 57104, under a lease expiring in
2002. Western Surety's office space, consisting of approximately 81,600 square
feet, is leased from a partnership in which Western Surety owns a 50% interest.
The annual rent, which is subject to annual adjustments, was $1.5 million as of
December 31, 1997. Western Surety also leases a 7,900 square foot branch office
in Dallas, Texas. Annual rent for the branch office was $0.2 million and the
lease expires in 1999. USA leases office space for its executive offices at 950
Echo Lane, Suite 250, Houston, Texas 77024, under a lease terminating in 2000
with an annual rent of $0.2 million. USA also leases space for 7 branch offices
for an additional annual rent of approximately $0.1 million.
ITEM 3. LEGAL PROCEEDINGS
The Company and its subsidiaries are parties to numerous 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 results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
The Company's common stock ("Common Stock") trades on the New York Stock
Exchange under the symbol SUR. On March 6, 1998, the last reported sale price
for the Common Stock was $16.00 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 the fourth quarter of 1997. Prior to September
30, 1997 the Company was not publicly traded.
HIGH LOW
------- -------
1997
4th Quarter............................................... $16.500 $12.875
The number of stockholders of record of Common Stock on March 6, 1998, was
approximately 2,100.
DIVIDENDS
The declaration and payment of dividends to holders of CNA Surety Common
Stock will be at the discretion of the CNA Surety Board and will depend upon
many factors, including CNA Surety's financial condition, operating
characteristics, projected earnings and growth, capital requirements of its
insurance subsidiaries, debt service obligations and such other factors as the
CNA Surety Board deems relevant. There can be no assurance that any future
dividends will be paid.
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15
ITEM 6. SELECTED FINANCIAL DATA
The following financial information has been derived from the Consolidated
Financial Statements and notes thereto which appear elsewhere in this Form 10-K.
CNA Surety Corporation is a newly formed holding company for the combined
surety business of CNAF and Capsure. Pursuant to a reorganization agreement,
CNAF and Capsure merged their respective operations at the close of business on
September 30, 1997. The surety operations of CNAF are referred to as CCC Surety
Operations ("Predecessor"). For a more detailed description of the merger
transactions and their effects on the Company's financial data, see the
Consolidated Financial Statements and related notes thereto and Management's
Discussion and Analysis of Financial Condition and Results of Operations
appearing in this Form 10-K.
The following information presented for CNA Surety is for the period from
September 30, 1997 (date of inception) through December 31, 1997 and as of
December 31, 1997. Selected financial data of the Predecessor is presented on
the following page.
(Dollars in thousands, except per share data)
Total revenues(1)........................................... $ 71,284
========
Gross written premiums...................................... $ 75,252
========
Net written premiums........................................ $ 73,989
========
Net earned premiums......................................... $ 65,433
========
Underwriting income(2)...................................... $ 15,086
Net investment income....................................... 5,766
Net investment gains (losses)............................... 85
Interest expense............................................ 1,831
Amortization of intangible assets........................... 1,447
--------
Income before income taxes.................................. 17,659
Income taxes................................................ 6,663
--------
Net income.................................................. $ 10,996
========
Basic and diluted earnings per common share................. $ 0.25
========
Loss ratio(2)............................................... 18.5%
Expense ratio............................................... 58.4
--------
Combined ratio(2)........................................... 76.9%
========
Invested assets and cash.................................... $419,667
Intangible assets, net of amortization...................... 161,962
Total assets................................................ 727,180
Insurance reserves.......................................... 304,217
Long-term debt.............................................. 118,000
Total liabilities........................................... 470,448
Stockholders' equity........................................ 256,732
Book value per share........................................ $ 5.93
- ---------------
(1) Includes investment income and investment gains for CNA Surety for the
period from September 30, 1997 (date of inception) through December 31,
1997.
(2) Includes the effect of recording releases of prior year loss reserves. The
dollar amount and the percentage point effect on the loss ratio of these
reserve revisions was $647 and 1.0% for the period from September 30, 1997
(date of inception) through December 31, 1997.
15
16
The following information of the Predecessor is presented for the three
months ended December 31, 1996, for the nine months ended September 30, 1997 and
1996 and for the years ended December 31, 1996, 1995, 1994 and 1993. The
selected financial information of the Predecessor does not include data with
respect to assets, liabilities (other than insurance reserves) and equity
because CNAF did not customarily allocate the investment portfolio or equity of
its operating subsidiaries to its business units like CCC Surety Operations.
THREE NINE MONTHS ENDED
MONTHS SEPTEMBER 30, YEARS ENDED DECEMBER 31,
ENDED ------------------- -----------------------------------------
12/31/96 1997 1996 1996 1995(1) 1994 1993
(Dollars in thousands) -------- -------- -------- -------- -------- -------- --------
Gross written premiums... $ 40,654 $116,075 $114,554 $155,208 $136,605 $ 94,182 $ 88,040
======== ======== ======== ======== ======== ======== ========
Net written premiums..... $ 37,641 $108,630 $106,263 $143,904 $122,012 $ 82,064 $ 73,005
======== ======== ======== ======== ======== ======== ========
Net earned premiums...... $ 36,767 $108,564 $112,302 $149,069 $130,603 $ 77,981 $ 72,632
Net loss and LAE(2)...... 9,394 (11,516) 23,612 33,006 32,440 8,580 12,508
Amortization of deferred
policy acquisition
costs(3)............... 16,665 48,075 49,717 66,382 58,243 34,202 27,928
Other direct expenses.... 4,631 10,173 8,637 13,268 11,840 6,716 6,029
Policyholders'
dividends.............. 324 1,426 1,641 1,965 1,508 1,009 1,005
-------- -------- -------- -------- -------- -------- --------
Excess of net earned
premiums over direct
operating expenses
before income
taxes(2)(3)............ $ 5,753 $ 60,406 $ 28,695 $ 34,448 $ 26,572 $ 27,474 $ 25,162
======== ======== ======== ======== ======== ======== ========
Loss ratio(2)............ 25.6% (10.6)% 21.0% 22.1% 24.8% 11.0% 17.2%
Expense ratio(3)......... 58.8 55.0 53.4 54.8 54.8 53.8 48.2
-------- -------- -------- -------- -------- -------- --------
Combined ratio(2)(3)..... 84.4% 44.4% 74.4% 76.9% 79.6% 64.8% 65.4%
======== ======== ======== ======== ======== ======== ========
Insurance reserves(4).... $214,828 $183,491 $210,340 $214,828 $239,716 $111,695 $112,764
- ---------------
(1) CNAF acquired The Continental Insurance Company ("Continental") in May 1995.
Results include the surety operations of Continental since its acquisition
in May 1995 which affects the comparability of financial information.
(2) Includes the effect of recording releases of prior year loss reserves. The
dollar amount and the percentage point effect on the loss ratio of these
reserve revisions, all of which were net reductions, were $1,232 or 3.4% for
the three months ended December 31, 1996, $35,000 or 32.2% and $8,510 or
7.6% for the nine months ended September 30, 1997 and 1996, respectively,
and $9,742 and 6.5%, $10,846 and 8.3%, and $8,454 and 10.8% for the years
ended December 31, 1996, 1995, and 1994, respectively.
(3) Does not include the effects of certain general and administrative expenses,
which are indirect or overhead in nature, since such costs were not
historically allocated to the CCC Surety Operations by CNAF or its
subsidiaries. Accordingly, the comparability of this data to other data that
include such costs is affected.
(4) The insurance reserves include both loss and loss adjustment expense and
unearned premium reserves. These reserves are shown before the effects of
ceded reinsurance. In accordance with the reorganization and related
reinsurance agreements, these reserves, as of the Merger Date, were
transferred to Western Surety, net of reinsurance which totaled $9,979 and
$23,876 for the nine months ended September 30, 1997 and 1996 and $21,779,
$31,060, $21,098, and $28,362 at December 31, 1996, 1995, 1994, and 1993,
respectively.
16
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS OF CNA SURETY CORPORATION AND STATEMENT OF CERTAIN ASSETS
AND LIABILITIES AND THE STATEMENTS OF CERTAIN REVENUES AND DIRECT
OPERATING EXPENSES OF PREDECESSOR
GENERAL
The following is a discussion and analysis of CNA Surety Corporation ("CNA
Surety" or the "Company") and its insurance subsidiaries' operating results,
financial condition, liquidity and capital resources as well as a discussion of
CCC Surety Operations' ("Predecessor") Statement of Certain Assets and
Liabilities and Statements of Certain Revenues and Direct Operating Expenses.
This discussion should be read in conjunction with the Consolidated Financial
Statements of CNA Surety and notes thereto and the audited Statement of Certain
Assets and Liabilities and Statements of Certain Revenues and Direct Operating
Expenses and the related notes thereto of CCC Surety Operations.
FORMATION OF CNA SURETY CORPORATION AND MERGER
In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings
Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF
with Capsure's insurance subsidiaries, Western Surety Company ("Western Surety")
and Universal Surety of America ("USA"), which are owned by a newly-formed
holding company, CNA Surety Corporation. CNAF, through its operating
subsidiaries, writes multiple lines of property and casualty insurance,
including surety business that is reinsured by Western Surety. Loews Corporation
owns approximately 84% of the outstanding common stock of CNAF. The principal
operating subsidiaries of CNAF that wrote the surety line of business for their
own account prior to the Merger were Continental Casualty Company and its
property and casualty affiliates (collectively, "CCC") and The Continental
Insurance Company and its property and casualty affiliates (collectively,
"CIC"). CIC was acquired by CNAF on May 10, 1995. The combined surety operations
of CCC and CIC are referred to herein as CCC Surety Operations ("Predecessor").
Pursuant to a reorganization agreement, CCC Surety Operations and Capsure
merged their respective operations at the close of business on September 30,
1997 ("Merger Date"). CNAF, through its property and casualty subsidiaries, CCC
and CIC contributed $52.25 million of capital to CNA Surety. Through reinsurance
agreements, CCC and CIC ceded to Western Surety all of their net unearned
premiums and loss and loss adjustment expense reserves, as of the Merger Date,
and will cede to Western Surety all surety business written or renewed by CCC
and CIC for a period of five years thereafter. Further, CCC and CIC have agreed
to assume the obligation for any adverse development on recorded reserves for
CCC Surety Operations as of the Merger Date, to limit the loss ratio on certain
defined business written by CNA Surety through December 31, 2000 and to provide
certain additional excess of loss reinsurance. CCC also agreed to provide
certain administrative services at specified rates, subject to inflationary
increases, for three years after the Merger, if CNA Surety chooses to purchase
such services.
Immediately after the Merger, CCC and CIC owned, on a diluted basis, 61.75%
of CNA Surety's common stock and the stockholders and option holders of Capsure
owned 38.25% of CNA Surety's common stock on a diluted basis. The reorganization
agreement provides for a mechanism, referred to as the "Lookback Adjustment,"
which could adjust the number of shares of CNA Surety common stock owned by CCC
in the event that either or both of Capsure's and the CCC Surety Operations'
actual net written premiums for 1997 varied from certain targets. See Note 16 to
the Consolidated Financial Statements for a discussion of the Lookback
Adjustment.
BUSINESS
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 37,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety and
USA. Western Surety writes, on a direct basis or as business assumed from CCC
and CIC, small fidelity and noncontract surety bonds, referred to as commercial
bonds; small, medium and large contract bonds; international surety and credit
insurance; and errors and omissions ("E&O") liability
17
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insurance, as a licensed insurer in all 50 states and the District of Columbia.
Western Surety's affiliated company, Surety Bonding Company of America ("SBCA"),
writes principally small commercial surety business and is licensed in 22
states. USA specializes in the underwriting of small contract and commercial
surety bonds. USA is licensed in 41 states and the District of Columbia with
most of its business generated in Texas.
The Company's strategy is to continue the underwriting focus of each of its
operating units and to achieve growth from cross-marketing opportunities and
building upon the established traditions of high-quality service and long-term
relationships.
Western Surety and USA are currently rated A+ (Superior) and A (Excellent),
respectively, by A.M. Best Company, Inc. ("A.M. Best"). Through intercompany
reinsurance and related agreements, CNA Surety's customers will continue to have
access to CCC's broader underwriting capacity. CCC is currently rated A by A.M.
Best.
RESULTS OF OPERATIONS
CNA SURETY RESULTS FROM SEPTEMBER 30, 1997 (DATE OF INCEPTION) THROUGH
DECEMBER 31, 1997 AND PREDECESSOR RESULTS FOR THE NINE MONTHS ENDED SEPTEMBER
30, 1997 COMPARED TO PREDECESSOR YEAR ENDED DECEMBER 31, 1996
As set forth in Note 1 to the Consolidated Financial Statements, the
results of operations of the Predecessor did not reflect investment income and
investment gains and losses. Additionally, certain general and administrative
expenses, which were indirect or overhead in nature, were not allocated to the
Predecessor by CNAF or its subsidiaries. As a result of these factors and
because the merger with Capsure significantly affected the combined
organization, it is not useful to compare CNA Surety operations to Predecessor
operations. Also, a comparison of the Predecessor results of operations for the
nine months ended September 30, 1997 to the year ended December 31, 1996 would
not be useful due to the different reporting periods of nine and twelve months.
Accordingly, the remainder of this discussion and analysis is formatted to
compare information for CNA Surety for various time periods in 1997 and 1996 as
if the merger had been consummated on January 1, 1996. Periods presented prior
to September 30, 1997 that are shown herein on this basis are therefore marked
pro forma. The following table of unaudited pro forma information has been
prepared as if the acquisition of Capsure had been consummated on January 1,
1996. This unaudited pro forma financial information gives effect to the
following: (i) adjustment to the Capsure statement of operations, as reported,
to reflect the income effects as if the $10 per share special distribution was
made on January 1, 1996; (ii) consummation of the Merger and the related
transactions and the contribution of capital to and the incurrence of additional
debt by CNA Surety; (iii) purchase accounting adjustments to reflect Capsure's
assets and liabilities at fair value; (iv) estimated indirect and overhead
expenses for the CCC Surety Operations; and (v) estimated interest expense
related to the additional debt. The unaudited pro forma financial information
does not include the estimated net investment income resulting from investment
of merger-related cash flows, including (i) the $50 million debt proceeds, (ii)
the $52.25 million capital contribution from CCC, and (iii) collection of the
receivable from CCC.
ANALYSIS OF CNA SURETY'S RESULTS FOR THE THREE MONTHS ENDED AND YEARS ENDED
DECEMBER 31, 1997 AND 1996
A discussion of CNA Surety's actual results of operations for the period
from September 30, 1997 (date of inception) through December 31, 1997 compared
to unaudited pro forma results of operations for the comparative period in 1996
and a discussion of unaudited pro forma results of operations for the years
ended December 31, 1997 and 1996 follows. The operating results of CNA Surety
for the period from September 30, 1997 (date of inception) through December 31,
1997 are hereinafter referred to as the customarily subscribed to terms "Three
Months Ended" or "Fourth Quarter."
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The components of income for the Company for the three months and years
ended December 31, 1997 and 1996 are summarized as follows (dollars in
thousands):
THREE MONTHS ENDED YEARS ENDED
DECEMBER 31, DECEMBER 31,
----------------------- --------------------
1997 1996 1997 1996
-------- ----------- -------- --------
(PRO FORMA) (PRO FORMA)
Total revenues.............................. $ 71,284 $ 62,754 $258,682 $250,194
======== ======== ======== ========
Underwriting income......................... $ 15,086 $ 8,989 $ 87,146 $ 46,682
Net investment income....................... 5,766 2,866 14,534 10,796
Net investment gains........................ 85 19 723 1,068
Interest expense............................ 1,831 1,807 7,232 7,660
Non-recurring charges and merger costs...... -- 1,524 12,087 8,565
Amortization of intangible assets........... 1,447 1,447 5,788 5,788
-------- -------- -------- --------
Income before income taxes.................. 17,659 7,096 77,296 36,533
Income taxes................................ 6,663 2,751 42,921 14,101
-------- -------- -------- --------
Net income.................................. $ 10,996 $ 4,345 $ 34,375 $ 22,432
======== ======== ======== ========
Net income per share........................ $ 0.25 $ 0.10 $ 0.79 $ 0.52
======== ======== ======== ========
Insurance Underwriting
Underwriting results for the Company for the three months and years ended
December 31, 1997 and 1996 are summarized in the following table (dollars in
thousands):
THREE MONTHS ENDED
DECEMBER 31, YEARS ENDED DECEMBER 31,
----------------------- ------------------------
1997 1996 1997 1996
-------- ----------- ---------- ----------
(PRO FORMA) (PRO FORMA)
Gross written premiums...................... $ 75,252 $ 64,126 $266,418 $251,414
======== ======== ======== ========
Net written premiums........................ $ 73,989 $ 59,808 $257,067 $235,186
======== ======== ======== ========
Net earned premiums......................... $ 65,433 $ 59,869 $243,425 $238,330
Net losses and loss adjustment expenses..... 12,134 11,237 5,648 41,450
Net commissions, brokerage and other........ 38,213 39,643 150,631 150,198
-------- -------- -------- --------
Underwriting income......................... $ 15,086 $ 8,989 $ 87,146 $ 46,682
======== ======== ======== ========
Loss ratio.................................. 18.5% 18.8% 2.3% 17.4%
Expense ratio............................... 58.4 66.2 61.9 63.0
-------- -------- -------- --------
Combined ratio.............................. 76.9% 85.0% 64.2% 80.4%
======== ======== ======== ========
Premiums Written
CNA Surety primarily markets contract and commercial surety bonds. Contract
bonds guarantee obligations covered by a written agreement between two parties.
The most common types include bid, performance and payment bonds. The commercial
surety market includes numerous types of bonds categorized as court judicial,
court fiduciary, public official, license and permit and many miscellaneous
bonds that include guarantees of financial performance. The Company also writes
fidelity bonds which cover losses arising from employee dishonesty, and E&O
liability insurance.
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Gross written premiums are shown in the table below (dollars in thousands):
THREE MONTHS ENDED
DECEMBER 31, YEARS ENDED DECEMBER 31,
----------------------- ------------------------
1997 1996 1997 1996
-------- ----------- ---------- ----------
(PRO FORMA) (PRO FORMA)
Contract.................................... $ 29,185 $ 31,639 $123,014 $124,477
Commercial.................................. 40,638 27,490 120,660 105,401
Fidelity.................................... 3,495 3,404 15,762 15,134
E&O and other............................... 1,934 1,593 6,982 6,402
-------- -------- -------- --------
$ 75,252 $ 64,126 $266,418 $251,414
======== ======== ======== ========
Gross written premiums increased 17.4%, or $11.1 million, in the fourth
quarter ended December 31, 1997 compared to the fourth quarter of 1996 and gross
written premiums increased 6.0%, or $15.0 million, for the year ended December
31, 1997 compared to 1996. These increases were primarily attributable to $10.1
million of international surety and credit business assumed in the fourth
quarter of 1997, as a result of the Company's initiative to more aggressively
expand its products and services into the international markets. In 1997, CNA
Surety expanded into the international surety and credit insurance market
through a quota share reinsurance treaty with an affiliate of CCC, CNA
Reinsurance Company Limited (London). Commercial surety, exclusive of
international surety and credit business, was up 11.0% for the fourth quarter
and 4.9% in 1997. The fidelity and other book of business, primarily written by
Western Surety, increased 8.6% and 5.6% in the fourth quarter and year ended
December 31, 1997, respectively. These increases in commercial surety and
fidelity and other business were offset by a decrease in contract surety
business of 7.8% in the fourth quarter and 1.2% for the full year ended December
31, 1997. The decreases in contract surety reflect the competitive pressures
primarily in the medium to large contract segment of the market and to a lesser
extent, the timing of the contractor accounts being awarded new business by
their customers.
Net written premiums are shown in the table below (dollars in thousands):
THREE MONTHS ENDED
DECEMBER 31, YEARS ENDED DECEMBER 31,
----------------------- ------------------------
1997 1996 1997 1996
-------- ----------- ---------- ----------
(PRO FORMA) (PRO FORMA)
Contract.................................... $ 27,836 $ 30,170 $118,138 $118,268
Commercial.................................. 41,272 25,157 118,160 97,407
Fidelity.................................... 3,516 3,395 15,750 15,090
E&O and other............................... 1,365 1,086 5,019 4,421
-------- -------- -------- --------
$ 73,989 $ 59,808 $257,067 $235,186
======== ======== ======== ========
For the three months and year ended December 31, 1997, net written premiums
increased 23.7%, or $14.2 million, and 9.3%, or $21.9 million, respectively,
over the comparable period in 1996. Net written premiums were up primarily due
to a 21.3% increase in commercial surety business for the full year of 1997. The
increase in commercial net written premiums includes the addition of the
aforementioned international surety and credit business as well as relatively
strong growth in Western Surety's core small commercial surety business
throughout 1997. Net written premiums, exclusive of the international business,
increased 6.8% and 5.0% for the three months and year ended December 31, 1997,
respectively. The rise in commercial net written premiums was offset by a
decrease in contract surety net written premiums as a result of the competitive
market conditions that exist in the contract surety market. Net written premiums
for contract surety decreased 7.7%, or $2.3 million, for the quarter and were
down slightly for the year ended December 31, 1997. The Company also
renegotiated its reinsurance agreements with its reinsurers increasing the
Company's net retention to $5 million per principal (e.g., the contractor on
contract surety bonds) on its commercial surety business. In the fourth quarter
of 1997, the Company received $3.8 million in previously ceded
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reinsurance premium from its reinsurers. Absent this returned premium, domestic
commercial surety net written premiums were up 8.6% for the quarter and 7.0% for
the year.
Underwriting Income
Underwriting income increased 67.8% to $15.1 million in the fourth quarter
of 1997 and increased 86.7% to $87.1 million for the year ended December 31,
1997 as compared to the similar periods in 1996. The period to period changes in
underwriting income and combined ratios were due to fluctuations in both the
loss and expense ratios as more fully described below.
Loss Ratio
The loss ratio for the fourth quarter 1997 was 18.5% compared to 18.8% for
the pro forma fourth quarter of 1996. The loss ratio included $0.6 million and
$4.9 million in favorable reserve development for the three months ended
December 31, 1997 and 1996, respectively.
The loss ratios for the years ended December 31, 1997 and 1996 were 2.3%
and 17.4%, respectively. Excluding the impact of the favorable reserve
development impact of $40.9 million and $16.6 million in 1997 and 1996,
respectively, the loss ratios would have been 19.1% and 24.4%, respectively.
Approximately $35.0 million in favorable reserve development in 1997 relates to
the Predecessor as more fully described in Note 8 to the Consolidated Financial
Statements. The decrease in the loss ratio is due to the ongoing favorable
economic trends that continue to benefit the surety business in addition to more
disciplined underwriting practices the Company has adopted since the acquisition
of CIC by CNAF in May of 1995.
Expense Ratio
The expense ratio decreased to 58.4% in the fourth quarter of 1997 compared
to 66.2% in the pro forma fourth quarter of 1996. The decline in the Company's
expense ratio for the quarter was largely due to the larger scale of the
combined organization as net earned premiums advanced 9.3% for the quarter while
total underwriting expenses decreased 3.6%. The $1.4 million decline in
underwriting expenses on a pro forma basis for the quarter is not necessarily
indicative of a trend management expects to continue near term.
The expense ratio for the year ended December 31, 1997 decreased to 61.9%
from 63.0% for 1996. This decline was also primarily due to the increased scale
of the Company as net earned premiums increased 2.1% and underwriting expenses
increased only 0.3%.
Investment Income
Net investment income was $5.8 million for the fourth quarter of 1997
compared to $2.9 million for the pro forma fourth quarter of 1996. Pro forma net
investment income for the years ended December 31, 1997 and 1996 was $14.5
million and $10.8 million, respectively. Increases in investment income for the
quarter and in pro forma investment income for the year ended December 31, 1997
are the direct result of higher actual invested cash balances in the fourth
quarter of 1997 which reflects the investment of merger-related cash flows.
However, pro forma investment income for periods prior to the Merger do not
include the pro forma effects of estimated net investment income resulting from
investment of merger-related cash flows as described below. The average pretax
yield was 5.7% for the three months ended December 31, 1997.
The above unaudited pro forma financial information does not include the
estimated net investment income resulting from investment of merger-related cash
flows, including (i) the $50 million debt proceeds, (ii) the $52.25 million
capital contribution from CCC, and (iii) collection of the receivable from CCC.
Investment earnings are an integral part of an insurance entity's operations. If
proceeds from these sources of funds were assumed to be invested in
high-quality, taxable fixed income securities with an average duration of
approximately 3 years, yielding 6.4%, net investment income would increase
approximately $11.3 million ($7.3 million net of tax, or $0.17 in pro forma
earnings per share) for the year ended December 31, 1997, and approximately $3.8
million ($2.5 million net of tax, or $0.06 in pro forma earnings per share) and
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approximately $14.2 million ($9.2 million net of tax, or $0.21 in pro forma
earnings per share) for the three months and year ended December 31, 1996,
respectively.
Net realized investment gains were $0.1 million in the fourth quarter of
1997 and pro forma net realized investment gains were $0.7 million and $1.1
million for the years ended December 31, 1997 and 1996, respectively. Net
realized investment gains on securities held at Capsure's parent company were
$0.8 million for the year ended December 31, 1996.
Analysis of Other Operations
Amortization expense was $1.4 million for the fourth quarter of 1997 and
1996 and $5.8 million for the years ended December 31, 1997 and 1996. Intangible
assets represent goodwill and identified intangibles arising from the
acquisition of Capsure and goodwill arising from the May 1995 acquisition of CIC
by CNAF that was allocated to the surety business of CIC. Intangible assets are
generally amortized over 30 years.
Interest expense for the fourth quarter of 1997 increased 1.3% compared to
pro forma fourth quarter 1996. While the average outstanding debt was down to
$117.3 million in the fourth quarter of 1997, the weighted average interest rate
was 5.9% compared to 5.6% in the fourth quarter of 1996. Pro forma interest
expense decreased 5.6%, or $0.4 million, for the year ended December 31, 1997
compared to the prior year. This decrease was primarily due to lower average
outstanding debt of $119.2 million in 1997 compared to $124.7 million in 1996.
The weighted average interest rate for the year ended December 31, 1997 was 5.8%
compared to 5.7% for the year ended December 31, 1996.
Capsure incurred $22.0 million, after applicable income taxes, or $0.51 per
share, in merger costs in 1997 compared to $5.7 million, after applicable income
taxes, or $0.13 per share in non-recurring charges and merger costs in 1996. In
the fourth quarter of 1996, Capsure incurred $1.1 million, after applicable
income taxes, or $0.03 per share, in non-recurring merger costs.
Income Taxes
Income tax expense was $6.7 million for the quarter ended December 31,
1997. The effective income tax rate for the three months ended December 31, 1997
was 37.7%. Income taxes were $42.9 million and $14.1 million and the effective
income tax rates were 55.5% and 38.6% for the years ended December 31, 1997 and
1996, respectively. The effective rate for the full year 1997 reflects the
effects of limitations placed on the Company's ability to utilize Capsure's
available NOLs to offset future taxable income.
LOOKBACK ADJUSTMENT
The reorganization agreement provides for a mechanism, referred to as the
"Lookback Adjustment", which may adjust the number of shares of CNA Surety
common stock owned by CNAF operating companies in the event that either or both
of Capsure's and the CCC Surety Operations' actual net written premiums for 1997
varied from certain targets. Application and interpretation of the provisions of
the Lookback Adjustment are presently under review, the ultimate outcome of
which is currently not known. Based on the facts currently available, the total
number of shares of CNA Surety common stock will either not change or be reduced
by approximately 2.5%. Such a change in total outstanding shares would have no
effect on net income; however, earnings per share for the period from September
30, 1997 (date of inception) through December 31, 1997 would have increased from
$0.25 to $0.26 and the ownership of the Company by CNAF operating companies
would be reduced from 61.75% to 60.79%.
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PREDECESSOR RESULTS OF OPERATIONS -- 1996 COMPARED TO 1995
PREMIUMS WRITTEN
Net written premiums for the years ended December 31, 1996 and 1995 of CCC
Surety Operations throughout the period and of CIC subsequent to May 10, 1995,
the date of acquisition, are shown in the table below (dollars in thousands):
1996 1995
-------- --------
Net written premiums:
Contract.................................................. $103,445 $ 88,566
Commercial................................................ 40,459 33,446
-------- --------
$143,904 $122,012
======== ========
Changes in net written premiums during this period were primarily due to
the acquisition of CIC in May of 1995 and, in 1996, also due to changes in the
reinsurance programs. CIC net written premiums have been included for
approximately seven and one-half months in the 1995 results and have been
included for the full year in the 1996 results. The more significant changes in
the reinsurance programs were that contract surety retentions increased from $3
million to $5 million per principal effective January 1, 1996. Similarly,
commercial bond retentions increased from $750,000 to $3 million effective
January 1, 1996. These changes in the reinsurance arrangements were made as a
result of the larger capital base of the combined operations, and allowed the
CCC Surety Operations to lower reinsurance costs and retain additional amounts
of surety premiums. The increase in retentions in 1996 accounted for
approximately 25% of the total 1996 increase in net written premiums.
Correspondingly, the increased retention by the CCC Surety Operations in part
contributed to the reduction of ceded loss reserves which decreased from $24.5
million at December 31, 1995 to $15.5 million at December 31, 1996. Although the
CCC Surety Operations' potential exposure increased as a result of the increased
retentions, CCC Surety Operations' management believed that, based upon the
favorable loss experience with respect to such business, the retention of
potentially profitable business offset such increased exposure.
Due to the significant effect of the CIC acquisition on the foregoing
balances and changes in the reinsurance programs, it is more meaningful to
review gross written premiums (premiums written before ceded premiums) during
the periods ended December 31, 1996 and 1995, for CCC and CIC, as if they had
been combined throughout this period (dollars in thousands):
PRO FORMA
--------------------------------------
1996 1995
----------------- -----------------
Gross written premiums:
Contract.......................................... $108,130 69.7% $113,255 69.1%
Commercial........................................ 47,078 30.3 50,588 30.9
-------- ----- -------- -----
$155,208 100.0% $163,843 100.0%
======== ===== ======== =====
Combined gross written premiums in 1996 declined from the combined 1995
level by $8.6 million. This decrease was attributable in part to the continued
program that commenced in 1995 to re-underwrite the CIC book of business on an
account-by-account basis and remove business with unsatisfactory profit
potential and risk. To a lesser extent, a portion of the decrease is believed to
be due to considerable management attention focused on effecting and completing
the integration of CIC and CCC. The decrease in gross written premiums in 1996
was 5.3%; this percentage decline was less than half of the 1995 percentage
decrease.
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OPERATING RESULTS
The following table is a summary of the pretax operating results of the CCC
Surety Operations and certain operating ratios for the years ended December 31,
1996 and 1995 (dollars in thousands). As described in Note 1 to the accompanying
financial statements, these pretax operating results do not include investment
income, realized capital gains and losses, and certain indirect or overhead type
expenses.
1996 1995
-------- --------
Net earned premiums.............................. $149,069 $130,603
Net losses and loss adjustment expenses.......... 33,006 32,440
Other direct costs and expenses(1)............... 81,615 71,591
-------- --------
Excess of net earned premiums over direct
operating expenses before income taxes(1)...... $ 34,448 $ 26,572
======== ========
Large losses..................................... $ 14,900 $ 13,900
======== ========
Loss ratio....................................... 22.1% 24.8%
Expense ratio(1)................................. 54.8 54.8
-------- --------
Combined ratio(1)................................ 76.9% 79.6%
======== ========
Effect of large losses on combined ratio......... 10.0% 10.6%
======== ========
- ---------------
(1) Does not include the effects of certain general and administrative expenses,
which are indirect or overhead in nature, since such costs were not
historically allocated to the CCC Surety Operations by CNAF or its
subsidiaries. Accordingly, the comparability of this data to other data that
include such costs is affected.
The year-over-year changes in the combined ratio was due to fluctuations in
the loss ratio as more fully discussed in the following paragraph.
LOSS RATIO
The loss ratio was 22.1% in 1996, compared to 24.8% in 1995. Prior to the
CIC acquisition, the average loss ratio was approximately 17% for the past ten
years and 19% for the past 15 years. This decrease in the loss ratio in 1996
compared to 1995 was attributable in part to the continued program that
commenced in 1995 to re-underwrite the CIC book of business on an
account-by-account basis and remove business with unsatisfactory profit
potential and risk in addition to more disciplined underwriting practices the
Company has adopted since the acquisition of CIC by CNAF in May of 1995. Also in
1996, large losses (individual claims which are in excess of $2.5 million, net
of reinsurance) were $14.9 million in aggregate compared to $13.9 million in
1995. These large losses had the effect of increasing loss ratios for 1996 and
1995 by 10.0% and 10.6%, respectively.
EXPENSE RATIO
The expense ratio was 54.8% in 1996, unchanged from 1995.
LIQUIDITY AND CAPITAL RESOURCES
It is anticipated that the liquidity requirements of CNA Surety will be met
primarily by funds generated from operations. The principal operating cash flow
sources are premiums, investment income, and sales and maturities of
investments. CNA Surety also may generate funds from additional borrowings under
the credit facility described below. The primary cash flow uses are payments for
claims, operating expenses, debt service on the credit facility, as well as
dividends, if any, 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.
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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 income tax sharing payments of its insurance
subsidiaries. At December 31, 1997, the carrying value of the Company's
insurance subsidiaries invested assets was comprised of $266.3 million of fixed
income securities, $140.2 million of short-term investments, $6.0 million of
other investments and $0.1 million of cash.
Cash flow at the parent company level is derived principally from dividend
and tax sharing payments from its insurance subsidiaries. The principal
obligations at the parent company level are to service debt and pay operating
expenses. At December 31, 1997, the parent company's invested assets consisted
of $7.0 million of short-term investments.
The Company's consolidated net cash flow provided by operating activities
was $29.0 million for the three months ended December 31, 1997. Consolidated
operating cash flow (pretax income excluding net investment gains and
amortization of intangibles assets) for the three months ended December 31, 1997
was $19.0 million.
The Company received $116.9 cash from CNAF on October 1, 1997. This payment
from CNAF reflects the effects of the reinsurance agreement whereby CCC and CIC
ceded all of their net unearned premiums and loss and loss adjustment expense
reserves for their surety business to Western Surety as of the Merger Date.
CNA Surety's bank borrowings are under a five-year unsecured revolving
credit facility (the "Credit Facility") that provides for borrowings of $130
million. CNA Surety borrowed $105 million as of September 30, 1997 and used the
proceeds to retire the existing Capsure debt of approximately $54 million and to
make a $50 million capital contribution to Western Surety. On October 6, 1997,
CNA Surety borrowed an additional $13 million to pay the $10.6 million closing
dividend to Capsure stockholders and other merger-related costs.
The interest rate on borrowings under the Credit Facility may be fixed, at
CNA Surety's option, for a period of one, two, three, or six months and is based
on, among other rates, the London Interbank Offered Rate ("LIBOR"), plus the
applicable margin. The margin, including the facility fee, varies based on CNA
Surety's leverage ratio (debt to total capitalization) and ranges from 0.25% to
0.40%. As of December 31, 1997, the weighted average interest rate was 6.17% on
the $118.0 million of outstanding borrowings.
The Credit Facility contains, among other conditions, limitations on CNA
Surety with respect to the incurrence of additional indebtedness and requires
the maintenance of certain financial ratios. As of December 31, 1997, the
Company was in compliance with all restrictions and covenants contained in the
Credit Facility agreement. The Credit Facility provides for the payment of all
outstanding principal balances after five years with no required principal
payments prior to such time. Principal prepayments, if any, and interest
payments are expected to be funded primarily through dividends from CNA Surety's
insurance subsidiaries.
As an insurance holding company, CNA Surety is dependent upon dividends and
other permitted payments from its insurance subsidiaries to pay cash dividends,
if any, as well as to pay operating expenses and meet debt service requirements.
The payment of dividends by the insurance subsidiaries are subject to varying
degrees of supervision by the insurance regulatory authorities in South Dakota
and Texas. In South Dakota, where Western Surety and SBCA are domiciled,
insurance companies may only pay dividends from earned surplus excluding surplus
arising from unrealized capital gains or revaluation of assets. In Texas, where
USA is domiciled, an insurance company may only declare or pay dividends to
stockholders from the insurer's earned surplus. The insurance subsidiaries may
pay dividends without obtaining prior regulatory approval only if such dividend
or distribution (together with dividends or distributions made within the
preceding 12-month period) is less than, as of the end of the immediately
preceding year, the greater of (i) 10% of the insurer's surplus to policyholders
and (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 and approved by the appropriate insurance
department prior to payment.
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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. Accordingly, dividend capacity for 1998 does
not fully reflect the effects of the Merger. Dividend capacity for 1998 is based
on statutory surplus and income at and for the year ended December 31, 1997
which will only include the results of the CCC Surety Operations for the period
from September 30, 1997 (date of inception) through December 31, 1997. Dividend
capacity for 1999 will be based on statutory surplus and income at and for the
year ended December 31, 1998 which will include the effects of the CCC Surety
Operations for all of 1998. Without prior regulatory approval in 1998, CNA
Surety's insurance subsidiaries may pay stockholder dividends of $16.3 million
in the aggregate. In the fourth quarter of 1997, CNA Surety received $5.0
million in dividends from its insurance subsidiaries.
In accordance with the provisions of intercompany tax sharing agreements
between CNA Surety and its subsidiaries, the tax of each subsidiary shall be
determined based upon each subsidiary's separate return liability, as calculated
in accordance with the Internal Revenue Code of 1986, as amended (the "Code").
Intercompany tax payments are made at such times as estimated tax payments would
be required by the Internal Revenue Service ("IRS"). CNA Surety received tax
sharing payments from its subsidiaries of $2.4 million in the period from
September 30, 1997 through December 31, 1997.
CNA Surety management believes that it will have sufficient available
resources to meet its present capital needs.
FINANCIAL CONDITION
INVESTMENT PORTFOLIO
The Company's policy is to primarily invest in fixed income securities with
high quality credit ratings. As of December 31, 1997, approximately 47% of the
investment portfolio was held in high-quality, short-duration mortgage
pass-through instruments, collateralized mortgage obligations ("CMOs") and other
asset-backed securities. CMOs differ from traditional fixed income securities in
that they may expose the investor to yield variability and even principal risk
due to such factors as high mortgage prepayment rates and defaults and
delinquencies in the underlying asset pool. Management believes it has reduced
prepayment variability by investing only in short tranches and by owning a
substantial amount of planned amortization class ("PAC") tranches which have
been structured largely to insulate the investor from prepayment risk. A PAC
tranche is structured to amortize in a predictable manner and, therefore, the
risk of prepayment of the underlying collateral is shifted to other tranches,
whose owners are willing to accept such risk. Further, management believes it
has minimized credit risk primarily by generally purchasing securities rated A
or better on the date of acquisition and which are collateralized or guaranteed
by U.S. Government agencies or have substantial credit enhancement in the form
of financial guarantees, mortgage insurance, letters of credit, over-
collateralization, subordinated structures and excess servicing spreads.
Management monitors the investment portfolio of the insurance subsidiaries and
the current rating of each security owned on a monthly basis.
The following table sets forth the ratings assigned by The Standard & Poors
Corporation ("S&P") or Moody's Investor Services, Inc. ("Moody's") of the fixed
income securities portfolio of the Company as of December 31, 1997 (dollars in
thousands):
CREDIT RATING FAIR VALUE PERCENT
------------- ---------- -------
AAA/Aaa..................................................... $232,133 87.2%
AA/Aa....................................................... 629 0.2
A/A......................................................... 26,757 10.1
BBB......................................................... 6,782 2.5
-------- -----
Total..................................................... $266,301 100.0%
======== =====
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As of December 31, 1997, 100% of the Company's fixed income securities were
considered investment grade by The Standard & Poors Corporation or Moody's
Investor Services, Inc., and 87% were rated at least AA by those agencies. In
addition, the Company's investments in fixed income securities did not contain
any significant geographic or industry concentration of credit risk.
RESERVES FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
CNA Surety's insurance subsidiaries employs accepted reserving approaches
in establishing the estimated liability for unpaid loss and loss adjustment
expenses that give consideration to the inherent difficulty and variability in
the estimation process. In addition, CNA Surety utilizes independent actuarial
firms of national standing to conduct periodic reviews of claim procedures and
loss reserving practices, and annually obtains actuarial certification as to the
reasonableness of actuarial assumptions used and the sufficiency of year-end
reserves for each of its principal insurance subsidiaries.
The estimated liability for unpaid losses and loss adjustment expenses
includes, on an undiscounted basis, estimates of (a) the ultimate settlement
value of reported claims, (b) incurred but not reported ("IBNR") claims, (c)
future expenses to be incurred in the settlement of claims and (d) claim
recoveries, exclusive of reinsurance recoveries which are reported as an asset.
These estimates are determined based on the Company's and surety industry loss
experience as well as consideration of current trends and conditions. The
estimated liability for unpaid losses and loss adjustment expenses is an
estimate and there is the potential that actual future loss payments will differ
significantly from initial estimates. The methods of determining such estimates
and the resulting estimated liability are regularly reviewed and updated.
Changes in the estimated liability are reflected in operating income in the year
in which such changes are determined to be needed.
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The following table presents selected loss and loss adjustment expense
information and highlights the impact of revisions to the estimated liability
established in prior years (dollars in thousands):
SEPTEMBER 30,
DATE OF PREDECESSOR
INCEPTION NINE(1) YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, ---------------------
1997 1997 1996 1995
------------- ------------- --------- ---------
Reserves at beginning of period:
Gross...................................... $ 122,281 $ 119,151 $ 138,657 $ 48,818
Ceded reinsurance.......................... 7,273 15,467 24,531 13,770
--------- --------- --------- ---------
Net reserves at beginning of period...... 115,008 103,684 114,126 35,048
Net reserves of CIC at May 10, 1995, date
of acquisition........................... -- -- -- 64,780
--------- --------- --------- ---------
Total net reserves.................... 115,008 103,684 114,126 99,828
--------- --------- --------- ---------
Net incurred loss and loss adjustment
expenses:
Provision for insured events of current
period................................ 12,781 23,484 42,748 43,286
Decrease in provision for insured events
of prior periods...................... (647) (35,000) (9,742) (10,846)
--------- --------- --------- ---------
Total net incurred.................... 12,134 (11,516) 33,006 32,440
--------- --------- --------- ---------
Net payments attributable to:
Current period events.................... 4,256 4,307 7,728 1,648
Prior periods events..................... 161 3,780 35,720 16,494
--------- --------- --------- ---------
Total net payments.................... 4,417 8,087 43,448 18,142
--------- --------- --------- ---------
Net reserves of Capsure at September 30,
1997, date of Merger..................... -- 30,927 -- --
Net reserves at end of period.............. 122,725 115,008 103,684 114,126
Ceded reinsurance at end of period......... 7,656 7,273 15,467 24,531
--------- --------- --------- ---------
Gross reserves at end of period....... $ 130,381 $ 122,281 $ 119,151 $ 138,657
========= ========= ========= =========
- ---------------
(1) Amounts are for Predecessor except for the net reserves of Capsure and both
ceded reinsurance and gross reserves at the end of the period which are for
CNA Surety.
Based on the CCC Surety Operations' study of reserves, the CCC Surety
Operations' management determined that it had been overly cautious in
interpreting claim data and had discounted favorable trends. Consistent with the
CCC Surety Operations' regular study of reserve levels, the CCC Surety
Operations released $35.0 million of prior year reserves in 1997. Approximately
$33 million of this reserve development related to CIC and principally to
accident years prior to 1996.
RISKED BASED CAPITAL ("RBC") AND OTHER REGULATORY RATIOS
The National Association of Insurance Commissioners ("NAIC") has
promulgated RBC requirements for property and casualty insurance companies to
evaluate the adequacy of statutory capital and surplus in relation to investment
and insurance risks such as asset quality, loss reserve adequacy, and other
business factors. The RBC information is used by state insurance regulators as
an early warning mechanism to identify insurance companies that potentially are
inadequately capitalized. In addition, the formula defines new minimum capital
standards that supplement the current system of fixed minimum capital and
surplus
28
29
requirements on a state-by-state basis. Regulatory compliance is determined by a
ratio (the "Ratio") of the enterprise's regulatory total adjusted capital, as
defined by the NAIC, to its authorized control level RBC, as defined by the
NAIC. Generally, a Ratio in excess of 200% of authorized control level RBC
requires no corrective actions on behalf of the company or regulators. As of
December 31, 1997, each of CNA Surety's insurance subsidiaries had a Ratio that
was in excess of the minimum RBC requirements.
CNA Surety's insurance subsidiaries require capital to support premium
writings. In accordance with industry and regulatory guidelines, the net written
premiums to surplus ratio of a property and casualty insurer should not exceed 3
to 1 (the terms of the Credit Facility also limit this ratio to 3 to 1 for
Western Surety and USA). On December 31, 1997, the Company had a combined
statutory surplus of $142.4 million. Western Surety's statutory surplus was
$128.7 million and its net written premiums to surplus ratio was 1.8 to 1. USA's
statutory surplus was $13.7 million and its net written premiums to surplus
ratio was 1.6 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 eleven key financial
ratios that address various aspects of each insurer's financial condition and
stability. In 1997, USA's IRIS ratios fell within all of the "usual ranges." Due
to the Merger and related reinsurance transactions that occurred on September
30, 1997, Western Surety's net writings, surplus and agents balances increased
significantly causing the applicable IRIS ratios to be outside the "usual
ranges." All of the remaining IRIS ratios for Western Surety were normal.
IMPACT OF YEAR 2000 ON THE COMPANY
The widespread use of computer programs, both in the United States and
internationally, that rely on two digit fields to perform computations and
decision making functions may cause computer systems to malfunction when
processing information involving dates after 1999. Such malfunction could lead
to business delays and disruptions. The Company is in the process of replacing
or upgrading its systems to accommodate business for the year 2000, and
anticipates that by December 31, 1998 it will have substantially completed its
program of replacements and the necessary upgrades to accommodate year 2000
processing of its business. However, due to the interdependent nature of
computer systems, the Company may be adversely impacted depending upon whether
it or other entities not affiliated with the Company (vendors and business
partners) address this issue successfully. The cost of achieving year 2000
compliance is estimated to be less than $1.0 million in excess of the cost of
normal software upgrades and replacements and will primarily be incurred in
1998.
Although the Company has not received any claims for coverage from its
customers based on losses resulting from year 2000 issues, there can be no
assurance that customers will not suffer losses of this type and seek
compensation under the Company's bonds or policies. If any claims are made,
coverage, if any will depend on the facts and circumstances of the claim and the
provisions of the bond or policy. At this time, the Company is unable to
determine whether the adverse impact, if any, in connection with the foregoing
circumstances would be material to the Company.
IMPACT OF ADOPTING STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS ("SFAS")
In February 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, "Earnings Per Share." SFAS No. 128 is effective for both interim
and annual periods ending after December 15, 1997. SFAS No. 128 replaces
Accounting Principles Board ("APB") Opinion No. 15, "Earnings Per Share." APB
Opinion No. 15 required that entities with simple capital structures present a
single earnings per common share ("EPS") on the face of the income statement,
whereas those with complex capital structures had to present both primary and
fully diluted EPS. SFAS No. 128 simplifies the computation of EPS by replacing
the presentation of primary EPS with a presentation of basic EPS and requires
dual presentation of basic and diluted EPS by entities with complex capital
structures. Basic EPS
29
30
includes no dilution and is computed by dividing income available to common
stockholders by the weighted average number of common shares outstanding for the
period, whereas primary EPS includes the dilutive effect of common stock
equivalents, such as stock options. Diluted EPS reflects the potential dilution
of securities that could share in the earnings of an entity, similar to fully
diluted EPS. The Company has adopted SFAS No. 128 in the accompanying
Consolidated Financial Statements.
In February 1997, the FASB issued SFAS No. 129, "Disclosure of Information
about Capital Structure," which establishes standards for disclosing information
about an entity's capital structure. The Statement consolidates existing
disclosure requirements for ease of retrieval and greater visibility to
nonpublic entities. The new Statement contains no change in disclosure
requirements for companies previously subject to the requirements of APB No. 10,
"Omnibus Opinion -- 1966," APB Opinion No. 15, "Earnings per Share," and FASB
Statement No. 47 "Disclosure of Long-Term Obligations," and as such the adoption
of SFAS No. 129 did not have any effect on the Company's financial reporting.
IMPACT OF ACCOUNTING PRONOUNCEMENTS NOT YET ADOPTED
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income," which establishes accounting standards for reporting and display of
comprehensive income and its components (revenues, expenses, gains, and losses)
in a full set of general-purpose financial statements. This Statement requires
that an enterprise (a) classify items of other comprehensive income by their
nature in a financial statement and (b) display the accumulated balance of other
comprehensive income separately from retained earnings and additional paid-in
capital in the equity section of a statement of financial position. This
Statement is effective for fiscal years beginning after December 15, 1997. This
Statement is not expected to result in a significant change in CNA Surety's
disclosures.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information," which establishes accounting standards
about the way public enterprises report information about operating segments in
its annual financial statements and requires that those enterprises report
selected information about operating segments in interim financial reports
issued to shareholders. It also establishes standards for related disclosures
about products and services, geographic areas and major customers. SFAS No. 131
replaces SFAS No. 14, "Financial Reporting for Segments of a Business
Enterprise." This statement is effective for fiscal years beginning after
December 15, 1997. This statement is not expected to have a significant impact
on CNA Surety's disclosures.
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits," which revises employers'
disclosures about pensions and other postretirement benefit plans. SFAS No. 132
does not change the measurement or recognition requirements of those plans under
the previous accounting standards. The new standardized disclosures require
additional information on changes in the benefit obligations and fair value of
plan assets as well as eliminate certain disclosures from prior accounting
standards that are no longer as useful. This statement is applicable for fiscal
years beginning after December 15, 1997. Restatement of disclosures of prior
periods for comparative purposes is required. This Statement is not expected to
result in a significant change in CNA Surety's disclosures.
In December 1997, the American Institute of Certified Public Accountants'
Accounting Executives Standards Committee issued Statement of Position ("SOP")
97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related
Assessments," which provides guidance on accounting by all entities that are
subject to insurance-related assessments. It requires that entities should
recognize liabilities for insurance-related assessments when all of the
following criteria have been met: an assessment has been imposed or a probable
assessment will be imposed; the event obligating an entity to pay an imposed or
probable assessment has occurred on or before the date of the financial
statements; and the amount of the assessment can be reasonably estimated. This
SOP is effective for financial statements for fiscal years beginning after
December 15, 1998. The Company does not expect the adoption of this SOP to have
a material effect on the Company's results of operations.
30
31
------------------------------------
"SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995: The statements which are not historical facts contained in this Form 10-K
are forward-looking statements that involve risks and uncertainties, including,
but not limited to, product and policy demand and market response risks, the
effect of economic conditions, the impact of competitive products, policies and
pricing, product and policy development, regulatory changes and conditions,
rating agency policies and practices, development of claims and the effect on
loss reserves, the performance of reinsurance companies under reinsurance
contracts with the Company, investment portfolio developments and reaction to
market conditions, the results of financing efforts, the actual closing of
contemplated transactions and agreements, the effect of the Company's accounting
policies, and other risks detailed in the Company's Securities and Exchange
Commission filings. No assurance can be given that the actual results of
operations and financial condition will conform to the forward-looking
statements contained herein.
31
32
ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCUSSIONS ABOUT MARKET RISK
Not Applicable.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
PAGE
----
FINANCIAL:
Independent Auditors' Report................................ 34
Consolidated Balance Sheet as of December 31, 1997 and
Statement of Certain Assets and Liabilities as of December
31, 1996.................................................. 35
Consolidated Statement of Income for the Period from
September 30, 1997 (date of inception) through December
31, 1997 and Statements of Certain Revenues and Direct
Operating Expenses for the Nine Months Ended September 30,
1997 and Years Ended December 31, 1996 and 1995........... 36
Consolidated Statement of Changes in Stockholders' Equity
for the Period from September 30, 1997 (date of inception)
through December 31, 1997................................. 37
Consolidated Statement of Cash Flows for the Period from
September 30, 1997 (date of inception) through December
31, 1997.................................................. 38
Notes to Consolidated Financial Statements.................. 39
FINANCIAL STATEMENT SCHEDULES:
Schedule I -- Summary of Investments........................ 57
Schedule II -- Condensed Financial Information of
Registrant................................................ 58
Schedule III -- Supplementary Insurance Information......... 61
Schedule IV -- Reinsurance.................................. 62
Schedule V -- Valuation and Qualifying Accounts............. 63
Schedule VI -- Supplemental Information Concerning Property
-- Casualty Insurance Operations.......................... 64
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEMS 10, 11, 12, AND 13. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT,
EXECUTIVE COMPENSATION, SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT, AND CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS
The Company will file a definitive proxy statement with the Securities and
Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act
of 1934 (the "Proxy Statement") relating to the Company's Annual Meeting of
Stockholders to be held on May 19, 1998, not later than 120 days after the end
of the fiscal year covered by this Annual Report on Form 10-K. Information
required by Items 10 through 13 will appear in the Proxy Statement and is
incorporated herein by reference.
32
33
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
PAGE
----
(a)(1) Financial:
Independent Auditors' Report.............................. 34
Consolidated Balance Sheet as of December 31, 1997 and
Statement of Certain Assets and Liabilities as of
December 31, 1996...................................... 35
Consolidated Statement of Income for the Period from
September 30, 1997 (date of inception) through December
31, 1997 and Statements of Certain Revenues and Direct
Operating Expenses for the Nine Months Ended September
30, 1997 and Years Ended December 31, 1996 and 1995.... 36
Consolidated Statement of Changes in Stockholders' Equity
for the Period from September 30, 1997 (date of
inception) through December 31, 1997................... 37
Consolidated Statement of Cash Flows for the Period from
September 30, 1997 (date of inception) through December
31, 1997............................................... 38
Notes to Consolidated Financial Statements................ 39
(a)(2) Financial Statement Schedules:
Schedule I -- Summary of Investments...................... 57
Schedule II -- Condensed Financial Information of
Registrant............................................. 58
Schedule III -- Supplementary Insurance Information....... 61
Schedule IV -- Reinsurance................................ 62
Schedule V -- Valuation and Qualifying Accounts........... 63
Schedule VI -- Supplemental Information Concerning
Property -- Casualty Insurance Operations.............. 64
(a)(3) Exhibits............................................. 65
(b) Reports on Form 8-K:
November 14, 1997: CNA Surety reports strong underwriting results for the
third quarter and nine months ended September 30, 1997.
33
34
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders of
CNA SURETY CORPORATION
We have audited the consolidated balance sheet of CNA Surety Corporation
and subsidiaries as of December 31, 1997, and the related consolidated
statements of income, stockholders' equity, and cash flows from September 30,
1997 (date of inception) through December 31, 1997. We have also audited the
accompanying special-purpose statement of certain assets and liabilities of CCC
Surety Operations, a business unit of CNA Financial Corporation, as of December
31, 1996 and the special-purpose statements of certain revenues and direct
operating expenses for each of the two years in the period ended December 31,
1996 and for the nine month period ended September 30, 1997. Our audit also
included the financial statement schedules listed in the Index at Item 14. These
financial statements and financial statement schedules are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
The accompanying special-purpose financial statements were prepared to
present certain assets and liabilities and certain revenues and direct operating
expenses of CCC Surety Operations and are not intended to be a complete
presentation of CCC Surety Operations. Note 1 to the consolidated financial
statements describes the basis of presentation of these special-purpose
financial statements.
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, 1997, and the results of their operations and
their cash flows from September 30, 1997 (date of inception) through December
31, 1997, in conformity with generally accepted accounting principles.
Furthermore, in our opinion, such special-purpose financial statements present
fairly, in all material respects, certain assets and liabilities of CCC Surety
Operations as of December 31, 1996, and certain revenues and direct operating
expenses for each of the two years in the period ended December 31, 1996 and for
the nine month period ended September 30, 1997, in conformity with generally
accepted accounting principles. 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.
Deloitte & Touche LLP
Chicago, Illinois
February 27, 1998
34
35
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET AND STATEMENT
OF CERTAIN ASSETS AND LIABILITIES OF PREDECESSOR
(AMOUNTS IN THOUSANDS)
DECEMBER 31,
-----------------------
PREDECESSOR
1997 1996
-------- -----------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost:
$265,545).............................................. $266,301 $ --
Short-term investments, at cost (approximates fair
value)................................................. 147,235 --
Other investments, at fair value.......................... 6,001 --
Cash...................................................... 130 --
-------- --------
419,667 --
Deferred policy acquisition costs........................... 64,144 37,689
Receivable from affiliates.................................. -- 131,478
Insurance receivables:
Premiums.................................................. 9,683 30,379
Reinsurance, including $47,856 from affiliates in 1997
(See Note 14).......................................... 55,151 20,069
Intangible assets, net of accumulated amortization of $1,447
and $619 at December 31, 1997 and 1996, respectively...... 161,962 6,897
Prepaid reinsurance premiums................................ 4,150 6,312
Other assets................................................ 12,423 --
-------- --------
Total assets........................................... $727,180 $232,824
======== ========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses................ $130,381 $119,151
Unearned premiums......................................... 173,836 95,677
-------- --------
304,217 214,828
Long-term debt.............................................. 118,000 --
Deferred income taxes, net.................................. -- 4,540
Payable for securities purchased............................ 10,609 --
Other liabilities........................................... 37,622 13,456
-------- --------
Total liabilities...................................... 470,448 232,824
-------- --------
Commitments and contingencies (See Note 9)
STOCKHOLDERS' EQUITY
Preferred stock, par value $.01 per share, 20,000 shares
authorized; none issued and outstanding................... -- --
Common stock, par value $.01 per share, 100,000 shares
authorized; none issued at December 31, 1996 and 43,320
shares issued and outstanding at December 31, 1997........ 433 --
Additional paid-in capital.................................. 244,829 --
Retained earnings........................................... 10,996 --
Unrealized gain on securities, net of deferred income
taxes..................................................... 474 --
-------- --------
Total stockholders' equity............................. 256,732 --
-------- --------
Total liabilities and stockholders' equity............. $727,180 $232,824
======== ========
The accompanying notes are an integral part of these financial statements.
35
36
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME AND STATEMENTS OF
CERTAIN REVENUES AND DIRECT OPERATING EXPENSES OF PREDECESSOR
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
SEPTEMBER 30, PREDECESSOR
DATE OF -------------------------------------
INCEPTION, NINE YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, --------------------
1997 1997 1996 1995
------------- ------------- -------- --------
Revenues:
Net earned premiums.................... $65,433 $108,564 $149,069 $130,603
Net investment income.................. 5,766 -- -- --
Net realized investment gains.......... 85 -- -- --
------- -------- -------- --------
71,284 108,564 149,069 130,603
------- -------- -------- --------
Expenses:
Net losses and loss adjustment
expenses............................ 12,134 (11,516) 33,006 32,440
Net commissions, brokerage and other
underwriting........................... 38,213 59,674 81,615 71,591
Interest expense....................... 1,831 -- -- --
Amortization of intangible assets...... 1,447 -- -- --
------- -------- -------- --------
53,625 48,158 114,621 104,031
------- -------- -------- --------
Income before income taxes (Excess of net
earned premiums over direct operating
expenses, before income taxes for
Predecessor)........................... 17,659 60,406 34,448 26,572
Income taxes............................. 6,663 21,241 12,188 9,385
------- -------- -------- --------
Net income (Excess of net earned premiums
over direct operating expenses, net of
income taxes for Predecessor).......... $10,996 $ 39,165 $ 22,260 $ 17,187
======= ======== ======== ========
Earnings per share....................... $ 0.25
=======
Earnings per share, assuming dilution.... $ 0.25
=======
Weighted average shares outstanding...... 43,302
=======
Weighted average shares outstanding,
assuming dilution...................... 43,552
=======
The accompanying notes are an integral part of these financial statements.
36
37
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA)
SEPTEMBER 30,
DATE OF
INCEPTION,
THROUGH
DECEMBER 31,
1997
-------------
Common Stock:
Beginning Balance......................................... $ --
Common stock issued for Capsure acquisition and as part of
the Merger............................................. 433
--------
Balance, December 31...................................... $ 433
========
Additional Paid-In Capital:
Beginning Balance......................................... $ --
Increase due to Capsure acquisition (See Note 2).......... 181,629
Capital contribution and the effects of reinsurance
agreements (See Note 2)................................ 62,859
Other..................................................... 341
--------
Balance, December 31...................................... $244,829
========
Retained Earnings:
Beginning Balance......................................... $ --
Net income................................................ 10,996
--------
Balance, December 31...................................... $ 10,996
========
Change in Net Unrealized Gain/(Loss) on Securities,
Net of Deferred Income Taxes:
Beginning Balance...................................... $ --
Change from September 30, 1997 (date of inception)
through December 31, 1997............................. 474
--------
Balance, December 31...................................... $ 474
========
COMMON STOCK
----------------------
ISSUED IN TREASURY
------- -----------
Shares:
Beginning Balance......................................... -- --
Increase due to common stock issued for Capsure
acquisition
and as part of the Merger.............................. 43,294 --
Issued through exercise of stock options.................. 26 --
------- -------
Balance, December 31, 1997................................ 43,320 --
======= =======
The accompanying notes are an integral part of these financial statements.
37
38
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
SEPTEMBER 30,
DATE OF
INCEPTION,
THROUGH
DECEMBER 31,
1997
-------------
OPERATING ACTIVITIES:
Net income................................................ $ 10,996
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization.......................... 1,915
Accretion of bond discount, net........................ 172
Net realized investment gains.......................... (85)
Changes in:
Reinsurance receivables................................ (12,930)
Reserve for unearned premiums.......................... 9,233
Reserve for unpaid losses and loss adjustment
expenses.............................................. 8,100
Deferred income taxes, net............................. 4,038
Other assets and liabilities........................... 7,559
---------
Net cash provided by operating activities................... 28,998
---------
INVESTING ACTIVITIES:
Securities available-for-sale:
Purchases -- fixed income securities................... (149,580)
Maturities -- fixed income securities.................. 8,654
Sales -- fixed income securities....................... 5,146
Change in short-term investments.......................... (117,919)
Other, net................................................ (586)
---------
Net cash used in investing activities....................... (254,285)
---------
FINANCING ACTIVITIES:
Proceeds from long-term debt.............................. 118,000
Collection of receivable from affiliates, net............. 116,939
Principal payments on long-term debt...................... (54,000)
Capital contribution from CCC............................. 52,250
Closing dividend to Capsure stockholders.................. (10,591)
Other..................................................... 126
---------
Net cash provided by financing activities................... 222,724
---------
Increase (decrease) in cash................................. (2,563)
Cash at beginning of period................................. 2,693
---------
Cash at end of period....................................... $ 130
=========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest............................................... $ 1,704
Income taxes........................................... $ --
Non-cash investing activities:
Common stock and options issued in connection with
Capsure acquisition................................... $ 182,062
The accompanying notes are an integral part of these financial statements.
38
39
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")
and Universal Surety of America ("USA"), which are owned by a newly-formed
holding company, CNA Surety Corporation ("CNA Surety" or the "Company"). CNAF,
through its operating subsidiaries, writes multiple lines of property and
casualty insurance, including surety business that is reinsured by Western
Surety. Loews Corporation owns approximately 84% of the outstanding common stock
of CNAF. The principal operating subsidiaries of CNAF that wrote the surety line
of business for their own account prior to the Merger were Continental Casualty
Company and its property and casualty affiliates (collectively, "CCC") and The
Continental Insurance Company and its property and casualty affiliates
(collectively, "CIC"). CIC was acquired by CNAF on May 10, 1995. The combined
surety operations of CCC and CIC are referred to herein as CCC Surety Operations
("Predecessor").
Pursuant to a reorganization agreement, CCC Surety Operations and Capsure
merged their respective operations at the close of business on September 30,
1997 ("Merger Date"). CNAF, through its property and casualty subsidiaries, CCC
and CIC contributed $52.25 million of capital to CNA Surety. Through reinsurance
agreements, CCC and CIC ceded to Western Surety all of their net unearned
premiums and loss and loss adjustment expense reserves, as of the Merger Date,
and will cede to Western Surety all surety business written or renewed by CCC
and CIC for a period of five years thereafter. Further, CCC and CIC have agreed
to assume the obligation for any adverse development on recorded reserves for
CCC Surety Operations as of the Merger Date, to limit the loss ratio on certain
defined business written by CNA Surety through December 31, 2000 and to provide
certain additional excess of loss reinsurance. CCC also agreed to provide
certain administrative services at specified rates, subject to inflationary
increases, for three years after the Merger, if CNA Surety chooses to purchase
such services.
Immediately after the Merger, CCC and CIC owned, on a diluted basis, 61.75%
of CNA Surety's common stock and the stockholders and option holders of Capsure
owned 38.25% of CNA Surety's common stock on a diluted basis. The reorganization
agreement provides for a mechanism, referred to as the "Lookback Adjustment",
which could adjust the number of shares of CNA Surety common stock owned by CCC
in the event that either or both of Capsure's and the CCC Surety Operations'
actual net written premiums for 1997 vary from certain targets. See Note 16 for
a discussion of the Lookback Adjustment.
Principles of Consolidation
The consolidated financial statements include the accounts of CNA Surety
Corporation and all majority-owned subsidiaries. The consolidated financial
statements include the actual combined consolidated operating results of CCC
Surety Operations and Capsure since the Merger Date.
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 37,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety and
USA. Western Surety writes, on a direct basis or as business assumed from CCC
and CIC, small fidelity and noncontract surety bonds, referred to as commercial
bonds; small, medium and large contract bonds; international surety and credit
insurance; and errors and omissions ("E&O") liability insurance, as a licensed
insurer in all 50 states and the District of Columbia. Western Surety's
affiliated company, Surety Bonding Company of America ("SBCA"), writes
principally small commercial surety business and is licensed in 22 states. USA
specializes in the underwriting of small contract and commercial surety bonds.
USA is licensed in 41 states and the District of Columbia with most of its
business generated in Texas.
39
40
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Predecessor Financial Information
The accompanying Statement of Certain Assets and Liabilities as of December
31, 1996 reflects assets and liabilities identified as being attributable to the
business of CCC Surety Operations, the Predecessor. Because CNAF did not
customarily allocate the investment portfolio or capital of its operating
subsidiaries to its business units like CCC Surety Operations, the Statement of
Certain Assets and Liabilities does not include investments or capital. The
receivable from affiliates is calculated at an amount necessary to balance all
other identified assets with the total of all identified liabilities.
The accompanying Statements of Certain Revenues and Direct Operating
Expenses for the years ended December 31, 1996 and 1995, reflect premiums
earned, losses incurred, loss adjustment expenses (allocated and unallocated)
and other direct operating expenses of CCC Surety Operations. Such operating
revenues and costs as investment income, realized gains and losses on
investments and certain general and administrative expenses, which are indirect
or overhead in nature, are not reflected in operating results since such items
were not historically allocated to CCC Surety Operations by CNAF or its
subsidiaries.
Since the accompanying Predecessor financial statements exclude certain
assets, liabilities, revenues, and expenses, as described in the preceding two
paragraphs, these financial statements are not intended to be a complete
presentation of CCC Surety Operations. Those assets, liabilities, revenues and
costs that are reflected in the accompanying financial statements have been
determined in accordance with generally accepted accounting principles.
Investments
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 is included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective yield method based on estimated cash flows.
Investment gains or losses realized on the sale of securities are determined
using the specific identification method. Investments with an other than
temporary decline in value are written down to fair value, resulting in losses
that are included in investment gains and losses.
Short-term investments are carried at amortized cost which approximates
fair value.
Deferred Policy Acquisition Costs
Policy acquisition costs, consisting of commissions and other underwriting
expenses which vary with, and are directly related to, the production of
business, net of reinsurance commission income, are deferred and amortized as a
charge to income as the related premiums are earned.
40
41
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Intangible Assets
The Merger of CCC Surety Operations and Capsure has been accounted for by
CNA Surety as an acquisition of Capsure, using purchase accounting. Intangible
assets represent goodwill and identified intangibles arising from the
acquisition of Capsure and goodwill arising from the May 1995 acquisition of CIC
by CNAF that was allocated to the surety business of CIC. Intangible assets are
amortized on a straight line basis generally over 30 years.
Management assesses the recoverability of intangible assets based upon
estimates of undiscounted future operating cash flows whenever significant
events or changes in circumstances suggest that the carrying amount of an asset
may not be recoverable.
Reserves for Unpaid Losses and Loss Adjustment Expenses
The estimated liability for unpaid losses and loss adjustment expenses
includes, on an undiscounted basis, estimates of (a) the ultimate settlement
value of reported claims, (b) incurred but not reported ("IBNR") claims, (c)
future expenses to be incurred in the settlement of claims and (d) claim
recoveries, exclusive of reinsurance recoveries which are reported as an asset.
These estimates are determined based on the Company's and surety industry loss
experience as well as consideration of current trends and conditions. The
estimated liability for unpaid losses and loss adjustment expenses is an
estimate and there is the potential that actual future loss payments will differ
significantly from initial estimates. The methods of determining such estimates
and the resulting estimated liability are regularly reviewed and updated.
Changes in the estimated liability are reflected in operating income in the year
in which such changes are determined to be needed.
Insurance Premiums
Insurance premiums are recognized as revenue ratably over the terms of the
related policies. Unearned premiums represent the portion of premiums written,
before ceded reinsurance, applicable to the unexpired terms of policies in force
calculated on a daily pro rata basis. Premium revenues are net of amounts ceded
to reinsurers.
Reinsurance
The Company assumes and cedes insurance with other insurers and reinsurers.
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 receivable
rather than netted against the estimated liability for unpaid losses and loss
adjustment expenses. Losses and loss adjustment expenses incurred are net of
estimated recoveries under reinsurance contracts.
Stock-Based Compensation
As allowed under Statement of Financial Accounting Standards ("SFAS") No.
123, "Accounting for Stock-Based Compensation," the Company accounts for its
stock option plans in accordance with Accounting Principles Board ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees." The Company has not
issued stock options where the exercise price is less than the fair market value
of the Company's common stock on the date of grant and, accordingly, no
compensation expense has been recognized.
41
42
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Income Taxes
Deferred income taxes are established for the future tax effects of
temporary differences between the tax and financial reporting bases of assets
and liabilities using currently enacted tax rates. Such temporary differences
primarily relate to net operating tax loss carryforwards ("NOLs"), deferred
policy acquisition costs and intangible assets. The effect on deferred taxes of
a change in tax rates is recognized in income in the period of enactment. In
addition, deferred tax assets are valued based upon the expectation of future
realization on a "more likely than not" basis.
Earnings Per Share
Earnings per common share is computed based on the weighted average number
of shares outstanding during the period. Diluted earnings per common share is
computed based on the weighted average number of shares outstanding plus the
dilutive effect of common stock equivalents which is computed using the treasury
stock method.
Accounting Changes
In February 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, "Earnings Per Share." SFAS No. 128 is effective for both interim
and annual periods ending after December 15, 1997. SFAS No. 128 replaces APB
Opinion No. 15, "Earnings Per Share." APB Opinion No. 15 required that entities
with simple capital structures present a single earnings per common share
("EPS") on the face of the income statement, whereas those with complex capital
structures had to present both primary and fully diluted EPS. SFAS No. 128
simplifies the computation of EPS by replacing the presentation of primary EPS
with a presentation of basic EPS and requires dual presentation of basic and
diluted EPS by entities with complex capital structures. Basic EPS includes no
dilution and is computed by dividing income available to common stockholders by
the weighted average number of common shares outstanding for the period, whereas
primary EPS includes the dilutive effect of common stock equivalents, such as
stock options. Diluted EPS reflects the potential dilution of securities that
could share in the earnings of an entity, similar to fully diluted EPS. The
Company has adopted SFAS No. 128 in the accompanying consolidated financial
statements issued for periods ending after December 15, 1997.
In February 1997, the FASB issued SFAS No. 129, "Disclosure of Information
about Capital Structure," which establishes standards for disclosing information
about an entity's capital structure. The Statement consolidates existing
disclosure requirements for ease of retrieval and greater visibility to
nonpublic entities. The new Statement contains no change in disclosure
requirements for companies previously subject to the requirements of APB Opinion
No. 10, "Omnibus Opinion -- 1966," APB Opinion No. 15, "Earnings per Share," and
FASB Statement No. 47 "Disclosure of Long-Term Obligations," and as such the
adoption of SFAS No. 129 did not have any effect on the Company's reporting.
SFAS No. 129 applies to all entities and is effective for financial statements
issued for periods ending after December 15, 1997.
Reclassifications
Certain reclassifications have been made to the Predecessor financial
statements to conform with the presentation in the 1997 Consolidated Financial
Statements.
42
43
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2. CAPSURE ACQUISITION
The purchase price for Capsure has been allocated to Capsure's assets that
were acquired and to Capsure's liabilities that were assumed based on the
estimated fair value of such assets and liabilities at the Merger Date. The
purchase price for the outstanding shares of Capsure common stock was determined
as follows (dollars in thousands):
Traded value of Capsure shares to be exchanged at $11.00 per
share..................................................... $178,177
Value of Capsure options.................................... 2,527
CCC Surety Operations merger-related costs.................. 1,358
--------
Total purchase price........................................ $182,062
========
The purchase price was allocated as follows (dollars in
thousands):
Capsure net assets at historical cost....................... $100,875
Fair value adjustments:
Purchased intangibles..................................... (73,844)
Intangibles arising from Merger........................... 155,031
--------
Purchase price.............................................. $182,062
========
CNA Surety's beginning stockholders' equity was comprised of
the following (dollars in thousands):
Purchase price.............................................. $182,062
Capital contribution of $52,250 from CCC and
the effects of reinsurance agreements..................... 62,859
--------
Stockholders' equity........................................ $244,921
========
Unaudited Pro Forma Results
The following table of unaudited pro forma information has been prepared as
if the acquisition of Capsure had been consummated on January 1, 1996. This
unaudited pro forma financial information gives effect to the following: (i)
adjustment to the Capsure statement of operations, as reported, to reflect the
income effects as if the $10 per share special distribution was made on January
1, 1996; (ii) consummation of the Merger and the related transactions and the
contribution of capital to and the incurrence of additional debt by CNA Surety;
(iii) purchase accounting adjustments to reflect Capsure's assets and
liabilities at fair value; (iv) estimated indirect and overhead expenses for the
CCC Surety Operations; and (v) estimated interest expense related to the
additional debt (dollars are in thousands, except per share amounts):
THREE MONTHS ENDED YEARS ENDED
DECEMBER 31, DECEMBER 31,
------------------- --------------------
UNAUDITED UNAUDITED
1997 1996 1997 1996
------- --------- -------- --------
ACTUAL PRO FORMA PRO FORMA
Revenues........................... $71,284 $62,754 $258,682 $250,194
Net income......................... $10,996 $ 4,345 $ 34,375 $ 22,432
Earnings per share................. $ 0.25 $ 0.10 $ 0.79 $ 0.52
43
44
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The foregoing unaudited pro forma operating results include non-recurring
charges, primarily merger-related costs of Capsure, of $22.0 million, net of tax
(or $0.51 per share) for the year ended December 31, 1997 and $1.1 million, net
of tax (or $0.03 per share) and $5.7 million, net of tax (or $0.13 per share) of
non-recurring charges and merger-related costs of Capsure for the three and
twelve month periods ended December 31, 1996, respectively.
This unaudited pro forma financial information is intended for information
purposes only and is not necessarily indicative of the results of operations
which would have been achieved and reported had the Merger and related
transactions been consummated on the dates assumed, nor is it necessarily
indicative of the future consolidated operating results of CNA Surety.
The Company paid a closing dividend on October 6, 1997 to the former
Capsure stockholders of record as of September 29, 1997. The dividend was
conditioned upon the consummation of the Merger in accordance with the
reorganization agreement. The $10.6 million ($0.65 per common share) closing
dividend was the aggregate amount of $3.5 million plus $58,600 per day from and
including June 1, 1997 through and including the day immediately preceding the
Merger Date.
3. INVESTMENTS
The estimated fair value and amortized cost of fixed income securities held
by CNA Surety at December 31, 1997, by investment category, were as follows
(dollars in thousands):
AMORTIZED GROSS GROSS ESTIMATED
COST OR UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- ---------
Fixed income securities:
U.S. Treasury securities and obligations of
U.S.
Government corporations and agencies:
U.S. Treasury............................ $ 59,140 $ 218 $ (3) $ 59,355
U.S. Agency.............................. 51,331 298 -- 51,629
Collateralized mortgage obligations...... 37,550 151 (134) 37,567
Mortgage pass-through securities......... 34,217 42 (89) 34,170
Obligations of states and political
subdivisions................................ 3,556 14 -- 3,570
Corporate bonds............................... 26,644 350 (154) 26,840
Non-agency collateralized mortgage
obligations................................. 19,654 41 (69) 19,626
Asset-backed securities:
Second mortgages/home equity loans....... 21,678 80 (16) 21,742
Credit card receivables.................. 6,498 15 -- 6,513
Other underlying assets.................. 5,277 18 (6) 5,289
-------- ------ ----- --------
Total fixed income securities.......... $265,545 $1,227 $(471) $266,301
======== ====== ===== ========
The Company's insurance subsidiaries, as required by state law, deposit
certain securities with state insurance regulatory authorities. At December 31,
1997, fixed income securities on deposit had an aggregate carrying value of $6.3
million.
Short-term investments are generally comprised of U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents.
44
45
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The amortized cost and estimated fair value of fixed income securities at
December 31, 1997, by contractual maturity, are shown below. Actual maturities
will differ from contractual maturities as borrowers may have the right to call
or prepay obligations with or without call or prepayment penalties (dollars in
thousands):
AMORTIZED ESTIMATED
COST FAIR VALUE
--------- ----------
FIXED INCOME SECURITIES:
Due within one year......................................... $ -- $ --
Due after one year but within five years.................... 112,097 112,616
Due after five years but within ten years................... 1,000 1,015
Due after ten years......................................... 27,574 27,763
-------- --------
140,671 141,394
Mortgage pass-through securities, collateralized mortgage,
obligations and asset-backed securities................... 124,874 124,907
-------- --------
$265,545 $266,301
======== ========
Major categories of net investment income and net realized investment gains
(losses) for the period from September 30, 1997 (date of inception) through
December 31, 1997 were as follows (dollars in thousands):
Investment income:
Fixed income securities................................... $3,061
Short-term investments.................................... 2,707
Other..................................................... 112
------
Total investment income................................... 5,880
Investment expenses......................................... (114)
------
Net investment income....................................... $5,766
======
Gross realized investment gains:
Fixed income securities................................... $ 90
Other..................................................... 11
Gross realized investment losses:
Other (16)
------
Net realized investment gain................................ $ 85
======
Net unrealized gain on securities included in stockholders' equity at
December 31, 1997 was comprised of the follow (dollars in thousands):
GAINS LOSSES NET
------ ------ -----
Fixed income securities................................. $1,227 $(471) $ 756
Other................................................... -- (27) (27)
------ ----- -----
$1,227 $(498) 729
------ -----
Deferred income taxes................................... (255)
-----
Net unrealized gain on securities....................... $ 474
=====
45
46
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
4. LONG-TERM DEBT
CNA Surety has a five-year unsecured revolving credit facility that
provides for borrowings of up to $130 million. The interest rate on borrowings
under the credit facility may be fixed, at CNA Surety's option, for a period of
one, two, three or six months and is based on, among other rates, the London
Interbank Offered Rate ("LIBOR") plus applicable margin. The margin, including
the facility fee, varies based on CNA Surety's leverage ratio (debt to total
capitalization) and ranges from 0.25% to 0.40%. The consolidated balance sheet
reflects total long-term debt of $118 million, comprised of borrowings of $54
million to retire pre-existing Capsure debt, $51 million of borrowings of which
$50 million was contributed to Western Surety in connection with the Merger and
$13 million of borrowings to pay the closing dividend and other merger-related
costs. The weighted average interest rate on outstanding borrowings was 6.17% at
December 31, 1997.
The credit facility contains among other conditions, limitations on CNA
Surety with respect to the incurrence of additional indebtedness and requires
the maintenance of certain financial ratios. As of December 31, 1997, the
Company was in compliance with all restrictions or covenants contained in the
credit facility agreement. The credit facility provides for the payment of all
outstanding principal balances after five years with no required principal
payments prior to such time. Principal prepayments, if any, and interest
payments are expected to be funded primarily through dividends from CNA Surety's
insurance subsidiaries.
5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table summarizes fair value information about financial
instruments, whether or not recognized in the balance sheet, for which it is
practicable to estimate that value. In cases where quoted market prices are not
available, fair values may be based on estimates using present value or other
valuation techniques. These techniques are significantly affected by the
assumptions used, including the discount rates and estimates of future cash
flows. Accordingly, the estimates presented herein are subjective in nature and
are not necessarily indicative of the amounts that the Company could realize in
a current market exchange. This information excludes certain financial
instruments and all nonfinancial instruments such as insurance contracts from
fair value disclosure. Thus, 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, 1997 were as follows (dollars in thousands):
CARRYING ESTIMATED
AMOUNT FAIR VALUE
-------- ----------
Fixed income securities..................................... $266,301 $266,301
Short-term investments...................................... 147,235 147,235
Other investments........................................... 6,001 6,001
Cash........................................................ 130 130
Long-term debt.............................................. 118,000 118,000
The following methods and assumptions were used by the Company in
estimating fair values of financial instruments:
Investments -- The estimated fair values for the fixed income securities
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.
46
47
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Cash, Short-Term Investments and Other Investments -- The carrying value
for these instruments approximates their estimated fair values.
Long-Term Debt -- The estimated fair value of the Company's long-term 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.
6. DEFERRED POLICY ACQUISITION COSTS
Policy acquisition costs deferred and the related amortization of deferred
policy acquisition costs was as follows (dollars in thousands):
SEPTEMBER 30,
DATE OF PREDECESSOR
INCEPTION, NINE(1) YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, --------------------
1997 1997 1996 1995
------------- ------------- -------- --------
Balance at beginning of period........... $ 69,094 $ 37,689 $ 42,727 $ 24,314
Deferred policy acquisition costs of CIC
at May 10, 1995, date of acquisition... -- -- -- 21,503
Costs deferred........................... 20,931 48,126 61,344 55,153
Amortization............................. (25,881) (48,075) (66,382) (58,243)
Deferred policy acquisition costs of
Capsure
at September 30, 1997, date of
Merger................................. -- 31,354 -- --
-------- -------- -------- --------
Balance at end of period................. $ 64,144 $ 69,094 $ 37,689 $ 42,727
======== ======== ======== ========
- ---------------
(1) Amounts are for Predecessor except for the deferred policy acquisition costs
of Capsure acquired and the balance at the end of the period which is for
CNA Surety.
7. REINSURANCE
The Company's insurance subsidiaries, in the ordinary course of business,
cede reinsurance to other insurance companies to limit their exposure to loss.
Reinsurance arrangements are used to limit maximum loss, provide greater
diversification of risk and minimize exposure on larger risks. Reinsurance
contracts do not ordinarily relieve the Company of its primary obligations to
claimants. Therefore, a contingent liability exists with respect to reinsurance
ceded to the extent that any reinsurer is unable to meet the obligations assumed
under the reinsurance agreements. The Company evaluates the financial condition
of its reinsurers, establishes allowances for uncollectible amounts and monitors
concentrations of credit risk. At December 31, 1997, CNA Surety's largest
reinsurance receivable, including prepaid reinsurance premiums of $1.0 million,
was approximately $2.7 million with a company rated A+ (Superior) by A.M. Best
Company, Inc.
47
48
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The effect of reinsurance on premiums written and earned was as follows
(dollars in thousands):
SEPTEMBER 30, PREDECESSOR
DATE OF INCEPTION, ---------------------------------------------------------------
THROUGH YEARS ENDED DECEMBER 31,
DECEMBER 31, NINE MONTHS ENDED -----------------------------------------
1997 SEPTEMBER 30, 1997 1996 1995
------------------- ------------------- ------------------- -------------------
WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED
-------- -------- -------- -------- -------- -------- -------- --------
Direct.......................... $24,561 $27,159 $114,969 $112,751 $152,517 $158,160 $135,803 $145,176
Assumed from affiliates......... 50,691 40,653 -- -- -- -- -- --
Assumed from non-affiliates..... -- -- 1,106 2,034 2,691 2,429 802 885
Ceded........................... (1,263) (2,379) (7,445) (6,221) (11,304) (11,520) (14,593) (15,458)
------- ------- -------- -------- -------- -------- -------- --------
Net premiums.................... $73,989 $65,433 $108,630 $108,564 $143,904 $149,069 $122,012 $130,603
======= ======= ======== ======== ======== ======== ======== ========
Assumed premiums from affiliates primarily is comprised of all surety
business written or renewed, net of reinsurance, by CCC and CIC after the Merger
Date that is reinsured by Western Surety pursuant to intercompany reinsurance
and related agreements.
The effect of reinsurance on losses and loss adjustment expenses incurred
was as follows (dollars in thousands):
SEPTEMBER 30, PREDECESSOR
DATE OF ---------------------------------
INCEPTION, NINE YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, -----------------
1997 1997 1996 1995
------------- ------------- ------- -------
Gross losses and loss adjustment expenses...... $12,613 $ (7,265) $29,952 $34,236
Reinsurance recoveries......................... (479) (4,251) 3,054 (1,796)
------- -------- ------- -------
Net losses and loss adjustment expenses........ $12,134 $(11,516) $33,006 $32,440
======= ======== ======= =======
48
49
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
8. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the reserves for unpaid losses and loss adjustment expenses was
as follows (dollars in thousands):
SEPTEMBER 30,
DATE OF PREDECESSOR
INCEPTION, NINE(1) YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, -------------------
1997 1997 1996 1995
------------- ------------- -------- --------
Reserves at beginning of period:
Gross........................................ $122,281 $119,151 $138,657 $ 48,818
Ceded reinsurance............................ 7,273 15,467 24,531 13,770
-------- -------- -------- --------
Net reserves at beginning of period........ 115,008 103,684 114,126 35,048
Net reserves of CIC at May 10, 1995, date of
acquisition................................ -- -- -- 64,780
-------- -------- -------- --------
Total net reserves...................... 115,008 103,684 114,126 99,828
-------- -------- -------- --------
Net incurred loss and loss adjustment
expenses:
Provision for insured events of current
period.................................. 12,781 23,484 42,748 43,286
Decrease in provision for insured events of
prior periods........................... (647) (35,000) (9,742) (10,846)
-------- -------- -------- --------
Total net incurred...................... 12,134 (11,516) 33,006 32,440
-------- -------- -------- --------
Net payments attributable to:
Current period events...................... 4,256 4,307 7,728 1,648
Prior periods events....................... 161 3,780 35,720 16,494
-------- -------- -------- --------
Total net payments...................... 4,417 8,087 43,448 18,142
-------- -------- -------- --------
Net reserves of Capsure at September 30,
1997, date of Merger....................... -- 30,927 -- --
Net reserves at end of period................ 122,725 115,008 103,684 114,126
Ceded reinsurance at end of period........... 7,656 7,273 15,467 24,531
-------- -------- -------- --------
Gross reserves at end of period......... $130,381 $122,281 $119,151 $138,657
======== ======== ======== ========
- ---------------
(1) Amounts are for Predecessor except for the net reserves of Capsure and both
ceded reinsurance and gross reserves at the end of the period which are for
CNA Surety.
Based on the CCC Surety Operations' study of reserves, management
determined that it had been overly cautious in interpreting claim data and had
discounted favorable trends. Consistent with the CCC Surety Operations' regular
study of reserve levels, the CCC Surety Operations released $35.0 million of
prior year reserves in 1997. Approximately $33 million of this reserve
development related to CIC and principally to accident years prior to 1996.
Asbestos and Environmental Claims
The Company does not bond contractors that specialize in environmental
remediation work. The Company does however bond several accounts that have
incidental environmental exposure with respect to which the Company provides
limited 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. 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
49
50
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
certain rights of ownership of the property in the completion of a defaulted
project or through salvage recovery.
To date, the Company has not received any environmental claim notices nor
is management aware of any potential environmental claims.
9. COMMITMENTS AND CONTINGENCIES
At December 31, 1997 the future minimum commitment under operating leases
was as follows: 1998 -- $3.6 million; 1999 -- $2.3 million; 2000 -- $1.9
million; 2001 -- $1.4 million and 2002 and thereafter -- $0.3 million. Total
rental expense for the period from September 31, 1997 (date of inception)
through December 31, 1997 was $0.8 million.
The Company and its subsidiaries are parties to numerous 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.
10. INCOME TAXES
The components of deferred income taxes as of December 31, 1997 and 1996
were as follows (dollars in thousands):
PREDECESSOR
1997 1996
------- -----------
Deferred tax assets:
Net operating losses...................................... $17,516 $ --
Unearned premium reserves................................. 11,737 6,256
Accrued expenses.......................................... 5,205 --
Loss and loss adjustment expense reserves................. 2,444 1,905
Other..................................................... 2,966 490
------- -------
Total gross deferred tax assets........................ 39,868 8,651
Valuation allowance....................................... 7,950 --
------- -------
Deferred tax asset, net of valuation allowance.............. 31,918 8,651
------- -------
Deferred tax liabilities:
Deferred policy acquisition costs......................... 22,450 13,191
Intangible assets......................................... 7,085 --
Unrealized gain on securities............................. 255 --
Other..................................................... 2,043 --
------- -------
Total deferred tax liabilities......................... 31,833 13,191
------- -------
Net deferred tax asset (liability).......................... $ 85 $(4,540)
======= =======
The net deferred tax asset for the year ended December 31, 1997 is included
in other assets in the consolidated balance sheet.
The Internal Revenue Service ("IRS") has not audited Capsure's tax returns
for the years in which Capsure reported net operating losses ("NOLs"). Under
Section 382 of the Internal Revenue Code of 1986, as amended (the "Code"),
restrictions on the utilization of Capsure's NOLs occurred due to the change in
ownership upon consummation of the Merger on September 30, 1997. The valuation
allowance reflects the restrictions placed upon CNA Surety's ability to utilize
Capsure's available NOLs in the future.
50
51
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
CNA Surety and its subsidiaries will file a consolidated federal income tax
return. As of December 31, 1997, approximately $50.0 million of consolidated
NOLs remained available to offset future taxable income of the Company and its
subsidiaries. Such carryforwards, which have an aggregate gross tax benefit of
$17.5 million, expire by tax year as follows: $39.2 million in 1998 and $7.1
million in 1999, $2.4 million in 2000, $0.9 million in 2001, and $0.4 million in
2002. Although realization is not assured, management believes that it is more
likely than not that CNA Surety will generate sufficient taxable income to
utilize approximately $9.6 million of tax benefits from its available NOLs as of
December 31, 1997. Such estimates consider the restrictions placed on the
Company's ability to utilize Capsure's NOLs, the earnings history of each of its
insurance subsidiaries and projections of future taxable income. The amount of
the deferred tax asset considered realizable, however, could be reduced in the
near term if estimates of future taxable income during the carryforward period
are reduced.
The income tax provisions consisted of the following (dollars in
thousands):
SEPTEMBER 30, PREDECESSOR
DATE OF ----------------------------------
INCEPTION, NINE YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, -----------------
1997 1997 1996 1995
------------- ------------- ------- ------
Federal current............. $2,558 $21,466 $13,294 $7,448
Federal deferred............ 4,038 (225) (1,106) 1,937
State....................... 67 -- -- --
------ ------- ------- ------
Total income tax expense.... $6,663 $21,241 $12,188 $9,385
====== ======= ======= ======
A reconciliation from the federal statutory tax rate to the effective tax
rate is as follows:
SEPTEMBER 30, PREDECESSOR
DATE OF -------------------------------
INCEPTION, NINE YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, --------------
1997 1997 1996 1995
------------- ------------- ----- -----
Federal statutory rate......... 35.0% 35.0% 35.0% 35.0%
Non-deductible expenses,
principally amortization of
goodwill..................... 2.4 0.2 0.4 0.3
State income tax, net of
federal
income tax benefit........... 0.2 -- -- --
Other.......................... 0.1 -- -- --
----- ----- ----- -----
Total income tax expense....... 37.7% 35.2% 35.4% 35.3%
===== ===== ===== =====
11. EMPLOYEE BENEFITS
CNA Surety sponsors a tax deferred savings plan ("401(k) plan") covering
substantially all of its employees. Under the 401(k) plan, the Company matches
70% of the participating employee's contribution up to 6% of eligible
compensation (4.2% maximum matching). 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 is based on the Company's underwriting results and may be
restricted by plan and regulatory limitations. The Company contribution,
including accrued profit sharing, to the 401(k) plan was $0.6 million for the
period from September 30, 1997 (date of inception) through December 31, 1997.
51
52
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Western Surety sponsors two post-retirement benefit plans covering certain
employees. One plan provides medical benefits, and the other plan provides sick
leave termination payments. The post-retirement health care plan is contributory
and the sick leave plan is non-contributory. The actuarially determined net
periodic post-retirement costs for these plans was $0.1 million for the period
from September 30, 1997 (date of inception) through December 31, 1997. The
unfunded accumulated post-retirement benefit obligation (for retirees and fully
vested active plan participants) was $4.7 million as of December 31, 1997 and is
included in other liabilities in the consolidated balance sheet.
12. STOCKHOLDERS' EQUITY
The Company has reserved shares of its common stock for issuance to
directors, officers, employees and certain advisors of the Company through
incentive stock options, non-qualified stock options and stock appreciation
rights ("SARs") to be granted under the CNA Surety 1997 Long-Term Equity
Compensation Plan ("CNA Surety Plan"). The Company has also reserved shares of
its common stock for issuance to Capsure option holders under the CNA Surety
Corporation Replacement Stock Option Plan ("Replacement Plan"). The CNA Surety
Plan and Replacement Plan are collectively referred to as the "Plan". The
aggregate number of shares available for which options may be granted under the
Plan is 3,000,000.
Options issued under the Replacement Plan have the same exercise price,
rights, benefits, terms and conditions as the Capsure options replaced. The
number of unexercised and outstanding Capsure options issued to the holders
under the Replacement Plan on September 30, 1997 was 335,235. The exercise
prices of the replacement options range between $0.05 and $8.00 per share.
The Incentive Compensation Committee (the "Committee") of the Board of
Directors, consisting of independent members of the Board of Directors,
administers the Plan. The Committee determines the option prices. Prices may not
be less than the fair market value of the Company's common stock on the date of
grant for incentive stock options and may not be less than the par value of the
Company's common stock for non-qualified stock options.
The Plan provides for the granting of incentive stock options as defined
under the Code. All non-qualified stock options and incentive stock options
granted under the Plan expire ten years after the date of grant and in the case
of the Replacement Plan the options expire ten years from the original Capsure
grant date.
WEIGHTED
SHARES SUBJECT AVERAGE OPTION
TO OPTION PRICE PER SHARE
-------------- ---------------
Balance at September 30, 1997......................... 335,235 $ 3.46
Options granted..................................... 463,500 $15.82
Options canceled.................................... (23,363) $15.58
Options exercised................................... (26,000) $ 4.86
-------
Balance at December 31. 1997 749,372 $10.68
=======
As of December 31, 1997, 237,422 shares were exercisable under the Plan.
The number of shares available for granting of options under the Plan were
2,224,628 at December 31, 1997.
The following table summarizes information about stock options outstanding
at December 31, 1997:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------------------- --------------------------------
WEIGHTED AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE
RANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISE
EXERCISE PRICES OUTSTANDING CONTRACTUAL LIFE PRICE EXERCISABLE PRICE
- ---------------- ----------- ---------------- ---------------- ----------- ----------------
$0.05 to $15.875 749,372 7.8 years $10.68 237,422 $3.40
======= ========== ====== ======= =====
52
53
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The weighted average fair market value (at grant date) per option granted
during the period from September 30, 1997 (date of inception) through December
31, 1997 was $6.62. 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 period from September 30, 1997 (date of inception) through
December 31, 1997; risk free interest rate of 5.76%; dividend yield of 0%;
expected option life of 6 years; and volatility of 30.6%.
The Company adopted the financial disclosure provisions of SFAS No. 123,
"Accounting for Stock-Based Compensation" with respect to its stock-based
incentive plans. The Company applies APB Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations, in accounting for its plans
as allowed for under the provisions of SFAS No. 123. Accordingly, no
compensation cost has been recognized for its stock-based incentive plans as the
exercise price of the granted options equals the market price at the grant date.
Had compensation cost for these plans been determined on the fair value at the
grant date for options granted, consistent with the provisions of SFAS No. 123,
the Company's pro forma net income for the period from September 30, 1997 (date
of inception) through December 31, 1997 would have been $10.9 million and net
income and diluted net income per share would have been $0.25.
13. STATUTORY FINANCIAL DATA
CNA Surety's insurance subsidiaries file financial statements prepared in
accordance with statutory accounting practices prescribed or permitted by
applicable insurance regulatory authorities. Prescribed statutory accounting
practices include state laws, regulations and general administrative rules, as
well as guidance provided in a variety of publications of the National
Association of Insurance Commissioners ("NAIC"). Permitted statutory accounting
practices encompass all accounting practices that are not prescribed. The
permitted statutory accounting practices of CNA Surety's insurance subsidiaries
did not have a material effect on reported statutory surplus or income. The
principal differences between statutory financial statements and financial
statements prepared in accordance with generally accepted accounting principles
are that statutory financial statements do not reflect deferred policy
acquisition costs and deferred income taxes and fixed income securities are
generally carried at amortized cost in statutory financial statements.
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
the company or regulators. As of December 31, 1997, each of CNA Surety's
insurance subsidiaries had a Ratio that was in excess of 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 1998, CNA Surety's insurance subsidiaries may pay stockholder
dividends of $16.3 million in the aggregate. Combined statutory surplus for the
insurance subsidiaries at December 31, 1997 was $142.4 million.
53
54
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. RELATED PARTY TRANSACTIONS
CCC and the insurance subsidiaries of the Company have entered into various
reinsurance agreements designed to protect against adverse loss reserve
development related to the CCC Surety Operations reserves at the Merger Date,
and help preserve, through the year 2000, the profitability of CCC Surety
Operations and certain additional accounts. The reinsurance agreements together
with the Services and Indemnity Agreement, that is described below, also affect
the transfer of the CCC Surety Operations to the insurance subsidiaries. The
reinsurance agreements entered into at the Merger Date are: (i) the Surety Quota
Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop Loss
Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety Excess of
Loss Reinsurance Contract (the "Excess of Loss Contract").
The Services and Indemnity Agreement provides the insurance subsidiaries
with the authority to perform various administrative, management, underwriting
and claim functions in order to conduct the business of the CCC Surety
Operations and to be reimbursed by CCC for services rendered. In consideration
for the provision of the foregoing services, CCC has agreed to pay the insurance
subsidiaries a quarterly fee of $50,000. At December 31, 1997, CCC owed the
insurance subsidiaries $50,000 for the period from September 30, 1997 (date of
inception) through December 31, 1997.
Through the Quota Share Treaty, CCC and CIC ceded, as of the Merger Date,
and subsequently paid on October 1, 1997, to Western Surety all of its net
unearned premiums and loss and loss adjustment expense reserves, net of $29.0
million of ceded commissions. The payment totaled $116.9 million.
Through the Quota Share Treaty, CCC and CIC will also transfer to Western
Surety all of the CCC Surety Operations' business written or renewed by CCC and
CIC after the Merger Date. CCC and CIC will transfer the related liabilities of
such business and pay to Western Surety an amount in cash equal to CCC's and
CIC's net written premiums written on all such business, minus a quarterly
ceding commission to be retained by CCC and CIC equal to $50,000 plus 28% of net
written premiums written on such business. CCC and CIC paid Western Surety, net
of commissions and reinsured loss payments, $21.2 million during the period from
September 30, 1997 (date of inception) through December 31, 1997. As of December
31, 1997, CNA Surety had a reinsurance receivable balance from CCC and CIC of
$47.9 million. This balance is primarily comprised of direct premium receivables
of CCC and CIC with respect to the surety business ceded to Western Surety.
CCC has guaranteed the loss and loss adjustment expenses transferred to
Western Surety by agreeing to pay Western Surety, within 30 days following the
end of each calendar quarter, the amount of any adverse development on such
reserves, as reestimated as of the end of such calendar quarter. There was not
any adverse reserve development for the period from September 30, 1997 (date of
inception) through December 31, 1997. The Quota Share Treaty has a term of five
years from the Merger Date.
The Stop Loss Contract protects the insurance subsidiaries from adverse
loss experience on certain business underwritten after the Merger Date. The Stop
Loss Contract between the insurance subsidiaries and CCC limits the insurance
subsidiaries' prospective net loss ratios with respect to certain accounts and
lines of insured business for at least three fiscal years following the Merger
Date. In the event the insurance subsidiaries' accident year net loss ratio
exceeds 24% in each of 1997 through 2000 on certain insured accounts (the "Loss
Ratio Cap"), the Stop Loss Contract requires CCC at the end of each calendar
quarter following the Merger Date, to pay to the insurance subsidiaries a dollar
amount equal to (i) the amount, if any, by which their actual accident year net
loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the
applicable net earned premiums. In consideration for the coverage provided by
the Stop Loss Contract, the insurance subsidiaries will pay to CCC an annual
premium of $20,000. The insurance subsidiaries paid CCC the annual premium
during the period from September 30, 1997 (date of inception) through December
31, 1997 and no amount was due to the insurance subsidiaries from CCC under the
Stop Loss Contract for the period from September 30, 1997 (date of inception)
through December 31, 1997.
54
55
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Excess of Loss Contract provides the insurance subsidiaries of CNA
Surety with the capacity to underwrite large surety bond exposures by providing
reinsurance support from CCC. The Excess of Loss Contract provides $75 million
of coverage in excess of the $55 million of coverage provided to the insurance
subsidiaries by third party reinsurers for losses discovered on surety bonds in
force at the Merger Date and for losses discovered on new and renewal business
written or assumed during the term of the Excess of Loss Contract. CCC is also
obligated to act as a joint insurer, or "co-surety," for business covered by the
Excess of Loss Contract when requested by the insurance subsidiaries. In
consideration for the reinsurance coverage provided by the Excess of Loss
Contract, the insurance subsidiaries will pay to CCC, on a quarterly basis, a
premium equal to 1% of the net written premiums applicable to the Excess of Loss
Contract, subject to a minimum premium of $20,000 per quarter. The insurance
subsidiaries paid CCC $80,000 for all minimum quarterly premiums due through
September 30, 1998 during the period from September 30, 1997 (date of inception)
through December 31, 1997. The Excess of Loss Contract has a term of five years
from the Merger Date.
CNA Surety also entered into an Administrative Services Agreement with CCC
as of the Merger Date. The agreement allows the Company continued use of certain
real and personal property owned or leased by CCC. The Company may cancel,
without penalty, any lease under the agreement by giving CCC sixty days notice.
The Company can also purchase many of the administrative services provided to
the CCC Surety Operations by CCC. CNA Surety, however, is under no obligation to
purchase any services under the Administrative Services Agreement. The aggregate
maximum annual cost for the use of real and personal property and for services
available under the agreement is approximately $7.9 million. Administrative
services are provided at specified rates, subject to inflationary increases. For
the period from September 30, 1997 to December 31, 1997, the Company was charged
$2.5 million for rents and services provided under the agreement. The Company
paid CCC $1.4 million and $1.1 million was reflected in other liabilities in the
Company's Consolidated Balance Sheet at December 31, 1997.
55
56
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the results of operations of CNA Surety for
the period from September 30, 1997 (date of inception) through December 31, 1997
and a summary of unaudited quarterly results of the Predecessor for the nine
months ended September 30, 1997 and year ended December 31, 1996. (dollars in
thousands, except per share amounts.)
CNA SURETY
INCEPTION TO
DECEMBER 31
------------
1997
Revenues............................. $71,284
=======
Income before income taxes........... $17,659
Income taxes......................... 6,663
-------
Net income........................... $10,996
=======
Basic and diluted earnings per common
share............................. $ 0.25
=======
PREDECESSOR
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
----------- ------- ------- -------
1997
Net earned premiums.................. $33,829 $36,155 $38,580 $ --
======= ======= ======= =======
Excess of net earned premiums over
direct operating costs............ $41,878 $ 8,174 $10,354 $ --
Income taxes......................... 14,690 2,894 3,657 --
------- ------- ------- -------
Excess of net earned premiums over
direct operating costs, net of
income taxes...................... $27,188 $ 5,280 $ 6,697 $ --
======= ======= ======= =======
1996
Net earned premiums.................. $37,029 $37,504 $37,769 $36,767
======= ======= ======= =======
Excess of net earned premiums over
direct operating costs............ $ 6,696 $ 8,527 $13,472 $ 5,753
Income taxes......................... 2,377 3,017 4,748 2,046
------- ------- ------- -------
Excess of net earned premiums over
direct operating costs, net of
income taxes...................... $ 4,319 $ 5,510 $ 8,724 3,707
======= ======= ======= =======
16. LOOKBACK ADJUSTMENT
The reorganization agreement provides for a mechanism, referred to as the
"Lookback Adjustment", which may adjust the number of shares of CNA Surety
common stock owned by CNAF operating companies in the event that either or both
of Capsure's and the CCC Surety Operations' actual net written premiums for 1997
vary from certain targets. Application and interpretation of the provisions of
the Lookback Adjustment are presently under review, the ultimate outcome of
which is currently not known. Based on the facts currently available, the total
number of shares of CNA Surety common stock will either not change or be reduced
by approximately 2.5%. Such a change in total outstanding shares would have no
effect on net income; however, earnings per share for the period from September
30, 1997 (date of inception) through December 31, 1997 would have increased from
$0.25 to $0.26 and the ownership of the Company by CNAF operating companies
would be reduced from 61.75% to 60.79%.
56
57
SCHEDULE I
CNA SURETY CORPORATION AND SUBSIDIARIES
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
AS OF DECEMBER 31, 1997
(AMOUNTS IN THOUSANDS)
FAIR CARRYING
COST VALUE VALUE
-------- -------- --------
FIXED INCOME SECURITIES:
Bonds:
U.S. Government and government agencies and
authorities......................................... $182,238 $182,721 $182,721
States, municipalities and political subdivisions...... 3,556 3,570 3,570
All other corporate bonds.............................. 79,751 80,010 80,010
-------- -------- --------
Total fixed income securities....................... 265,545 266,301 266,301
-------- -------- --------
Short-term investments................................... 147,235 147,235
Other investments........................................ 6,027 6,001
-------- --------
Total investments................................... $418,807 $419,537
======== ========
57
58
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY)
BALANCE SHEET
(AMOUNTS IN THOUSANDS)
AS OF
DECEMBER 31,
1997
------------
ASSETS
Investments in and advances to Capsure Holdings Corp. and
subsidiaries.............................................. $368,843
Short-term investments...................................... 7,021
Cash........................................................ 26
Deferred income taxes....................................... 1,107
Other assets................................................ 314
--------
$377,311
========
LIABILITIES
Long-term debt.............................................. $118,000
Other liabilities........................................... 2,579
--------
120,579
--------
STOCKHOLDERS' EQUITY
Common stock................................................ 433
Additional paid-in capital.................................. 244,829
Retained earnings........................................... 10,996
Unrealized gain on securities, net of deferred income
taxes..................................................... 474
--------
Total stockholders' equity.................................. 256,732
--------
$377,311
========
See Note to Condensed Financial Information and Notes to Consolidated Financial
Statements.
58
59
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY) -- (CONTINUED)
STATEMENT OF INCOME
(AMOUNTS IN THOUSANDS)
SEPTEMBER 30,
DATE OF
INCEPTION,
THROUGH
DECEMBER 31,
1997
-------------
Revenues:
Net investment income..................................... $ 33
Net realized investment gains (losses).................... --
Other income.............................................. --
-------
33
-------
Expenses:
Interest expense.......................................... 1,831
Corporate expense......................................... 1,364
-------
3,195
-------
Loss from operations before income taxes and equity in net
income of subsidiaries.................................... (3,162)
Income taxes................................................ (1,107)
-------
Loss before equity in net income of subsidiaries -- Parent
only...................................................... (2,055)
Equity in net income of subsidiaries........................ 13,051
-------
Net income.................................................. $10,996
=======
See Note to Condensed Financial Information and Notes to Consolidated Financial
Statements.
59
60
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY) -- (CONTINUED)
STATEMENT OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
SEPTEMBER 30,
DATE OF
INCEPTION,
THROUGH
DECEMBER 31,
1997
-------------
OPERATING ACTIVITIES:
Net loss.................................................. $ (2,055)
Cash dividends from subsidiaries....................... 4,970
Tax payments received from subsidiaries................ 2,449
Federal and state income tax payments.................. --
Adjustments to reconcile net loss to net cash provided
by operating activities:
Deferred income taxes, net........................... (1,107)
Other assets and liabilities......................... (261)
---------
Net cash provided by operating activities................... 3,996
---------
INVESTING ACTIVITIES:
Net advances to subsidiaries.............................. (65,075)
Capital contribution to Western Surety Company............ (50,000)
Change in short-term investments.......................... (7,021)
---------
Net cash used in investing activities....................... (122,096)
---------
FINANCING ACTIVITIES:
Proceeds from long-term debt.............................. 118,000
Other..................................................... 126
---------
Net cash provided by financing activities................... 118,126
---------
Increase in cash............................................ 26
Cash at beginning of period................................. --
---------
Cash at end of period....................................... $ 26
=========
NOTE TO CONDENSED FINANCIAL INFORMATION
1. BASIS OF PRESENTATION
The condensed financial information of the parent company includes the
accounts of CNA Surety Corporation ("CNA Surety"). On September 30, 1997 CNA
Surety was formed as part of the merger of Capsure Holdings Corp. and its
subsidiaries (Western Surety Company and Universal Surety of America) and the
surety business of CNA Financial Corporation. The merger was accounted for as a
purchase of Capsure.
60
61
SCHEDULE III
CNA SURETY CORPORATION AND SUBSIDIARIES AND PREDECESSOR
SUPPLEMENTARY INSURANCE INFORMATION
CNA SURETY CORPORATION AS OF DECEMBER 31, 1997 AND FOR THE
PERIOD SEPTEMBER 30, 1997 (DATE OF INCEPTION) THROUGH DECEMBER 31, 1997 AND
PREDECESSOR AS OF AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND
YEARS ENDED DECEMBER 31, 1996 AND 1995
(AMOUNTS IN THOUSANDS)
SEPTEMBER 30, PREDECESSOR
DATE OF -------------------------------------
INCEPTION, NINE YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, --------------------
1997 1997 1996 1995
------------- ------------- -------- --------
Deferred policy acquisition costs........ $ 64,144 $ 37,740 $ 37,689 $ 42,727
======== ======== ======== ========
Future policy benefits, losses, claims
and loss expenses...................... $130,381 $ 88,914 $119,151 $138,657
======== ======== ======== ========
Unearned premiums........................ $173,836 $ 94,577 $ 95,677 $101,059
======== ======== ======== ========
Other policy claims and benefits
payable................................ $ -- $ -- $ -- $ --
======== ======== ======== ========
Net premium revenue...................... $ 65,433 $108,564 $149,069 $130,603
======== ======== ======== ========
Net investment income.................... $ 5,766 $ -- $ -- $ --
======== ======== ======== ========
Benefits, claims, losses and settlement
expenses............................... $ 12,134 $(11,516) $ 33,006 $ 32,440
======== ======== ======== ========
Amortization of deferred policy
acquisition costs...................... $ 25,881 $ 48,075 $ 66,382 $ 58,243
======== ======== ======== ========
Other operating expenses................. $ 12,332 $ 11,599 $ 15,233 $ 13,348
======== ======== ======== ========
Net premiums written..................... $ 73,989 $108,630 $143,904 $122,012
======== ======== ======== ========
61
62
SCHEDULE IV
CNA SURETY CORPORATION AND SUBSIDIARIES AND PREDECESSOR
REINSURANCE
CNA SURETY CORPORATION FOR THE PERIOD SEPTEMBER 30, 1997
(DATE OF INCEPTION) THROUGH DECEMBER 31, 1997 AND
PREDECESSOR FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND
YEARS ENDED DECEMBER 31, 1996 AND 1995
(AMOUNTS IN THOUSANDS)
PERCENTAGE
CEDED TO ASSUMED OF AMOUNT
GROSS OTHER FROM OTHER NET ASSUMED
AMOUNT COMPANIES COMPANIES AMOUNT TO NET
-------- --------- ---------- -------- ----------
CNA SURETY CORPORATION
SEPTEMBER 30, 1997
(DATE OF INCEPTION) THROUGH
DECEMBER 31, 1997
Premiums:
Property and casualty
insurance.................... $ 27,159 $ 2,379 $40,653 $ 65,433 62.1%
-------- ------- ------- -------- ----
Total premiums............... $ 27,159 $ 2,379 $40,653 $ 65,433 62.1%
======== ======= ======= ======== ====
PREDECESSOR
NINE MONTHS ENDED
SEPTEMBER 30, 1997
Premiums:
Property and casualty
insurance.................... $112,751 $ 6,221 $ 2,034 $108,564 1.9%
-------- ------- ------- -------- ----
Total premiums............... $112,751 $ 6,221 $ 2,034 $108,564 1.9%
======== ======= ======= ======== ====
YEAR ENDED DECEMBER 31, 1996
Premiums:
Property and casualty
insurance.................... $158,160 $11,520 $ 2,429 $149,069 1.6%
-------- ------- ------- -------- ----
Total premiums............... $158,160 $11,520 $ 2,429 $149,069 1.6%
======== ======= ======= ======== ====
YEAR ENDED DECEMBER 31, 1995
Premiums:
Property and casualty
insurance.................... $145,176 $15,458 $ 885 $130,603 0.7%
-------- ------- ------- -------- ----
Total premiums............... $145,176 $15,458 $ 885 $130,603 0.7%
======== ======= ======= ======== ====
62
63
SCHEDULE V
CNA SURETY CORPORATION AND SUBSIDIARIES AND PREDECESSOR
VALUATION AND QUALIFYING ACCOUNTS
CNA SURETY CORPORATION FOR THE PERIOD SEPTEMBER 30, 1997
(DATE OF INCEPTION) THROUGH DECEMBER 31, 1997 AND
PREDECESSOR FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND
YEARS ENDED DECEMBER 31, 1996 AND 1995
(AMOUNTS IN THOUSANDS)
ADDITIONS
------------------------
BALANCE AT CHARGED TO CHARGED TO BALANCE
BEGINNING OF COSTS AND OTHER AT END OF
PERIOD(1) EXPENSES ACCOUNTS DEDUCTIONS(2) PERIOD
------------ ---------- ---------- ------------- ---------
CNA SURETY CORPORATION
SEPTEMBER 30, 1997 (DATE OF
INCEPTION) THROUGH DECEMBER
31, 1997
Allowance for possible losses
on premiums receivable.... $893 $(46) $ -- $ -- $847
==== ==== ==== ==== ====
Allowance for possible losses
on reinsurance
receivable................ $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
PREDECESSOR
NINE MONTHS ENDED SEPTEMBER 30,
1997
Allowance for possible losses
on premiums receivable.... $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
Allowance for possible losses
on reinsurance
receivable................ $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
YEAR ENDED DECEMBER 31, 1996
Allowance for possible losses
on premiums receivable.... $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
Allowance for possible losses
on reinsurance
receivable................ $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
YEAR ENDED DECEMBER 31, 1995
Allowance for possible losses
on premiums receivable.... $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
Allowance for possible losses
on reinsurance
receivable................ $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
- ---------------
(1) Acquired balance of Capsure Holdings Corp. on September 30, 1997.
(2) Accounts charged against allowance.
63
64
SCHEDULE VI
CNA SURETY CORPORATION AND SUBSIDIARIES AND PREDECESSOR
SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY
INSURANCE OPERATIONS
CNA SURETY CORPORATION AS OF DECEMBER 31, 1997 AND FOR THE
PERIOD SEPTEMBER 30, 1997 (DATE OF INCEPTION) THROUGH DECEMBER 31, 1997 AND
PREDECESSOR AS OF AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND
YEARS ENDED DECEMBER 31, 1996 AND 1995
(AMOUNTS IN THOUSANDS)
SEPTEMBER 30, PREDECESSOR
DATE OF -------------------------------------
INCEPTION, NINE YEAR ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, --------------------
1997 1997 1996 1995
------------- ------------- -------- --------
Deferred policy acquisition costs........ $ 64,144 $ 37,740 $ 37,689 $ 42,727
======== ======== ======== ========
Reserves for unpaid claims and claim
adjustment expenses.................... $130,381 $ 88,914 $119,151 $138,657
======== ======== ======== ========
Discount (if any) deducted............... $ -- $ -- $ -- $ --
======== ======== ======== ========
Unearned premiums........................ $173,836 $ 94,577 $ 95,677 $101,059
======== ======== ======== ========
Net earned premiums...................... $ 65,433 $108,564 $149,069 $130,603
======== ======== ======== ========
Net investment income.................... $ 5,766 $ -- $ -- $ --
======== ======== ======== ========
Net claims and claim adjustment expenses
incurred related to:
Current year........................ $ 12,781 $ 23,484 $ 42,748 $ 43,286
======== ======== ======== ========
Prior years......................... $ (647) $(35,000) $ (9,742) $(10,846)
======== ======== ======== ========
Amortization of deferred policy
acquisition costs...................... $ 25,881 $ 48,075 $ 66,382 $ 58,243
======== ======== ======== ========
Net paid claims and claim adjustment
expenses............................... $ 4,417 $ 8,087 $ 43,448 $ 18,142
======== ======== ======== ========
Net premiums written..................... $ 73,989 $108,630 $143,904 $122,012
======== ======== ======== ========
64
65
(A)(3)EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
2(1) Reorganization Agreement dated as of December 19, 1996 among
Capsure Holdings Corp., Continental Casualty Company, CNA
Surety Corporation, Surety Acquisition Company and certain
affiliates of Continental Casualty Company (filed on
December 27, 1996 as Exhibit 2 to Capsure Holdings Corp.'s
Form 8-K, and incorporated herein by reference).
2(2) First Amendment to the Reorganization Agreement dated as of
July 14, 1997 among Capsure Holdings Corp., Continental
Casualty Company, CNA Surety Corporation, Surety Acquisition
Company and certain affiliates of Continental Casualty
Company (filed on July 16, 1997 as Exhibit 2 to Capsure
Holdings Corp.'s Form 8-K, and incorporated herein by
reference).
3(1) Certificate of Incorporation of CNA Surety Corporation dated
December 10, 1996 (filed as Exhibit 3.1 to CNA Surety
Corporation's S-4 dated August 15, 1997, and incorporated
herein by reference).
3(2) Amendment to Certificate of Incorporation of CNA Surety
Corporation dated May 27, 1997 (filed as Exhibit 3.2 to CNA
Surety Corporation's S-4 dated August 15, 1997, and
incorporated herein by reference).
3(3) Bylaws of CNA Surety Corporation (filed as Exhibit 3.3 to
CNA Surety Corporation's S-4 dated August 15, 1997, and
incorporated herein by reference).
3(4) Amendment to Bylaws of CNA Surety Corporation dated March 3,
1998.
4(1) Specimen certificate of CNA Surety Corporation (filed as
Exhibit 4.1 to CNA Surety Corporation's S-4 dated August 15,
1997, and incorporated herein by reference).
4(2) Form of Registration Rights Agreement, between CNA Surety
Corporation and Equity Capsure Limited Partnership (filed as
Exhibit 4.2 to CNA Surety Corporation's S-4 dated August 15,
1997, and incorporated herein by reference).
9 Not applicable.
10(1) Employment Agreement dated as of September 22, 1994 by and
among Universal Surety Holdings Corp., Universal Surety of
America, Capsure Financial Group, Inc., Capsure Holdings
Corp. and John Knox, Jr. (filed as Exhibit 10.5 to CNA
Surety Corporation's S-4 dated August 15, 1997, and
incorporated herein by reference).
10(2) Agreement dated as of June 30, 1997 by and among John Knox,
Jr., Capsure Holdings Corp. and CNA Surety Corporation
(filed as Exhibit 10.6 to CNA Surety Corporation's S-4 dated
August 15, 1997, and incorporated herein by reference).
10(3) Employment Agreement dated as of April 26, 1996 (effective
as of April 15, 1996) by and between Western Surety Company
and Steven T. Pate (filed as Exhibit 10.7 to CNA Surety
Corporation's S-4 dated August 15, 1997, and incorporated
herein by reference).
10(4) Stock Purchase Agreement among John Knox, Jr., Universal
Surety Holding Corp., Capsure Financial Group, Inc. and
Capsure Holdings Corp. dated July 26, 1994 (filed on October
6, 1994 as Exhibit 2 to Capsure Holdings Corp.'s Current
Report on Form 8-K, and incorporated herein by reference).
10(5) Non-Competition and Non-Solicitation Agreement between
Capsure Holdings Corp. and Frontier Insurance Company, dated
as of May 22, 1996 (filed as Exhibit 10.9 to CNA Surety
Corporation's S-4 dated August 15, 1997, and incorporated
herein by reference).
10(6) Contract Surety Bond Reinsurance Agreement dated as of
September 22, 1994 between Western Surety Company, a South
Dakota corporation, and Universal Surety of America, a Texas
corporation (filed on March 30, 1995 as Exhibit 10.23 to
Capsure Holdings Corp.'s Annual Report on Form 10-K, and
incorporated herein by reference).
10(7) Co-Employee Agreement dated as of September 22, 1994 between
Western Surety Company and Universal Surety of America
(filed on March 30, 1995 as Exhibit 10.24 to Capsure
Holdings Corp.'s Annual Report on Form 10-K, and
incorporated herein by reference).
10(8) Form of The CNA Surety Corporation Replacement Stock Option
Plan (filed as Exhibit 10.12 to CNA Surety Corporation's S-4
dated August 15, 1997, and incorporated herein by
reference).
10(9) Form of CNA Surety Corporation 1997 Long-Term Equity
Compensation Plan (filed as Exhibit 10.13 to CNA Surety
Corporation's S-4 dated August 15, 1997, and incorporated
herein by reference).
65
66
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
10(10) Form of Aggregate Stop Loss Reinsurance Contract by and
between Western Surety Company, Universal Surety of America,
Surety Bonding Company of America and Continental Casualty
Company (filed on December 27, 1996 as Exhibit 2 to Capsure
Holdings Corp.'s Form 8-K, and incorporated herein by
reference).
10(11) Form of Surety Excess of Loss Reinsurance Contract by and
between Western Surety Company, Universal Surety of America,
Surety Bonding Company of America and Continental Casualty
Company (filed on December 27, 1996 as Exhibit 2 to Capsure
Holdings Corp.'s Form 8-K, and incorporated herein by
reference).
10(12) Form of Surety Quota Share Treaty by and between Western
Surety Company and Continental Casualty Company (filed on
December 27, 1996 as Exhibit 2 to Capsure Holdings Corp.'s
Form 8-K, and incorporated herein by reference).
10(13) Employment Agreement dated as of October 1, 1997 by and
between CNA Surety Corporation and Dan L. Kirby.
10(14) Employment Agreement dated as of October 3, 1997 by and
between CNA Surety Corporation and Mark C. Vonnahme.
11 Earnings per share computation.
12 Not Applicable.
21 Subsidiaries of the Registrant.
22 Not Applicable.
23 Consent of Deloitte & Touche LLP dated March 20, 1997.
24 Not Applicable.
27 Financial Data Schedule.
66
67
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
By: /s/ MARK C. VONNAHME
-----------------------------------
Mark C. Vonnahme
President and Chief Executive
Officer
(Principal Executive Officer)
By: /s/ JOHN S. HENEGHAN
-----------------------------------
John S. Heneghan
Vice President and Chief Financial
Officer
(Principal Financial and Accounting
Officer)
DATED: MARCH 20, 1998
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.
DATE TITLE SIGNATURE
---- ----- ---------
March 20, 1998 Chairman of the Board and Director /s/ ROBERT T. VAN GIESON
---------------------------------------------
Robert T. Van Gieson
March 20, 1998 Director /s/ GIORGIO BALZER
---------------------------------------------
Giorgio Balzer
March 20, 1998 Director /s/ PHILIP H. BRITT
---------------------------------------------
Philip Britt
March 20, 1998 Director /s/ DAVID T. CUMMING
---------------------------------------------
David T. Cumming
March 20, 1998 Director /s/ ROD F. DAMMEYER
---------------------------------------------
Rod F. Dammeyer
March 20, 1998 Director /s/ BRUCE A. ESSELBORN
---------------------------------------------
Bruce A. Esselborn
March 20, 1998 Director /s/ MELVIN GRAY
---------------------------------------------
Melvin Gray
March 20, 1998 Director /s/ JOE P. KIRBY
---------------------------------------------
Joe P. Kirby
March 20, 1998 Director /s/ ROY E. POSNER
---------------------------------------------
Roy E. Posner
March 20, 1998 Director /s/ ADRIAN M. TOCKLIN
---------------------------------------------
Adrian M. Tocklin
March 20, 1998 Director /s/ MARK C. VONNAHME
---------------------------------------------
Mark C. Vonnahme
67